Since a nation’s VAT (value added tax) has a direct impact on price and profits, it is important to understand the VAT of the country where manufacturing and products are being sourced. Here is a look at China’s VAT and how it affects China sourcing.

How VAT works and how it applies to China sourcing.

While VAT works differently in different countries, it is basically a tax paid on the value added to a product as it moves down the supply chain to the end user. For example, the raw materials of a widget are purchased by a manufacturer and a tax is paid. Then, when value is added to the materials by turning them into a widget, a tax is paid on the added value. Finally, a tax is paid on the final added value of the widgets when they are sold to the final consumer.

For example, if the VAT is 10% and the manufacturer pays $50 the materials, $5 goes to the government. Then, if the manufacturer sells the widgets for $80, $8 go to the government ($3 additional dollars since $5 was already paid). Finally, if the widgets are sold to the final consumer for $100, $10 goes to the government (an additional $2 since $8 has already been paid). VAT can also be looked at as a kind of a sales tax that is paid in part before the goods ever reach the final end user. Because the tax is being paid earlier and more often, it is more difficult to avoid than a regular sales tax.

In China, the VAT rate is 17% on most goods. However, the government often refunds at least part of the VAT when the goods are exported. The amount refunded varies with the product, and the Chinese government uses the VAT as a tool to influence industry. Usually, the refund is highest on those goods the government wants to encourage production of in China (e.g. higher value-added products) and lowest or non-existent for products the government is less interested in seeing manufactured in China. An example of this was seen in 2007 when the VAT system was changed and VAT refunds for many high-energy, high-polluting goods were greatly reduced or eliminated.

In its most simplified form, the VAT refund for an exported product works like this. If the VAT rate is 17%, and the refund rate is 10%, on a $17 VAT paid, $10 would be returned to the exporter while the government would keep $7.

Why understanding the VAT is important for importers

Importers who do not understand the VAT system are exposing themselves to the following potential problems and extra costs:

The best pricing starts with transparency. When breaking down pricing, comparing between suppliers, negotiating etc., it is critical to know the suppliers true costs. Without an accurate breakdown of the costs with the VAT rate clearly stated, the supplier has more room to manipulate the price.   Some manufacturers may not tell the purchaser about the VAT refund or tell them the refund was a lower rate that they actually received and pocket the difference (it is also sometimes possible to negotiate the customs classification and therefore the VAT rate). To get all the cost saving due through VAT refunds, every importer needs to be fully away of the classification and rebate for the products being purchased.   If a manufacturer lacks the proper import-export rights or VAT processing abilities, they may be forced to rely on third parties that will likely inflate the price and make the relationship with the manufacturer more complicated.   In a gray area of the law, some suppliers are able to avoid the VAT for smaller orders. While this will give the purchaser a lower price in the short term (although this runs the risk the goods will be trapped in China without proper documentation to export them), the importer will suddenly be hit with the tax when their business grows and the order size reaches a point where the VAT cannot be avoided. This tax increase will likely to be greater than any discount from larger order quantities.

With these point in mind, when doing business in China or any nation with the VAT, is imperative to know the classification and VAT for every product and ask the supplier to outline their VAT policies. Doing so will enable the purchaser to avoid unexpected costs or other problems while getting the best price possible.