VZCZCXRO5627
RR RUEHCN RUEHGH RUEHVC
DE RUEHGZ #0862/01 2110815
ZNR UUUUU ZZH
R 300815Z JUL 07
FM AMCONSUL GUANGZHOU
TO RUEHC/SECSTATE WASHDC 6327
INFO RUEHOO/CHINA POSTS COLLECTIVE
RUEAIIA/CIA WASHDC
RUEKJCS/DIA WASHDC

UNCLAS SECTION 01 OF 03 GUANGZHOU 000862 
 
SIPDIS 
 
SENSITIVE 
SIPDIS 
 
E.O. 12958: N/A 
TAGS: ETRD ECIN EINV PGOV CH
SUBJECT: Have You Heard?  China Slashes VAT Refunds 
 
¶1. (SBU) Summary:  What's the impact on local companies in the 
region of the July 1 cut/elimination of export tax rebates on almost 
3,000 products?  Local companies are unanimous: the price of most 
goods imported from China just went up.  Even so, foreign-invested 
enterprises (FIEs) here are not cutting back on operations -- and a 
lucky few might even find that their situations have improved. 
Still, there is some debate over whether the move will give local 
companies an increased competitive advantage, as they may now have 
yet another tax to evade, while their FIE counterparts are left to 
pay in full.  At least one consultant has begun counseling clients 
that while they can not be sure when it will occur, they can count 
on some type of ongoing VAT changes, and they should prepare 
accordingly.  End Summary. 
 
Export Rebates Slashed Across the Board 
---------------------------------------- 
 
¶2. (SBU) China earlier this month quietly took a dramatic step 
toward slowing down its soaring export industry.  On July 1, Beijing 
cut the tax rebates for exports on more than 2,200 products, and 
eliminated the rebates entirely on another 553 products.  The latter 
primarily targeted high-energy-consuming and polluting products, 
while the former focused on low-tech commodities likely to trigger 
trade disputes. 
 
¶3. (SBU) The move affects U.S. business across the board said import 
consultant Eli Ben-Avner.  Additionally, since the new policy is not 
covered by any transitional rule which would allow existing 
contracts to continue operating under the old VAT rebate, the impact 
has been immediate. 
 
¶4. (SBU) The new refund policy does allow an exception for contracts 
covering the export of ships and building materials in long-term 
construction projects, where the contracts were signed before July 
¶1.  This has helped companies like BCD, Inc. avoid liability for the 
added costs of long-term building projects under the new VAT export 
policy.  COMMENT: This exception may also potentially explain why 
there was little warning given to companies prior to the VAT reform 
(See paragraph 9, below), as the government may have not wanted to 
offer companies in this industry a chance to lock in numerous 
long-term contracts which could evade the new tax policy.  END 
COMMENT. 
 
Motivations behind the Change 
----------------------------- 
 
¶5. (SBU) There are various opinions circulating about what motivated 
the sudden change to China's VAT refund structure.  According to 
Aaron Finley, Manager of Deloitte in Guangzhou, the move was 
primarily driven by economics.  Finley believes the new policy is a 
reflection of the country's desire to encourage more companies to 
invest locally by selling to local markets.  Even more importantly, 
the products targeted by the new policy make it clear that China is 
stepping up its efforts to curb production of low-tech goods and 
discouraging altogether the production of chemical and energy 
products which either cut into the country's scarce natural 
resources or harm the local environment.  As the new head of the 
Guangdong Overseas Businessmen Association, Zhou Zerong, recently 
told us, low-tech companies are not actively discouraged, but just 
don't enjoy the favorable conditions provided to technology and 
market-leading firms. 
 
¶6. (SBU) Some believe the change was driven by politics.  According 
to Vivian Desmonts, Managing Partner for South China's leading 
European law firm, DS Law Firm, the move may have been triggered as 
a response to the persistent lobbying by the U.S. and Europe on 
China's currency reform and expanding trade surplus.  By penalizing 
U.S. and European investment, Desmonts believes that China is 
sending a clear message that it has no problem complying with 
requests to cool down exports, particularly in areas where FIEs will 
absorb the worst of the blow.  (COMMENT: we think the real motive is 
economic, but certainly don't discount the possibility that the 
Chinese might see an opportunity to signal displeasure over U.S. 
efforts to get their attention on issues of importance to us.  END 
COMMENT.) 
 
Price Already Being Passed on to Consumers 
------------------------------------------ 
 
¶7. (SBU) According to Deloitte's Finley, suppliers throughout South 
China have already begun restructuring their contracts to pass the 
entire refund adjustment on to the consumer.  In fact, David Lee, 
Director of the China office of one of America's largest hardware 
companies, Ultra Hardware, has stated that among his fifty factory 
suppliers in South China, only six have been willing to share some 
of the increased cost.  As a result, while the company still plans 
on sourcing from the region, it has already begun negotiating with 
suppliers in Vietnam and Cambodia, which may now be able to offer 
lower prices. 
 
 
GUANGZHOU 00000862  002 OF 003 
 
 
Investment Not Expected To Leave. . . Yet 
------------------------------------------ 
 
¶8. (SBU) Consensus among business professionals is that the recent 
VAT reform will not drive away most foreign investment.  According 
to Maarten Roos, Legal Consultant for local law firm Wang Jing & 
Co., there are simply too many other reasons for FIEs to stay. 
However, Roos does acknowledge that the long-term effect will be to 
shift some investment to areas like Laos, Vietnam and Thailand, 
where some products may be sourced at a lower cost. 
 
¶9. (SBU) This sentiment was echoed by Finley, who added that the 
biggest complaint among FIEs in the region was not the change in the 
policy itself, but rather the abruptness with which it occurred.  No 
companies were made aware of the change earlier than one week prior 
its issuance.  In fact, even local customs officials were caught 
off-guard by the restructuring, as the new policy evidently sparked 
a flurry of confused activity in the ports regarding how to 
implement the newly-established export tax refund system. 
 
¶10. (SBU) If the changes in VAT do have an adverse impact on foreign 
investment anywhere, it is likely to be in South China, where most 
manufacturing investment takes place.  Moreover, since large FIEs in 
the region typically produce for sale to the China market, the brunt 
of this is expected to fall on small to medium-sized enterprises 
(SMEs), which engage almost exclusively in export-oriented 
production. 
 
No Refund, No Problem 
---------------------- 
 
¶11. (SBU) The sweeping VAT reform has hurt most exporters in the 
region, but a select few may actually experience improvements in 
their tax status.  As Finley explains, companies which previously 
exported a single product input may now stand to profit by exporting 
the entire product.  For instance, instead of exporting the copper 
fitting used in the production of a chair (which is now subject to a 
reduced VAT refund), some companies may now choose to design and 
export the entire chair - a practice which would result in a zero 
percent export VAT, thus nullifying the need for any refund.  In 
such cases, companies will need to move assembly productions to 
China.  However, the impact on the U.S. job market is expected to be 
small, with Mexico and other labor-intensive economies bearing the 
brunt of such a policy. 
 
Concerns of Discriminatory Treatment 
------------------------------------ 
 
¶12. (SBU) Some of our contacts have expressed concern that the VAT 
change will add yet another layer of competitive disadvantage to 
FIEs.  As Dan Harris, Managing Partner for Harris & Moure puts 
forth, taxes tend to be paid primarily by law-abiding foreign 
companies, thus increasing the competitive advantage of Chinese 
companies.  Therefore, if a foreign company is paying a 17 percent 
tax on its exports from China (as will be paid by all companies 
whose VAT refund was completely removed) and a Chinese company 
making the same product is paying only five percent or less (or 
trying to avoid payments altogether), the Chinese company would 
immediately gain a large cost advantage that should allow it to sell 
and export more products than its foreign competitor. 
 
¶13. (SBU) There are some experts, however, who are not ready to 
endorse this concern.  According to Finley, large U.S. companies 
play by the book in most cases, since their exposure would simply be 
too great if they chose to do otherwise.  However, Finley said that 
numerous unlisted FIEs in the region are still pushing the envelope, 
and thus he warns that it may not only be local companies that are 
evading taxes.  Finley believes this perception has been mistakenly 
driven by the fact that the tax bureau targets individual foreigners 
because they are in a high income group, a practice which he says 
does not translate to business tax investigations, as those are 
categorized by industry, not income. 
 
More Changes on the Way 
----------------------- 
 
¶14. (SBU) Much of the business community was caught off-guard by the 
recent widespread reduction in VAT refunds, so much so that some 
have already begun to make preparations for the next round of 
changes.  Aroma Housewares' Purchasing Supervisor Lisa Huang told us 
that speculation about other possible changes in the VAT for 
additional products has led many in the small appliance industry to 
delay signing long-term contracts for fear that they will be left 
holding the bag when the other shoe drops.  Deloitte has also begun 
counseling clients that while they can not be sure when it will 
occur, they can count on some type of ongoing VAT changes, and 
whether it means re-designing production or leaving the region 
altogether, they should prepare accordingly. 
 
 
 
GUANGZHOU 00000862  003 OF 003 
 
 
GOLDBERG