Processing trade has been one of the most popular international trade models in China. While there is no clear definition, processing trade is largely divided into two forms, import processing trade and contract processing trade. Import processing trade means that a processing firm sources and pays for imported inputs prior to export of finished products. In contract processing trade, however, a processing firm simply receives a processing fee without taking ownership of either foreign inputs or finished products for export. As such, foreign inputs are normally shipped to free trade zones for processing without going through import procedure.

Despite the prominencfe of processing trade, domestic inputs have increasingly been used in the processing by exporters, thus creating renewed attention on ordinary assembly trade. In traditional ordinary assembly trade, a processing firm received a processing fee from exporters without taking ownership of either domestic inputs or finished products for export. On May 25, 2012, the Ministry of Finance and the State Administration of Taxation jointly issued Caishui [2012] No. 39 ("Circular 39") to reset ordinary assembly trade with domestic inputs, among others. The below analysis is to discuss such reset from a foreign-invested exporter standpoint.

Sell-buyback Model

Under Section 4.5 of Circular 39, to claim a refund of value-added tax ("VAT"), a foreign-invested exporter must present one single VAT invoice with the total amount as stated, which generally includes price of domestic inputs as well as processing fee. It goes on to mandate that such exporter sell domestic inputs to a processing firm and then buy finished products back from the processing firm. Needless to say, the sell-buyback scheme will effectively ensure the total amount to be included into one single VAT invoice. The underlying rationale is that the Chinese tax authorities would be able to unify the different VAT refund rates applicable to domestic inputs and processing fee, thus easing the administrative burden. Thus the foreign-invested exporter only needs to summit a single invoice for subsequent VAT refund from the Chinese tax authorities.

The sell-buyback requirements as imposed by Circular 39 have created some business headaches to foreign-invested exporters. In traditional ordinary assembly trade, a processing firm generally knows nothing about the pricing of domestic inputs and thus has no clue about an exporter's profit margin. Circular 39 forces exporters to disclose the pricing of domestic inputs and predictably enhances processing firms' bargaining position for a higher processing fee. The enhanced position of processing firms could potentially unbalance or even disrupt the long-term business protocol with foreign-invested exporters. This is not what Circular 39 is supposed to do.

Split-off Model

A foreign-invested exporter is often a wholly foreign owned enterprise ("WFOE"). To the extent that a foreign-invested exporter is not ready to accept the sell-buyback model due to whatever reasons, it can certainly seek to consider a split-off model as an alternative based on business needs and tax calculations. Under the split-off model, a separate manufacturer WFOE is to be established from an exporter WFOE. The manufacturer WFOE purchases domestic inputs such as raw materials and outsources the processing to a processing firm, while the exporter WFOE exports only.

Under such structure, a processing firm will receive a processing fee only, without learning about the pricing of raw materials or bargaining for a higher fee based on this knowledge. The manufacturer WFOE sells finished goods to the exporter WFOE, which will receive a single invoice from the manufacturer WFOE for a VAT refund. The manufacturer WFOE generally does not have to sell domestic inputs to the processing firm. For this structure, both business operational costs and tax costs could rise. In addition, the related party transactions between the two WFOEs may well be a focus of the Chinese tax authorities' review.

Bonded Processing Trade

Arguably, bonded processing trade offers another escape from the sell-buyback model, depending on the nature of raw materials used in the processing. Although it is permitted by laws that non-bonded materials (purchased from domestic market in China) could be used in bonded processing trade, no regulation is set to expressly specify what would be the permitted ratio of non-bonded materials to the total. It is a foreign-invested exporter's obligation to report to the Chinese customs agency its plan of such ratio, as well as type, specification, and quantity of each material. The customs agency will then decide whether to issue a bonded processing trade manual to the exporter or not. The manual notes a registration of processing firms with the customs agency. To the extent that nearly all raw materials are non-bonded, however, it will pose substantial risks on the final VAT refund.

Moreover, bonded processing trade requires certain assistance from processing firms to complete each step from an application for the requisite manual to allowing the customs officials to pay on-site visits. Depending on a foreign-invested exporter's control over processing firms, any dispute may cause a refusal to cooperate and result in a failure to receive a VAT refund of the processing fee from the Chinese tax authorities eventually. The delicate balance with processing firms will certainly add one extra layer of vulnerability to a foreign-invested exporter.

Conclusion

Ordinary assembly trade has been around for years. Circular 39 imposes a sell-buyback model for the purposes of easing tax administrative burden, while disrupting longstanding business arrangements. The split-off model could be a supplemental option, depending on business needs and tax calculations. Further, bonded processing trade could be another escape from the sell-buyback model, while overwhelmingly domestic raw materials will pose substantial tax risks. It is unclear how long the sell-buyback model will be sustained.