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Success story of Hong Kong services company on the mainland – Selling processing trade products in China's domestic market

Interview with Li Yancheng, Senior Advisor of Shenzhen Council for the Promotion of International Investment


Under the impact of the financial tsunami that inflicted on the global economy in 2008, the manufacturing industry of China which is regarded as the world factory has been badly hit. The business of enterprises engaged in processing trade with supplied materials as well as those in export trade has been dampened. In response, China has taken steps to encourage enterprises to turn to domestic sale since the beginning of 2009 with a view to solving the problems arising from the dwindling overseas markets as well as to maintaining its economic growth by stimulating its domestic demand. In the light of this, the Hong Kong Trade Development Council has invited Li Yancheng, Senior Advisor of Shenzhen Council for the Promotion of International Investment, to speak to Hong Kong companies and explain to them the issues that require the attention of processing trade enterprises when conducting domestic sale.

As pointed out by Li Yancheng, the most important issue involved in shifting from processing trade to domestic sale is the tackling of tax problems. This is because some raw materials used in processing are imported in bond and only upon payment of the related taxes can their finished products be sold on the mainland. However, different types of processing enterprises are subject to different taxation arrangements.

First of all, we have to understand the characteristics of processing trade. Raw materials or parts used in processing trade are all imported in bond from external sources (i.e. the materials are purchased and imported by the processing enterprises with temporary tax exemption). Having been processed or assembled by a processing enterprise on the mainland, the finished products are exported for sale. The main feature of such an operation is that "both ends are external". That is to say, both the raw materials and finished products are outside the country where the raw materials are imported and the finished products are exported. The materials used are imported in bond and exempted from import duty, value added tax and consumption tax on a temporary basis.

There are three different types of processing trade. The first one is processing with supplied materials which are imported and supplied by a foreign company and the processing enterprise has no need to pay any foreign exchange for their import. In this case, the processing enterprise will charge a processing fee and the finished goods will be handed over to the foreign company for sale. The main feature of such an operation is that both the materials and finished products belong to the foreign company. If the products are to be put to domestic sale, the processing enterprise has to buy them back from the foreign company and a repayment of the required taxes has to be made.


The second one is processing with imported materials which are imported by the processing enterprise upon payment of foreign exchange. The commodities produced subsequently will be sold back to the foreign company for export sale. The main feature of such an operation is that both the materials used and the finished products belong to the processing enterprise which can import the materials, draw up the production and sale arrangements as well as bear the responsibility for all the profits and losses involved. As the ownership of the finished products belongs to the processing enterprise, they can be put on sale in the domestic market.

The third one refers to general import and export trade where the import or export through Customs is undertaken unilaterally. The main feature of such an operation is that its import and export involve the payment of all import and export duties and taxes under the law. After Customs clearance, the goods in question can be put on sale freely without being subject to Customs supervision.

Repayment of taxes involved in domestic sale

In simple terms, there are two crucial factors that determine whether a processing enterprise can conduct domestic sale: they are the ownership of the goods and the repayment of taxes. In terms of ownership, if the goods still belong to the foreign company, they have to be bought back from the foreign company before they can be put on sale. As regards repayment of taxes, if the raw materials are imported in bond and the products made subsequently are not exported, the required taxes have to be repaid before they can go for domestic sale.

On the other hand, processing with supplied materials involves a trading enterprise and a processing enterprise (i.e. the factory processing with supplied materials). A trading enterprise is responsible for the conclusion of contracts with import and export trading rights, whereas a processing enterprise with its own production plant, equipment and workers is entrusted by the trading enterprise mainly for undertaking assembling operation. At present, factories processing with supplied materials in Guangdong province generally do not have any import or export trading rights. Under the recent government policy of encouraging the conversion of processing trade into domestic sale, processing trade goods can, upon approval, be transferred to domestic sale under general trading practices by way of tax repayment.

As pointed out by Li Yancheng, wholly-owned companies mainly adopt three kinds of domestic sale models. Under the first model, the production components are purchased on the mainland where no import or export is involved. All the goods produced can thus be sold on the mainland without the need to register with Customs. Under the second model, the products are made from materials with duties paid and are not classified as products of processing trade. They can therefore be sold in the domestic market directly. Under the third model, the raw materials are imported in bond and the goods processed are expected to be exported. But under exceptional circumstances, applications can be made to have these goods transferred to domestic sale. Upon approval and repayment of the required taxes, they can be sold in the domestic market directly. As for the processing enterprise, an application can also be made under exceptional circumstances to have the products transferred to domestic sale upon repayment of taxes. However, the applicant for domestic sale upon repayment of taxes must be a trading enterprise since processing factories generally do not have any import or export trading rights and are thus not eligible to apply for domestic sale.

According to Li, governments at both the central and provincial levels have introduced new policies that support the transfer to domestic sale by processing enterprises since the latter half of 2008. These policies are drawn up in response to the financial tsunami and they mainly focus on the guiding principles. In particular, the Shenzhen Municipal Government and the Guangzhou Municipal Government have introduced some award programmes. Yet these programmes only apply to the domestic sale that involves a relatively large ratio of products whereas small and medium-sized processing enterprises generally may not be able to benefit from them. Nevertheless, the introduction of various policies in support of domestic sale reflects that the government is, after all, in favour of the transfer to domestic sale by enterprises.

Domestic sale channels of processing trade goods

There are a few domestic sale channels for processing trade goods that have been bonded. The first one is the so-called "one-day tour by way of Hong Kong" where the goods involved are exported to Hong Kong and transported back to China as re-imports. Besides, the goods can also make a one-day tour to a supervised export warehouse which has been set up under the approval of Customs for the storage, bond logistics and distribution of goods that have completed the export procedures of Customs. These warehouses are set up at Futian or Yantian and are generally managed by logistics companies. The enterprise can, in the light of its cost budget, decide whether the goods should go through a one-day tour by way of Hong Kong or be put in a supervised warehouse. In general, delivery from a warehouse can reduce the cost as it only requires some mainland truck transportation without involving the use of mainland-Hong Kong vehicle or mainland customs clearance vehicle.

The advantage of re-import following export is that it can do away with interest expenses incurred by deferred tax payment involved in the direct domestic sale of goods requiring tax-repayment. There is no need to go through the various vetting procedures and the customs formalities can also be reduced. If, for some special reasons, the goods cannot be re-imported following their export under the relevant requirement, an application can also be made to have them transferred to domestic sale directly upon the repayment of taxes.

Only on the basis of special reasons will bonded goods be approved for domestic sale. The goods involved must meet one of the following six conditions before an application for domestic sale can be made:
1. The foreign client has for some reason requested for an early termination of the contract and as a result, the goods cannot be exported. For example, during the financial tsunami, there were cases that goods could not be exported because many American clients had stopped the collection of goods, cut the price or breached the contract by forfeiting their deposit. In these cases, an application can be made to have these goods transferred to domestic sale provided the trading enterprise can provide sufficient proof to the effect that the goods cannot be exported due to any of the above reasons.

2. As a result of falling prices in the international market, the trading enterprise is expected to sustain heavy financial losses if it were to continue with the performance of the contract. It has thus successfully sought an early termination of the contract from its foreign client.

3. The quality of the finished goods falls short of the specified requirements and thus cannot be exported. For these cases, the trading enterprise must present supporting documents from the export commodity quality inspection departments or the mainland's quality supervision departments.

4. The goods in question are made from raw materials that are made surplus due to the reduction of raw material consumption as a result of technological improvement. For these cases, the trading enterprise must produce relevant proof to support its application.

5. The goods produced cannot be exported as force majeure has rendered the export contract that has been concluded impossible to be performed.

6. For other cases with valid reasons for domestic sale, the approving authorities will consider them on the basis of their individual merits.

As pointed out by Li Yancheng, the approving authorities play an important role in determining the success of the applications. In the past, domestic sale of processing trade goods was under the jurisdiction of commerce authorities and provincial authorities which were of higher levels and attached greater importance to policies. But after the year 2007, district-level governments are also entrusted with the approving authority and applications with valid reasons for domestic sale can usually gain their support. Yet some approving conditions still have to be met. First, the applicant for domestic sale must be a trading enterprise and not a general processing factory. Second, the application must be made prior to the stipulated re-export date or deadline of the finished products concerned. Third, for domestic sale of goods classified as import goods under an import quota licence or subject to registration management, the related general trading import licence or registration proof should be submitted and the application should be approved by the provincial commerce authorities or the Ministry of Commerce.
In respect of the application procedures for transferring goods processed from bonded materials to domestic sale, the enterprise should first submit an application to the relevant approving commerce authorities and the applicant must be a trading enterprise. Where the application is to be made by a factory processing with supplied materials, the application should be affixed with the stamp of the trading enterprise to signify its agreement. Upon approval by the commerce authorities, a Domestic Sale Approval Certificate will be issued. Upon receipt of the Certificate, a representative of the applicant can go to Customs to complete the procedures on repayment of taxes for domestic sale. Subsequently, the goods can be cleared from Customs and be released for domestic sale.

Li Yancheng stressed that the model of approving goods processed from bonded materials for direct domestic sale has its benefits under the current contraction in overseas markets. However, the government still stipulates that this direct domestic sale model can only be applied under exceptional circumstances. Even though the required procedures have been simplified, the process involved is still very complicated and enterprises should not take it as a long-term operation model. In his opinion, if a factory processing with supplied materials has to resort to domestic sale on a long-term basis, it should consider converting into a wholly-owned company that operates with diversified domestic sale models. At present, governments of different levels have introduced new measures to encourage factories processing with supplied materials and keeping their production in situ to convert into a wholly-owned company. Such a development has provided a good opportunity for making the transfer.

If the problems involving brands, sale channels and networks of domestic sale have to be tackled more properly, consideration can be given to setting up an import and export trading company on the mainland to conduct commercial, distribution or retail business. To a wholly-owned company basically engaged in production, it will also be a very good development for it to take part in commercial operation concurrently.

from special correspondent Ray Chung, Hong Kong

Content provided by Hong Kong Trade Development Council
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