Customs – from enforcer to enabler

The General Administration of Customs (GAC) in China is making a strong effort to build Customs' image as more business friendly, technology savvy, and adherent to international standards. It has made and will make more important strides in pursuit of this objective including:

• the recent slew of mutual recognition agreements that China Customs has entered or is planning to enter into;

• the signing of the China-Switzerland free trade agreement (FTA), which has been the subject of growing interest among multinational companies recently; and

• the new rules that clarify how FTA-qualifying goods that are first stored in China bonded zones can still enjoy FTA treatment when sold for domestic consumption.

More specific initiatives being undertaken at the local level particularly include:

• the ongoing transition to paperless customs declarations to be carried out until 2015;

• the expected changes to Customs valuation rules involving bonded goods; and

• the new methodology that Customs may soon employ in determining the consumption and scrap rates for processing trade companies which appear to mirror the World Trade Organisation (WTO) rules on Customs valuation.

China Customs has been bolstering its bilateral ties with other Customs authorities in the region through increased initiatives to sign mutual recognition agreements for trade facilitation under Advanced Economic Operator (AEO) schemes. After entering into such an agreement with Singapore Customs last year, China Customs has now signed another one with Korea, which is a bigger trading partner. With many large Korean companies investing in China, many are optimistic significant economic benefits may be realised through this agreement.

Although already signed, the agreement is not expected to take effect until next year as both parties need time to make internal assessments, prepare their systems and allocate adequate resources for its implementation. Once online, qualified importers and exporters in China and Korea will be able to access a green channel where less administrative burdens and checks would be performed at the border, resulting in smoother and faster clearance times.

While preparations are underway for the China-Korea AEO scheme, China is also leading negotiations with the EU and the US to gain recognition under the EU AEO and US Customs Trade Partnership against Terrorism (C-TPAT) programmes. The overall economic benefit and risks between China and the US/EU are still being assessed. Negotiations with the EU appear to be more advanced as talks are expected to be completed this year. However, no definite timeframe has yet been set for the conclusion of negotiations with the US.

Driven by manpower and resource constraints, more AEO initiatives are expected in the next five to 10 years. In fact, negotiations are also underway for AEO recognition with Japan, Taiwan, and Hong Kong. It is interesting to note that while trade volumes have increased significantly in China, the number of China Customs officers has remained nearly constant at 50,000 nationwide, which makes it impossible to screen each and every shipment that enters the country. Having more AEO agreements in place would therefore enable Customs to deploy and dedicate its resources more in scrutinising lower tier importers.

At any rate, China's Customs systems may already be geared for AEO implementation. Its electronic Customs systems are practically ready to accommodate AEO requirements based on several years of implementing its enterprise classification system, whereby top tier companies (that is, with an AA status), are selected and granted privileges similar to AEO. In fact, under the mutual recognition agreement between China and Singapore, an AA rating is already synonymous with having AEO status. Once the China – Korea AEO comes into effect, qualified companies will be able to apply for a special code with China Customs. This code will be indicated in the declaration form and can readily identify AEO-qualified companies to which the necessary privileges should be extended.

At least two significant developments relating to FTAs took place in China this year. First was the signing of a landmark FTA between China and Switzerland, and another was the issuance of rules clarifying the FTA qualification of goods that are imported through bonded zones in China.

The Switzerland-China FTA was signed last July and is expected to take effect in the middle of 2014. From the date of enforcement, 99.7% of Chinese exports to Switzerland will be immediately exempt from duties and a relatively slower tariff elimination process will commence for Switzerland exports to China (with a zero duty target on 84.2% of Swiss exports in China within 15 years).

In addition to Switzerland, China has already signed FTAs with more than 20 countries and regions including ASEAN countries, and New Zealand. Furthermore, it now provides preferential duty rates to 37 least developed countries as a form of aid akin to the Generalised System of Preferences (GSP) accorded by the US and EU.

Nevertheless, it is a common observation that many importers in China have not benefited fully from FTAs or preferential duty programmes due to a lack of understanding of relevant regulations. For example, some importers may believe that a transshipment, storage or sale through another country would disqualify automatically the goods from enjoying the preferential duty rates, even if the goods originated from a beneficiary country. In fact, for as long as exporters are able to obtain certificates of origin under relevant agreements, importers can still benefit from preferential duty rates as long as the transportation and storage of these goods would meet the 'direct transportation' rule.

Direct transportation generally requires the goods to be transported directly from a beneficiary country or region to China, without any transshipment via any other countries. However, regulations in China also indicate that goods transported via other countries could still be recognised as directly transported if the goods do not undergo operations other than those necessary to preserve them in good condition and are under customs supervision in those countries. If importers can make sure about the two conditions, that is, obtain the preferential certificate of origin and direct transportation, they would still be able to enjoy the preferential duty rates after providing adequate documents to the customs.

Many multinational companies use China's customs areas (such as free trade zones and bonded logistics parks) to store high duty rate goods under bonded status. In the past, if these bonded goods were qualified for FTA treatment (that is, are covered by a certificate of origin) these would be denied the FTA rate when released in to the domestic market due to the absence of clear regulations. However, in June 2013, the GAC issued Circular No 36, which clarified the procedure required for a company to use preferential duty rates for goods imported via these customs areas and the documents required for the application.

With Circular No 36, we may foresee some customs areas in China becoming preferred international distribution centres in the future where FTA qualification is retained not just for goods to be locally sold, but for those to be transshipped to other FTA destinations as well. If the Chinese government could issue certificates of non-manipulation for goods warehoused in China bonded zones areas, as Singapore does, more companies would be able to benefit from preferential rates under FTA after first being stored in bonded warehouses in China.

Among the most important reforms implemented by China Customs over the past three years is the establishment of a paperless customs clearance facility. This measure is expected to improve the balance between strengthening customs supervision while enabling smoother clearance processes. Reforms commenced in 2012, but the process will only be completed in 2015, by which time it is hoped that China's customs systems will be comparable to those of other developing countries where importers and agents can lodge customs declarations from the comfort of their own desks.

The overall impact of these reforms will be significant across various industries. Most importantly, it may transform the manner in which Customs agents and freight forwarding companies conduct business as they may be obliged to redefine their roles, innovate and provide more value added services to their clients rather than simply lodge declarations. Secondly, manufacturing and trading companies (especially multinational corporations) that have outsourced their Customs functions would have to consider these implications that paperless filing may bring:

• The company may need to rethink the customs clearance and logistics management function to determine which types of arrangements and which customs brokers/agents would have the best value for the company.

• Human resources staff could be deployed more efficiently and re-equipped with the necessary skills. For example, field logistics personnel may be relocated to the main offices and provide additional skills training to in-house logistics staff on how to conduct paperless declarations, as well as its corresponding advantages and risks.

• It would be necessary for information systems to be upgraded to match the requirements set for paperless filing. Along with this, information technology (IT) security protocols should be enhanced to protect the integrity of company data since paperless filing may require the sharing of information across different departments.

• Last and certainly not least, new internal controls and checks on accountability would have to be developed since the critical function of making customs declarations will be moved even closer to company premises which could imply possible Customs visits and questions in the future on the accuracy and quality of the declarations made.

The implementation of the paperless customs clearance programme will be linked to the enterprise classification management system. Companies with a rating of C or D will not be allowed to apply for paperless declarations, but are encouraged to make the effort to improve their systems and performance to qualify for an upgrade and paperless filing. On the other hand, those under AA, A, and B status are likewise enjoined to maintain their levels of performance to avoid the risk of being downgraded.

Since the reforms are still in process, we would recommend companies, regardless of their enterprise rating, to pay close attention to any developments or pronouncements by China Customs regarding various areas of customs management and determine how they can prepare from the standpoint of system efficiencies, internal controls, internal procedures/manuals and resource allocation. Adapting to these reforms should be a high priority for companies at least in the next two years.

The GAC is expected to issue a regulation in the future that will govern the customs valuation of bonded and processing trade goods. Different rules are applied on how to assess the customs value of a good that is released from a bonded zone to the domestic market (for example, depending on the type of bonded zone the goods are stored in). The proposed regulation will set a consistent national standard on how bonded and processing trade goods should be valued for customs purposes when these are entered for domestic consumption. The draft of these new rules has already been submitted to the legislation department of the GAC for discussion.

We understand that WTO valuation principles will still be followed for determining the customs value of goods imported or exported under general trade, while the cost plus method could be adopted as to determine the customs value of bonded goods in the future.

The last major change in China's Customs valuation policy was the Measures of the PRC Customs on Determination of Dutiable Value for Imports and Exports (No 148 GAC Order), enacted in 2006. Since then, there have not been any notable changes in China's Customs valuation policy for nearly eight years, with the exception of two regulations:

• Provisions for Examination of Customs Valuation using Formula Pricing (No 11 GAC Circular issued in 2006)

• Provisional Measures for the Pre-valuation of Imports (Shushuifa No 419 issued in 2011).

These two regulations are both related to the pre-verification of the customs value of imported goods. No 11 GAC Circular deals with the customs valuation of special products which use formula pricing for transaction value, while Shushuifa No 419 applies to A and AA grade companies enterprises that are entitled to apply for a pre-verification of their import price with local Customs.

China Customs is planning to release a new set of rules to rationalise the determination of the proper scrap and raw material consumption rates for finished products under processing trade.

Ascertaining the actual (or the closest approximation of) raw material consumption and scrap rate for finished products is among the biggest challenges in processing trade management. In fact, inconsistencies in consumption rates are among the primary reasons for discrepancies between theoretical and actual customs handbook balances.

These rates are not easy to confirm since they vary from industry to industry and some can only be validated by industry professionals rather than Customs officials. Often, disputes and conflicts between Customs officials and the business community arise due to technical disagreements over what should constitute the proper scrap and consumption rate for a particular product.

In the past, two ways were used to determine consumption and scrap rates:

• The first was to self-report these rates to Customs, which in turn reviews the company's bills of materials (BOM) and decides on what the acceptable rates are. However, this approach may be problematic since Customs officials are generally not technically competent or equipped to make an authoritative determination as to what the proper rates should be.

• The second method was for Customs officials and industry associations to cooperate in investigations to ascertain the acceptability of consumption and scrap rates. Although this approach is more consultative, its main drawback is that practically all of the technical experts come from the business sector, which can cause the investigation to lose its impartiality.

To bridge the shortcomings of these methods, the new rules instil a change in the mindset on how consumption rates are set. These new methods appear to incorporate elements of the WTO valuation methods and are more open to negotiations between Customs and business.

Under the proposed rules, consumption rates would be determined through these hierarchical methods:

1. Analysis – The applicant will supply detailed technical information to the Customs authorities for the latter to conduct a desktop review. If Customs deems the information sufficient and is confident in their knowledge of the industry, it will decide on the applicant's consumption rate.

2. Assessment – If an analysis is not sufficient, Customs will conduct measurements and laboratory testing on the amounts of raw materials consumed in the manufacture of a finished product. At this time, the enterprises will provide detailed production information to Customs.

3. Calculation – If the production information does not yield a satisfactory result, Customs can opt to make input/output calculations based on financial and production records.

4. Comparison – In case no conclusion could be drawn from the calculations, Customs can then compare the company's application with its historical BOM and decide based on past experience.

5. Other reasonable methods – As a last resort, Customs can combine principles from the aforesaid methods and, after possibly negotiating with the company, arrive at a reasonable consumption rate.

Although these new rules are relatively more objective, scientific and efficient, they are not expected to resolve all BOM issues. Rather, they provide an avenue for companies to consult better with Customs and share technical knowledge that would be critical in mending potential gaps between theoretical and actual BOMs. To fully leverage these opportunities, companies would do well to align the objectives and activities of their customs/logistics department with their more technical functions such as production planning and engineering.

It cannot be denied that China Customs is making a conscious effort to rebrand itself more as a business partner than a trade regulator. The success of this strategy is clearly premised and dependent on the success of its enterprise classification system, which distinguishes between low risk and high risk companies. We can expect Customs to dedicate more resources in maintaining the effectiveness of this selectivity system by conducting more audits and scrutinising companies' internal risk management/internal control systems. After low risk clients have been identified and properly categorised (for example, AA, A), its enforcement will focus more on those with high risk profiles (that is, C and D companies).

Companies therefore are faced with a two-pronged challenge. First, they can vie for an upgrade to a higher enterprise rating which may involve increased interactions and possible validation audits with Customs, though for the right reasons to further improve their internal systems. Alternatively, companies can opt to remain at the higher risk category which would be tantamount to taking a chance at being at the full receiving end of China Customs' enforcement arm. Our recommendation of course is for companies to consider the former and ride on this wave of reforms China Customs is undergoing.

Indeed, with the proper guidance and a sound management of its relationship with China Customs, the benefits of being able to lodge declarations remotely and mitigate scrutiny on its inbound and outbound shipments would definitely outweigh the risks of penalties due to unintentional, non-routine findings of non-compliance.

Finally, the development of newly former special customs-supervised super zones such as the Qianhai Cooperation Zone and the Shanghai Pilot Free Trade Zone will help further liberate trades, simplify customs procedures and improve the infrastructures and logistics that facilitate cross-border transactions. The further guidelines to be issued on the implementation of customs rules of these super zones are definitely something to look forward to in the coming year.

Dong Cheng, Philip Xia and Raphael Madarang of KPMG China also contributed to this article.

Biography
		Lilly Li Tax Partner KPMG China 38th Floor, Teem Tower 208 Tianhe Road Guangzhou 510620, China Tel: +86 20 3813 8999 Fax: +86 20 3813 7000 Email: lilly.li@kpmg.com Lilly Li became a partner at KPMG China in 2005. Before joining the firm, she worked at the China Tax Bureau and the Australian Taxation Office in the areas of international tax administration, tax audit and transfer pricing. She specialises in China tax, transfer pricing and customs advisory services. She provides business and tax advisory services to numerous multinationals as well as Chinese domestic companies on their M&A, corporate restructuring, cross-border transfer pricing, outbound investment, supply chain integration and initial public offering (IPO) activities. In the area of customs and trade advisory, Lilly has assisted many clients in reviewing and improving their customs-related processes and compliance with processing trade. She has also provided support to clients regarding their customs valuation audit defence. Lilly has also actively led and participated in the technical interflows with the respective customs offices in the areas of related-party transfer pricing and customs verification audit.

Biography
		Anthony Chau Tax Partner KPMG China 50th Floor, Plaza 66 1266 Nanjing West Road Shanghai 200040, China Tel: +86 21 2212 3206 Fax: +86 21 6288 1889 Email: anthony.chau@kpmg.com Anthony Chau started his tax advisory career in 1999 in the corporate tax department of KPMG in Sydney. Upon returning to Hong Kong in 2000, he started practising in the areas of PRC taxation, customs duty and business advisory matters. He was based in Guangzhou and Chengdu before relocating to KPMG in Shanghai in July 2010. Besides his tax related roles in Shanghai, he manages the tax practice for KPMG in Chengdu and also leads the trade and customs practice for Central China. Over the years, Anthony has advised multinational clients regarding their expansion plans, holding structures, and operational and related crossborder transactions as well as their restructuring matters from both a taxation and business regulatory perspective. He has also assisted numerous clients negotiate with the PRC tax/customs authorities on their daily compliance and audit matters. Anthony is also a regular speaker in public seminars on taxation, customs and business advisory matters.

Biography
		Eric Zhou Tax Partner KPMG China 8th Floor, Tower E2, Oriental Plaza 1 East Chang An Avenue Beijing 100738, China Tel: +86 10 8508 7610 Fax: + 86 10 8518 5111 Email: ec.zhou@kpmg.com Eric Zhou worked for China Customs for more than nine years before joining KPMG China in 2004. Eric specialises in cross-border customs advisory/defence services such as HS (Harmonised System) codes determination, customs valuation and processing trade management concerning multinational enterprises in industrial markets and consumer markets. He also has extensive experience of corporate income tax, customs valuations, and VAT and transfer pricing, which are closely linked to customs issues.