Auto industry – bumpy rides ahead

KPMG's 2013 Global Automotive Executive Survey shows that automotive markets continue to mirror the general economic gloom in Western Europe and Japan, with a significant proportion of respondents believing that sales and production will continue to decline in the next five years. Though the exception is the US, where more than 40% of the executives surveyed believe that both sales and overall vehicle output will either stay the same or go up, the global focus in the automotive world appears to be overwhelmingly shifting to emerging markets. Indeed, China appears to be the top choice for investment from all automakers globally, with 70% of respondents indicating that they will begin or increase investments into China.

At the same time, regulations are getting tougher in China for the establishment and operation of production facilities. Respondents to the Global Automotive Executive Survey expect environmental restrictions to remain challenging and foresee increases in governmental interventions and rises in import and export duties. As is often the case in most economies, government interventions can come under the guise of taxation.

Already, we are seeing increasing audits on companies with the High-New Technology Enterprise (HNTE) status so often enjoyed by many players in the auto parts industry as well as growing scrutiny being placed by customs officials on the classification of imports. On the other hand, the shifting sands of the regulatory environment are keeping companies on their toes as the HNTE qualification criteria has been made more difficult to meet by changes to Chinese labour law and the phasing-out of the 2+3 corporate income tax (CIT) holiday has foreign auto companies rethinking their structures in China. Even new reforms that seemingly have little to do with the auto industry can still have an impact as the VAT reforms could influence logistics costs; however, existing regimes such as the foreign currency controls continue to present challenges to the auto industry.

However, these challenges are by no means insurmountable so long as appropriate planning is in place and properly executed.

China is increasingly seeking to transform itself from a manufacturing powerhouse to an innovation centre. Authorities across different levels, functions and locations in China are keen to offer incentives and special tax benefits in an effort to attract investment and encourage innovation. This bodes well for the auto industry, whose executives, like many of those in other industries with competitive markets, now recognise that the path to success lies in innovation.

The HNTE qualification is a popular incentive often accessed by auto parts manufacturing companies that grants a 15% preferential CIT rate to companies in China that meet the criteria. However, expanding business activities coupled with ever-changing regulations have made it more difficult for certain companies to continue to satisfy certain HNTE qualification criteria.

One of the HNTE qualification criteria requires at least 30% of a company's personnel to hold college or higher degrees, at least 10% of which must be engaged in R&D activities. Yet many auto parts companies, being typically manufacturing businesses, find this criterion challenging to fulfil due to the labour-intensive nature of their work and the high number of staff they usually require.

Therefore, a common arrangement adopted by companies seeking to qualify this criterion is to arrange for staff loans with labour agents. Under these arrangements, workers legally employed by labour agents are loaned to the companies to provide manufacturing services. The companies then argue that the loaned workers should not be considered as their employees and therefore should be excluded from total headcount.

However, China's new labour contract law effective from July 2013 stipulates that the employment of labour forces by way of staff loan arrangements should only be applicable for temporary or auxiliary positions and such positions should not last for more than six months. This means that workers loaned to a company from labour agents may need to be employed by the company as its own employees in the future if these workers are to be employed for more than six months. As a result, total number of staff of the company will increase and the percentage of the qualified scientific technology staff over the total number of staff may drop to a level below the threshold.

In light of this development, companies should:

• assess the possibility that the labour authority will implement the revised PRC Labour Contract Law strictly and require the manufacturer to employ loaned staff as its own employees.

• re-consider its staffing arrangements and closely monitor the headcount ratio to ensure it satisfies the criteria for HNTE.

• consider measures that might minimise the exposure, such as outsourcing labour-intensive, but low-profit manufacturing processes to a related-party manufacturer (who is not seeking HNTE status) or splitting the company into two legal entities, with one engaged in labour-intensive and low-profit manufacturing activities and the other maintaining operations qualifying as an HNTE.

Companies seeking to qualify as an HNTE must also ensure that their ratio of R&D expenditure to total sales is no less than 3% to 6% (depending on the total sales of the company). This poses a challenge for companies expanding their businesses and growing their sales, who may need to keep increasing their R&D expenditure to satisfy the said R&D expenditure requirement and to maintain their HNTE status.

An alternative, however, would be to reduce total sales. For instance, a company may consider selling its products to a related-party trading company at a price lower than the price it would ordinarily sell to third-party customers at. This reduction in total sales would make it easier for the company to satisfy the R&D expenditure requirement.

Although this arrangement would mean that the portion of the profit transferred to the related-party trading company would be subject to the higher standard CIT rate of 25%, the majority of the profit would still remain with the HNTE, subject to the lower preferential CIT rate of 15%. This is still preferable to the situation where the company loses its HNTE status entirely so that all its profits are subject to 25% CIT.

In implementing such an arrangement, it is important to ensure that the sales between the HNTE and the related trading company are still conducted on an arm's-length basis. A detailed transfer pricing study supporting the arm's-length range of pricing charged by the HNTE to the related trading party based on the risks and functions transferred to the trading company should be conducted, and the necessary documentation should be put in place.

Of the auto industry executives surveyed in the 2013 KPMG Global Automotive Executive Survey, 54% of respondents anticipate increases in import/export duties in China in 2013, compared with just 27% in 2012. Given this more intense focus on imports and exports, tariff classification is increasingly being scrutinised by China Customs officials.

China provides a Harmonisation System (HS) code for most goods imported into China. As well as customs duties, the HS code also determines the appropriate import licences/certificates that a company needs to hold and the value added tax (VAT) refund rates. More and more companies have been challenged by customs authorities over the HS codes they have adopted for some of their goods. The incorrect adoption of an HS code can result in penalties if it leads to the underpayment of duties and taxes, excessive VAT refunds, or the failure to hold the appropriate licences/certificates.

This issue is especially important when it comes to the importation of auto parts, where special rules mean that detailed studies need to be carried out by technical specialists before the right HS code can be determined. For example, issues such as how the composition of rubber elements and the level of processing a part has undertaken could change the HS code. And different HS codes also apply depending on the physical state of the product; different tariff classifications and rates apply when the goods are assembled and when they are broken down into components, sub-assemblies or individual parts.

Given the nuanced nature of tariff classification for the auto parts industries, it is important for the companies carrying out these businesses to pay close attention to the rules governing how and when different tariff classifications come into play.

A common conundrum often faced by foreign car and auto parts companies expanding their presence in China is whether to incorporate a new legal entity or to use their existing Chinese subsidiaries to set up a new branch. Where previously foreign auto companies have almost always preferred to set up legal entities instead of branches to enjoy the 2+3 CIT holiday policy, this is no longer the case.

The 2+3 CIT holiday was a tax incentive scheme introduced to encourage foreign investment into China, where Foreign Invested Enterprises (FIEs) were entitled to two years of exemption from CIT followed by three years of a 50% reduced CIT rate. However, with the phasing out of the 2+3 CIT holiday under the new CIT regime, many foreign car and auto parts companies are looking into streamlining their legal structure in China and converting existing legal entities into branches or setting up new branches under an existing Chinese subsidiary. Unlike legal entities, no additional registered capital is required to set up a branch. Under the branch structure, tax losses can be used more efficiently due to the consolidated CIT filing mechanism for head office and its branches.

Even so, it is still pertinent to consider some of the pitfalls of setting up a branch instead of a legal entity; compared with a legal entity, branches often find it more difficult to be awarded local financial subsidies and to obtain local government approval for establishment. Uncertainties also remain about whether branches are required to file CIT and VAT returns locally, and if so, how the taxes should be calculated. This is because, despite the ability to file a consolidated CIT return, a portion of the total CIT is still payable to the local tax authority by an "operational branch" (manufacturing branches are very likely treated as operational branches) where that branch is located.

For example, a Chinese company whose head office is incorporated in Shanghai has an operational branch in Nanjing; under consolidated CIT filing, the CIT liability will be calculated on a branch-head office consolidated basis. While a portion of the total CIT payable under the consolidated filing is payable to the local tax authority in charge of the Nanjing branch, how this portion is calculated is still subject to uncertainties. That is, although regulations stipulate that the portion of the CIT belonging to the local authority is to be calculated based on operating revenue, salaries and wages, and total assets, questions remain as to how these factors are to be determined (for example, whether the equipment purchased by the head office but used by the branch should be considered the branch's asset).

On the other hand, while there is no technical requirement for a manufacturing branch, which does not conclude a sales contract with and collect sales proceeds from customers directly, to file VAT returns locally, some local tax authorities may still ask for it on the basis that the branch is carrying out manufacturing activities locally and consumes local resources. This then begs the question of how revenue should be determined for VAT purposes for branches carrying on manufacturing activities, a question that cannot be clearly answered based on VAT regulations.

In light of this, it is important to appreciate and weigh up fully the benefits of establishing branches over legal entities. The relevant regulations and local practices regarding CIT and VAT filing obligations must be understood to minimise potential challenges from the tax authorities not only in charge of the head office, but also in charge of the branch.

Some of the discussions above involve interventions and policies that more or less have a direct impact on the automotive industry in China. But it is equally important to appreciate that other areas of reform in China have produced unintended consequences for the automotive industry. One such example is China's VAT pilot programme.

This reform programme rolled out across all remaining cities and provinces in China from August 1 2013. In anticipation of the rollout, the Ministry of Finance (MoF) and the State Administration of Taxation (SAT) jointly issued Circular Caishui [2013] No 37 (Circular 37), setting out new regulations and consolidating previous VAT regulations.

One significant change introduced in Circular 37, the repeal of the net basis calculation method under business tax (BT) due to the substitution of BT with VAT for certain types of services, has wide-ranging consequences for a number of industries. Under the BT rules, the net basis calculation method allowed intermediary companies such as forwarding companies and shipping agents to claim a deduction on freight fees paid to airlines and shipping companies for international transportation services and to pay 5% BT on the net amount. However, since the VAT pilot programme seeks to replace BT with VAT for the transportation and logistics industries (among others), the net basis calculation method is effectively redundant.

Instead, the VAT pilot programme provides that the provision of transportation service is subject to VAT at 11% and the provision of logistics and ancillary services is subject to VAT at 6%. Chinese companies providing international transportation services enjoy a VAT rate of zero, while many international shipping companies are exempt from VAT under bilateral tax treaties between China and their home countries. Purchasers of these services can claim a VAT input credit when valid VAT special invoices are obtained.

Therefore, under the VAT pilot programme, freight forwarding companies and shipping agents can no longer claim a deduction for the freight fees, but instead, are directed to apply for a VAT input credit incurred on the freight fees. The problem with this treatment is that in practice, it is difficult for freight forwarding companies and shipping agents to obtain VAT special invoices, which are required by them to claim the VAT input credit.

Without the ability to claim the VAT input credit, an additional tax burden falls on these companies and their financial performance can be affected significantly. Therefore, to mitigate this additional tax burden, some forwarding companies and shipping agents have begun to pass the cost onto their customers.

As an industry that normally has substantial import and export transactions, the automotive industry, particularly companies in the auto parts business, would do well to anticipate increased international logistics charges from their forwarding and shipping agents. This could mean that auto industry companies should take a fresh look at their existing supply chains and seek to optimise existing transaction flows, and work together with their forwarding companies and shipping agents to minimise VAT costs.

Lastly, though not a new measure, the foreign exchange regime in China has often posed challenges for both foreign and domestic entities that conduct international transactions. Moreover, attempts to overcome difficulties in remitting money abroad with changes to contractual terms can also result in unintended tax consequences. Although these difficulties are encountered by all participants in the automotive industry in China, this issue is of particular relevance to auto parts manufacturers that seek compensation from their customers (for example, auto original equipment manufacturers (OEM) or higher-tier auto parts manufacturers) for the cost of developing or purchasing the moulds required for production.

The foreign exchange regime in China makes it difficult for Chinese auto OEM or auto parts manufacturer customers to make such payments to a foreign entity since there is no actual physical importation of the moulds into China. One solution that has been employed to circumvent these foreign exchange restrictions is for overseas suppliers to incorporate the cost of the moulds into each unit price. However, this can cause the unit price of the products to fluctuate substantially, particularly where suppliers seek to recover the costs earlier rather than evenly over a period of time. Moreover, such an arrangement also makes it difficult to justify any transfers of the legal title of the moulds.

Alternatively, PRC customers should consider settling the payment as a form of compensation for mould R&D expenses or rental expenses with overseas suppliers, which should minimise the unit price fluctuations. Under this alternative, though the settlement of compensation in the form of service fees overseas may be relatively straightforward under the newly promulgated foreign exchange regulation Circular 30 (as only a simple referential filing with tax authority is required before the settlement for single payments of more than $50,000), additional taxes such as CIT and VAT or BT may apply on such cross-border payment of R&D expenses.

It should be noted that similar tax and foreign exchange issues may also arise where the situation is reversed and foreign companies attempt to make the same payments to auto parts manufacturers in China. Conversely, where both the supplier and the customer are located in China, the credibility of the input VAT on the payment for moulds may be called into question if the moulds are not physically delivered to the customers.

In light of this, it is important for both parties to perform a full analysis of current arrangements and consider if an alternative structure can mitigate any identified tax and customs risks.

With the auto industry in mature markets such as Europe and Japan in decline for the time being, it is little wonder that the industry is looking to engage more with emerging markets. At the same time, the rapid upskilling and development of China's abundant workforce and growing demand from its increasingly affluent middle class has made it an attractive place for foreign auto companies to invest in.

The government has made innovation one of its priorities in its 12th Five-Year Plan, and it is certainly an opportune time for foreign auto companies, whose route to success depends in part on the success of new R&D, to take advantage of the incentives being offered.

On the other hand, the rise of the Chinese car industry has also attracted scrutiny from customs and tax authorities, keen to ensure that a fair share of the industry's success remains in China. The topics discussed here are only a sample of the common issues faced by auto companies in China; other questions on consumption tax, permanent establishment exposure and transfer pricing rules also regularly challenge the auto industry. As an industry sensitive to changes in the regulatory environment, changes in these areas need to be closely monitored by companies.

Biography
		William Zhang Tax Partner KPMG China 50th Floor, Plaza 66 1266 Nanjing West Road Shanghai 200040, China Tel: +86 21 2212 3415 Fax: +86 21 6288 1889 Email: william.zhang@kpmg.com William Zhang has been providing China business, tax and regulatory advisory services for various multinational companies since 1997. He has assisted many multinational companies in making investments in China and has extensive experience in serving clients engaged across a wide spectrum of industries. William's experience includes assisting multinational companies in formulating expansion strategies into China; setting up and structuring their business operations in China; fulfilling relevant registration and filing requirements to the stage of working out practical solutions to various tax issues; and exploring possible tax planning ideas for clients. In particular, William has advised many multinational companies engaged in the industrial and consumer markets (including the electronics industry, home appliance manufacturing, auto and auto components, and chemistry) on their day-to-day operations, including performing tax health checks to identify non-compliance tax issues and tax planning opportunities; performing tax due diligence work; and providing tax restructuring advice for M&A activities, and advising on tax efficient investment and exit strategies.

Biography
		David Ling Tax Partner in Charge of Northern China KPMG China 8th Floor, Tower E2, Oriental Plaza 1 East Chang An Avenue Beijing 100738, China Tel: + 86 10 8508 7083 Fax: + 86 10 8518 5111 Email: david.ling@kpmg.com David Ling is the China tax partner in charge of the Northern China tax practice. David joined an international accounting firm in the US in 1992 after obtaining his master's degree in US taxation. He transferred to China in 1993 and has worked in the Hong Kong, Beijing, Shanghai and Shenzhen offices. He became a tax partner in 2002 and joined KPMG's Beijing office the same year. David has extensive experience in China tax planning and tax negotiation with counterparties. His expertise includes advising foreign companies in establishing operations in China, particularly in the establishment of investment holding companies and foreign invested trading companies. He also has extensive knowledge of China Customs regulations, foreign exchange control policies, and other regulatory regulations. David has long-standing relationships with various Chinese authorities including the Ministry of Commerce, the State Administration for Industry and Commerce, the State Administration for Foreign Exchange, Customs and the tax authorities at both central and local levels.

Biography
		Sam Fan Tax Partner KPMG China 9th Floor, China Resources Building 5001 Shennan East Road Shenzhen 518001, China Tel: +86 755 2547 1071 Fax: +86 755 8266 8930 Email: sam.kh.fan@kpmg.com Sam Fan started his tax consulting career in Hong Kong in 2001. In 2003, Sam relocated to Shenzhen to focus on China tax advisory. With more than 12 years in the Southern China region, Sam has extensive practical experience. Sam provides China tax compliance and consultancy services to multinational companies. He also advises clients on taxation and business regulatory matters relating to their initial investment, ongoing operations as well as their holding/funding structures of Chinese business entities. Sam has also been involved in a number of due diligence projects in different sectors, including consumer markets, infrastructure, mining and manufacturing. He focuses on regulatory and tax structuring aspects of various inbound M&A transactions and foreign direct investments in the PRC. Sam specialises in the trade and customs areas. Sam provides customs advisory services in relation to processing trade, customs valuation and classification. He has extensive experience in handling customs audit cases for clients.