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Why does my supplier fight a move from FOB to EXW terms? What role does VAT play?

by Mike Bellamy

Question to our mailbag:

I am the inventor, importer and distributor of a proprietary electromechanical device that is sold in major retailers across Europe and the USA. A few years ago, I appointed a primary vendor (contract manufacturer) in China to perform the final assembly. He sells to me under “FOB China Port” terms. I worked with the primary vendor to identify and qualify the various sub-suppliers for every line item in the BOM (Bill of Material). The primary vendor implied that I would have transparency at the BOM level in terms of sub supplier identity and pricing. In the beginning I was given a list of sub-suppliers and their delivery price to the primary vendor.

Things were smooth at first, but now I am experiencing quality fade with each order. After intense discussions, the primary vendor promises to get their act together. But I have my reservations. I have recently set up my own office in China to consolidate the orders from various suppliers of various products, including this new primary vendor. My office has the import export rights and is licensed to collect the VAT rebate upon exportation. As mentioned above, originally the primary vendor was selling to me under FOB terms. Thus they were the exporter of record and factored the VAT rebate into their price to me. But now that I have my own office set up in China, I want them to sell to me under ExW terms and I will be the exporter of record and process the VAT rebate on my own. 

Because I have doubts that the primary vendor will actually solve the quality problems, I would also like to explore the costs of doing the final assembly under my roof in China and remove the primary vendor from the project. This would mean dealing with the sub-suppliers directly. When I ask them for pricing information they are not very forthcoming. And trying to get the primary vendor to quote ExW rather than FOB is like pulling teeth.

In my mind, the sub-suppliers would be making the same amount of money if they sell direct to me or to the primary vendor. What is the big deal? What am I missing?

And it feels illogical to me that the primary vendor is so sensitive about me buying ExW from him, rather than FOB. I have even explained that I understand I need to pay a higher price for ExW because I will get the rebate later upon export, so in the end it should even out for all parties involved. So why is my primary vendor not willing to quote ExW?  I have a hunch it has something to do with VAT and/or hidden margins.

Thanks for your email and well laid out question. I was asked to provide an answer because I work for a contract manufacturer called PassageMaker which serves as a primary vendor doing final assembly in China. I have been in this role for almost 15 years and have helped a number of clients migrate their terms from FOB to ExW. I have also helped buyers set up direct relationships with their sub-suppliers when the previous primary vendor dropped the ball. Along the way I have dealt with every imaginable excuse from the suppliers as to why they can not do it. In every case, it can be done, but it is just a question of how much leverage does the buy side have over the supply chain and how deep the sellers have been operating in the gray area of Chinese tax law.

Here are my comments and suggestions based on my understanding of the situation you have described.

Why the lack of transparency in the supply chain?

VAT can be very tricky in China as the system is quite different from the system in other countries.  Also, the way the government calculates the rebate is not always intuitive (I will explain below). Perhaps the most frustrating part is that Chinese suppliers do not like transparency. Unless the buy side has a lot of leverage at both the supplier and sub supplier level, it is very hard to get to the truth without conducting research among outside suppliers for reference/benchmark.

Here are some of the reasons why:

  • Often there are kickbacks, accounting irregularities and lack of paperwork between the sub suppliers and supplier that make it very hard to the foreign buyer to get to the bottom of the true costs.
  • There can be kickbacks between exporter and tax authority to alter the VAT rebate rates and/or HS codes.
  • If that was not enough to drive you crazy, many suppliers run multiple sets of books. One for the tax man, one for partners/investors (that the factory wants to dupe) and one accurate set of books that only the owner himself sees!
  • Plus anytime that you want to change what a buyer may consider, “little things” (like having sub suppliers direct their delivery of components to a new final assembly location or asking supplier to quote “ExW with receipts” rather than “FOB port”) the suppliers in China will complicate matters by using this opportunity to adjust the relationship and/or renegotiate pricing to their favor. Usually the buyer does not realize that the ground is shifting under their feet. It is all smoke and mirrors when it comes to VAT in China.
  • The original exporter may or may not be exporting the product in a fully legal manner (in order to pocket some extra money, as explained in the overview of the system below).
  • When the primary vendor has a role in selecting the sub-suppliers, even if the primary vendor says things will be transparent, the primary vendor almost always steers the foreign buyer toward sub-suppliers that are either giving a hidden commission and/or are friends/ family of the primary vendor. BTW, it is a red flag if you are buying in Guangdong, but your primary vendor is originally from Hunan and so are all of the current sub suppliers!

In short, the suppliers are never going to tell a 3rd party (especially a foreigner) exactly how they really operate.  

My article “What is VAT and why should I worry about it? [pdf] [html]” gives an overview of the system. Generally speaking, when a client or prospect comes to my firm with a question like you have raised below, we would offer to conduct a VAT survey (service and price explained at http://www.psschina.com/services-and-pricing/value-added-tax-planning/). A proper survey takes about 45 days to complete when the supplier and sub suppliers are cooperative. Around 90 days when we have to do benchmarking outside on multiple BOM line items. But in the interest of getting you pointed in the right direction, let me share some key points.

First the bad news:

As I understand it, you are hoping to get a feel for what you should pay the sub suppliers if final assembly is moved away from the current primary vendor to a new location in China. Therefore you are also probably looking to get a feel for how much VAT rebate would be returned to the new exporter of record (which could be you or a new primary vendor).  In other words, you are looking for the “ExW with receipts” pricing on your BOM so that you can build up your cost/rebate models.

Unless your assembly partner is 100% honest and transparent, it will be very hard to complete this research from the bottom up. And even if you were able to get pricing at the BOM level, how could you be 100% sure it was accurate? You would still need to do benchmarking on each line item in the BOM to verify that they are being honest and to get an accurate going rate for that item under “ExW with receipts” terms.

But let us assume the sub suppliers gave you accurate “ExW invoice pricing”, you would also need to make sure you do your calculations for the VAT rebate at exportation correctly based on China VAT rules. At the risk of oversimplifying, here is an overview of how the export VAT rebate is calculated:

First, we calculate via two methods:

Method 1

The “export VAT rebate amount” = export value * the VAT rebate %

(note: “export value” = “FOB China port” rather than “CIF USA” for example)

        Method 2

When the factory pays for raw materials (BOM) they get receipts from the sub-suppliers which state the value of VAT paid by the sub-suppliers.  This is the “input VAT paid”. 

“Export Value” * (17% – VAT rebate%) = X

X is then subtracted from the “input VAT paid”

 Second, we need to compare method 1 against method 2.

If 1 > 2, exporter gets the amount found in method 2 from government If 1 < 2, exporter get the amount found in method 1 from government

As you can see, this discovery session can be complex, costly and time consuming.

Finally, the good news…

If I was in your shoes, I would simply ask all the sub suppliers to quote “ExW receipts”, then I would apply my best estimate of what the former final assembly partner was allocating for final assembly labor and domestic transport, then I would apply the rebate calculations (explained above) and get a feel for the FOB price (adjusted for VAT rebate based on the correct HS code). If the numbers are close to the original FOB price …great…problem solved. But if the numbers are way off, then somebody is being sneaky. So at that point, you rank your BOM in order from largest value to lowest and you go down the list doing research at a national level to find the going rate for that component in China under “ExW receipts” terms. You either switch sub-suppliers or you leverage the power of your information to get better pricing.

Conclusion

During my 15 years in China, even when I sat down to show suppliers and their sub-suppliers that I understand VAT and know exactly what they should be charging, never once have I had a supplier admit they were playing tricks with the taxes and fluffing the pricing. That would be a total loss of face for them. So they always come up with some kind of excuse why my understanding of the VAT system as it applies to their particular company is not fully accurate. You will be dragged down into a quagmire if you try to refute every excuse the suppliers give you. And if you do succeed in proving them wrong, they lose face and may not want to work with you.

So focus on the big picture. If you have done your homework correctly, you basically tell the sub-suppliers what price you can pay for their line item which allows you to hit the target the final product, adjusted for VAT rebate. If they do not meet that price, you find a new supplier. Do not get into a debate about the way the VAT system works, you ca not win this battle because often the suppliers are making up the “facts” as they go!

Thanks again for your question. Hope my comments help you get to the bottom of things. Best wishes on your China sourcing projects.


Question answered by Mike Bellamy, an Advisory Board Member & Featured Blogger at the not-for-profit China Sourcing Information Center. Mike is also the author of "The Essential Reference Guide to China Sourcing" and founder of PassageMaker Sourcing Solutions.

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