Firms in levies recovery dilemma
CHINA companies listed in Hong Kong and the mainland's tax authorities are grappling with a problem linked to whether levies on inventory made last year are recoverable.
Crosby Securities points out that the problem arises out of a change in tax regime with the scrapping of a sales tax, the Industrial and Commercial Consolidated Tax (ICCT) and the introduction of a new Value Added Tax (VAT).
Investors should be aware of the distorting impact these tax arrangements can have in boosting profits.
This change, on January 1, 1994, resulted in a one-off payment made under the old tax regime. This was left in the accounts as a deferred receivable in the accounts.
Under the old regime the sales tax went through company profit and loss accounts and was recorded in sales and purchases.
The old tax varied between 3.03 per cent and 5.05 per cent. The new VAT of about 17 per cent does not appear in the profit and loss account in line with similar tax regimes in the West.
'If a widget was not yet sold at December 31, 1993, the ICCT would be included in the opening value of inventory at January 1, 1994,' said Crosby.
With the agreement of the State Tax Bureau, a deemed amount of VAT was created on opening inventories.
This deemed VAT was actually the old sales tax paid.
The deemed VAT could be transferred from the carrying value of stock to a VAT recoverable account, a debtor account. 'When the widget is sold it is then the net amount that is transferred to cost of sales,' said Crosby.
Under the Grandfather Rule, netting off can cause a credit to the profit and loss account, boosting profits or reducing losses.
Under rules for Foreign Investment Enterprises (FIEs) a special dispensation was made in which firms were paying more VAT tax than the old sales tax. This dispensation will last until December 31, 1998.
Apparently Qingling Motors will qualify for such credits and so will most FIEs.
'This may explain why some China-related businesses have recorded margin expansion in recently published results. While this may be a recurring benefit for the next five years, we are concerned that the Chinese authorities will not continue to offer this benefit,' said Crosby.
If the arrangement is cut margins will contract. 'We are also concerned that the refund, if any, can distort the analysis of a company's core profitability,' said Crosby.
For some firms the amount transferred from inventory to the deemed input VAT has been larger than the original ICCT suffered when the inventory was bought.
So when the inventory is sold at market prices an apparent rise in profit margin is recorded.
Investors also need to be assured of the recoverability of the deemed input VAT.
Offsetting arrangements rely on the January 1, 1994, inventory to be sold. If inventory falls then the January 1, 1994, inventory is deemed to have been sold.
If inventory is not sold because of poor sales or grows because the company might be expanding the offsetting arrangements might not be utilised. 'In these circumstances, the realisation of the deemed VAT is very questionable,' said Crosby.