CHINA has decided to adopt a flexible approach on value added tax (VAT) refunds owing to a mounting backlog that is depleting state coffers and hampering exporters' cash flow. In a circular issued in mid-June by the State Council, China formalised the unofficial practice of 'offsetting', which allowed the VAT payable for domestic sales to be offset by VAT rebates on exports. The circular announced a three per cent cut on VAT rebates on exports beginning on July 1. But there are doubts as to whether the new offsetting policy will be implemented effectively. Although the new rebate rate has theoretically been in effect for more than a month, the State Administration of Taxation (SAT) and the Ministry of Finance have yet to release details of its implementation. A SAT official said the implementation of the new rule would be flexible at local levels, depending on the amount to be refunded. 'If it is substantial, we might have to refund the exporter every one or two months. But we can wait for a few months before offsetting the rebates, if the amount is small,' the official said. Offsetting is seen as a better practice than holding up the rebates. As exporters are required to pay VAT each month, the backlog of refunds will put a heavy interest burden on the authorities. Exporters not only stand to lose interest on their money held by the tax authorities but are also faced with cash flow problems. Besides, they could stand to suffer should they need to take loans. For the tax authorities, clearing up the backlog poses a problem. Although the state has assigned a quota to each city for tax refunds, central and local government officials admit it is difficult to spare such large amount of cash. While offsetting might be a way out, problems linger regarding the calculation of the share of local and central government revenues. Under the VAT system, a quarter of the VAT collected goes to local governments and the state takes the rest. But SAT is responsible for making the full refund. Consequently, SAT local offices must fork out 25 per cent in refunds, collected by regional authorities besides the 75 per cent collected by the central government. However, the amount usually adds up to more than 25 per cent because of widespread tax evasion and forged invoices. The circular also stated that the refunds would be made directly to export manufacturers instead of to export agents. Consequently, manufacturers will not have to rely on the goodwill of export agents to secure their refunds. The circular also stated that refunds would be granted with foreign exchange documents. Therefore, if the goods are sold in the domestic market, they would not qualify for tax rebates. The circular also specified that large exported machinery would be eligible for VAT rebate if the contracts for them were signed before July 1. Critics are however concerned that the VAT might dampen exporters' incentive to source domestic raw material which are subject to the tax. But the crux of the VAT issue is how to implement the complex tax system that involves so many parties in various parts of the country. Hong Kong accountants said SAT was considering whether it should pass on some of its tax collection duties to regional tax bureaus so that it could concentrate on the implementation of the VAT. But such a move might defeat the purpose of the tax reform, of marking a distinction between the state and regional tax bureaus. Another issue hampering the implementation of the VAT is the problem of fraud. A local tax official once said: 'Fake invoices are not problems and I don't think it is difficult to distinguish them. 'But the headache is the forgery amounts on genuine invoices.' Guangdong tax bureau is reported to have launched an annual registration of VAT payers to clamp down on forgery invoices. Another tax official said VAT could best be implemented through computerisation of tax bureaus across the country, which started this year.