Value-added tax fraud is booming in China. As Ren Wei explains on the front page of today’s Business Post, a thriving industry has grown up around diddling the VAT man, with mainland businesses buying and selling illicit VAT invoices in order to minimise their tax payments and maximise their profits.
The scale of the racket is enormous. According to one recent estimate, more VAT revenue is lost to fraud than is actually collected by the government. Considering that VAT is now Beijing’s biggest single source of tax income, that’s a swindle of gargantuan proportions.
The scam is so big, you could even say VAT fraud is China’s national sport. But cheating the mainland taxman isn’t solely a domestic game. Indeed, if VAT fraud is really the national sport, then Hong Kong, not the Bird’s Nest in Beijing, is China’s true national stadium.
The fiddle works because of the favourable treatment that foreign-invested companies enjoy on the mainland. Although the authorities have been working hard to eliminate foreigners’ tax breaks over recent years – Beijing unified the corporate income tax regime in 2008 and began collecting urban maintenance and education taxes from foreign companies just last month – when it comes to VAT, the playing field is still tilted heavily in favour of foreign-invested companies.
To encourage inward investment, local governments offer foreign companies a wide range of VAT exemptions and rebates. Some allow foreign-invested enterprises to import capital goods VAT-free. Others give rebates to foreign companies buying locally-made machinery. High technology companies in Shenzhen, for example, can enjoy VAT rebates of up to 50 per cent.
That’s a significant advantage. According to a study by Hung-Gay Fung, Jot Yau and Gaiyan Zhang in the January edition of the Journal of International Business Studies, the average mainland-funded business pays an effective VAT rate equal to 8 per cent of its sales revenues. In contrast, the average foreign-invested enterprise pays an effective rate of just 3 per cent. That makes it well worthwhile to be classed as a foreign-invested enterprise.
Of course, many business executives don’t want to bring in real foreign investors, with all their tedious insistence on transparency, compliance and honest accounting. That would be far too much hassle.
Happily for them, there is a convenient way around the problem. Mainland companies simply understate the export revenues they declare to the authorities, allowing them to retain money offshore. Alternatively, they overstate the cost of the goods they import. Either way, they accumulate a pot of money offshore, usually in Hong Kong.
The two charts below from Fung and his co-authors give an idea of the size of fiddle. Correcting for trans-shipments, the first shows the mainland’s exports to Hong Kong as declared to the authorities, compared with Hong Kong’s actual imports from the mainland. The second chart shows the difference between China’s official imports from Hong Kong and Hong Kong’s actual exports to the mainland.
Between 2000 and 2004, the combined cumulative gap came to some US$180 billion.
The money didn’t stay in Hong Kong. Most of it was immediately channelled back into the mainland in the guise of foreign direct investment, allowing the recipient companies – now classed as foreign-invested enterprises – to enjoy a host of benefits including lower land fees, favourable trade tariffs and, of course, that hefty VAT advantage.
Tax fraud isn’t the only motivation for round-tripping cash in this way. By understating their export revenues (or overstating their import bills), booking the proceeds offshore and then channelling them back to the mainland as inward investment, managers at state-owned companies are effectively siphoning off state assets into their own pockets. Not surprisingly, state companies are reckoned to be the biggest offenders when it comes to misreporting trade figures.
Despite repeated attempts to crack down on the scam, the fraud continues unabated. Over the first 10 months of last year, the mainland attracted US$82 billion in foreign direct investment. Of that, US$45.7 billion – almost 56 per cent – came from Hong Kong. Some of that was genuine investment.
But according to one estimate, as much as US$33 billion consisted of Chinese money illicitly round-tripped through Hong Kong back into the mainland to exploit VAT breaks.
So although Hong Kong may be suffering doubts about its future as China’s premier financial centre, its position as the mainland’s pre-eminent tax fraud facilitator is clearly unchallenged.