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Philip Robinson, Ernst & Young, UK
Philip Robinson is Global Indirect Tax Leader at Ernst & Young, UK
Doing business in new markets is not always easy. This article looks at the issues and opportunities which can occur in the rapid growth markets.
Since 2008, many developed economies have seen flat or negative growth rates. Multinational businesses have responded by transforming their supply chains to reduce production costs and overheads and to pursue growth in new markets. The emerging markets are not only attracting inward investment, they are also creating a new generation of global traders. As a result, despite the global economic downturn, overall levels of global trade remain high, and the mix of countries involved is constantly evolving.
Business models are also transforming as advances in technology are allowing new goods and services to be designed, manufactured and delivered in new ways.
Indirect taxes apply to every stage of the supply chain not only for goods but also for services. Managing these taxes - to reduce costs and avoid errors that lead to penalties and business disruption is crucial to maintaining profitability. But doing business in new markets is not always easy. Keeping pace with rapid business developments, changing supply chains, and unfamiliar local laws and practices creates complexity and risk, which can be difficult to manage. The result can be higher indirect tax costs and elevated indirect tax risk. But opportunities do exist to improve indirect tax performance in these circumstances to sustain growth.
Rapid Growth Markets (RGMs) offer a variety of tax and business incentives to attract investment in specific regions and areas of industry by offsetting the cost of taxes and other investment activities, or by providing financing at favourable rates. Economic incentives are generally used to encourage job creation, capital expenditure, research and development (R&D), and the sustainable sourcing of energy. As RGM economies develop, they are also transforming the activities that they undertake, with many moving up the value chain away from low-cost manufacturing to focus on innovation.
Given their diversity and availability, a wide variety of companies can use incentives to reduce costs and negotiate packages that meet their needs. However, companies need to evaluate the incentives that are available in a location carefully, as some may be difficult to obtain or may prove less attractive in practice than others. Compliance also is an important consideration as the cost of complying with the terms of an incentive may outweigh the benefits or, once an incentive has been granted, the company may find it hard to comply with its terms in the medium- to long-term, leading to claw-back.
Companies that invest in RGMs may encounter unfamiliar indirect tax laws and obligations, but they are not always prepared to meet the challenges in the new environment. Lack of experienced indirect tax staff and opaque regulations further complicate companies' efforts.
As companies move into new markets, they often wish to adopt the business models, processes and practices that they have used successfully in other parts of the world. But local indirect tax rules may require them to adapt their plans for operating in unfamiliar territory. For example, although an RGM country may be a World Trade Organization (WTO) member, the customs authority may apply unfamiliar interpretations on the valuation or origin of goods, leading to additional duties, fines and delays. Similarly, the VAT/GST rate in a country may be relatively low, but the system itself may be highly complex or may be undergoing reform, so that there are high levels of uncertainty, leading to errors and risk. The increased use of technology to supply services cross-border is also challenging indirect tax legislation, leading to the risk of double taxation in some RGMs and non-taxation in others.
Decisions about new investments are rightly intended to obtain operational and financial benefits. Understandably, indirect tax considerations may not be at the forefront of an expanding company's planning process in these circumstances - despite the fact that the indirect tax treatment of its transactions, its compliance obligations and the customs regimes and incentives that it can use may be greatly affected by any changes and that failure to plan for these issues may hold up the project or greatly add to its costs. For example, processes such as VAT registration, that may be straightforward in advanced economies may be more complex and time-consuming in RGMs, leading to business delays, increased costs and poor cashflow if they are not managed proactively.
On the other hand, effective forward planning can help to enhance a company's return on investment. For example, acting early can allow companies to recover VAT/GST on set-up costs and to import equipment and goods without encountering delays. Most significantly, it can help to identify the best location to benefit from a range of tax and non-tax grants and incentives, for example, free zones that provide exemption from customs duties or that allow foreign-owned companies to operate.
As RGM economies develop, so do their indirect tax systems, leading to changes in VAT/GST, customs and grants and incentives that must be taken into account for day-to-day operations and for future plans. Some countries, such as China, India and Malaysia, are undergoing major system reform or are expected to do so. In others, such as Turkey and South Africa, their systems may develop in response to changes in business practices or in response to a rapidly developing economy.
Multinational companies need to anticipate the changes, evaluate their impact, react quickly and adapt their business models, processes and reporting systems accordingly. This is an ongoing process. But, being ready for change is vital to avoid costly errors and pitfalls and take advantage of growth opportunities.
Customs duties are taxes levied upon importation of certain goods into the customs territory of a country to raise state revenue or protect domestic industries from competitors from abroad.
Customs duties - unlike VAT/GST - represent a cost for the importer of the goods. A reduction of customs duties immediately improves the cashflow and costs of importing companies.
In most cases, customs duties are raised as a percentage of the customs value of the goods, but they may be levied on the basis of other parameters, such as weight or volume. In addition to standard customs duties, other duties as part of anti-dumping measures and countervailing measures may be levied on the importation of certain goods. These are intended to protect the home market against imported products being dumped on the market or benefiting from unlawful or dramatically different subsidies abroad.
In principle, the level of customs duties depends on the customs value, tariff code and the origin of the goods being imported. In order to identify the various types of goods, specific tariff (HS) codes have been agreed upon internationally to determine import duties (often expressed as a percentage). But the origin of the goods is also a factor. Many countries have agreed bilateral and even multilateral FTAs that call for reduced or zero-rate tariff duties for goods originating from a preferred trade partner. Furthermore, specific valuation methods have been agreed within the WTO to properly determine the value of the goods being imported. In most cases, the transaction value (price actually paid or payable) can be used as the basis for the customs value. As a result, any price adjustments after importation (e.g., due to transfer pricing changes) need to be properly reported to the customs authorities.
Imports of goods into RGMs include raw materials and components used in manufacturing, and for processing and finished goods imported prior to sale on the local market or for distribution to other countries in the region. The company representatives and Ernst & Young professionals that we spoke with for this report identified a wide range of customs issues related to importation in RGMs, including the following.
• Importer of record: In many RGMs (such as Argentina, Brazil, China and Turkey) non-residents cannot act as the importer of record. In others, while it is technically possible to have a non-resident importer, the non-resident importer cannot recover VAT paid at importation (e.g., Mexico and South Korea). Consequently, as a practical matter, if a non-resident wants to import goods (e.g., to undergo processing for re-export) in many cases, the company must establish a local presence, which may have other tax consequences. Restrictions also may apply to the companies that can export goods (such as South Korea).
• Customs brokers and import/export agents:Complex importation forms and local language requirements can make it difficult for non-residents to import goods without local assistance. Some countries require importing companies to use customs brokers to fulfil these requirements. However, over-reliance on third-party agents may significantly add to risk, and properly directing and monitoring the activities of the importer's agent can be expensive and time-consuming.
• International supply chains: Restrictions related to importers and exporters can have a negative impact on global supply chains using, for example, a non-resident principle company that owns goods that will be sold or will undergo processing in the RGM. Business structures and processes may need to be adjusted to comply with local RGM rules and achieve the desired tax and business outcome. Options may include, for example, the use of dual principle structure or the use of an agency structure instead of buy/sell structure for global procurement company.
• Supply chain costs: Customs costs and the costs and delays arising from meeting regulatory requirements may be hard to identify, but they erode profitability. Special preferred importer/ exporter programmes (such as The Approved Economic Operator (AEO) in Europe and the Blue Line programme in Brazil) can mitigate expense and speed up delivery times by as much as one week.
• Royalties: In some RGMs (such as Peru and Brazil), royalty structures that are commonly used by international groups of companies are treated as dutiable, adding to the landed cost of imported products. International groups of companies may reduce costs by designing a global structure that identifies the royalties for individual markets and components, to reduce the impact on dutiable values.
FTAs and relaxed national borders help to promote world trade. However, the “dark side” of more relaxed international trade is the potential for harmful goods and people to cross borders more easily. These concerns have been amplified in recent years by international terrorist threats and by wars and political unrest in areas such as the Middle East.
As a result, many countries impose very strict controls or prohibitions on the export of some goods and technologies to certain markets. These controls may apply to products (such as equipment that is used, or could be used, for military purposes) and to certain destinations (for example, countries that have experienced political instability or that are considered to be politically oppressive). Several RGM countries are subject to export controls, especially for goods exported from developed markets, such as the EU and US.
Companies that export affected products must ensure that they comply strictly with export restrictions and controls or they risk incurring penalties, seizure of their goods and even business closure and criminal sanctions. They need robust compliance processes to identify affected products and to obtain the necessary export licenses, documentation and approvals. These processes can be time-consuming and costly, but technology and automation can help to increase efficiency, improve compliance accuracy and reduce administrative costs.
Countries offer a variety of incentive programs to lessen the burdens associated with customs duties, which can take several forms, such as exemptions, reductions or refunds. Some exemptions are dependent on the location of an existing operation or new investment, such as free trade zones where companies are exempt from paying customs duties on the importation of capital goods into the zone. Other programmes are industry specific, for example, Brazil provides an exemption from import duties to software companies that derive at least 70 percent of their revenue from export transactions. Malaysia also offers an import duty exemption on raw materials and machinery for biotechnology companies.
Other programmes, such as India's Export Promotion Capital Goods (EPCG) scheme and Brazil's Ex Tarifário scheme, allow an exporter of goods or services to import capital goods at a concessional customs duty rate. Indonesia, India and several other RGM countries also offer a duty drawbacks programme whereby companies may receive a rebate of the duty charged on any imported materials used as inputs for the manufacture of goods that are exported.
Despite their increasing reliance on indirect taxes for revenue, many RGMs are creating or expanding rules applicable to special zones to encourage export-focused investments by reducing or eliminating taxes on certain goods and services. The operation and benefits of free trade zones vary among RGMs. For example, Colombia's free trade zones are increasingly popular with importers, and Mexico's well-established IMMEX program, allowing manufacturing under customs bond, employs an estimated 2.2 million workers. Turkey's free trade zones are similarly attractive, with benefits including exemption from a corporate income tax for manufacturing companies, exemption from customs duties and VAT, and exemption from special consumption taxes.
Rules in some countries seek to incentivise certain activities through the establishment of industry parks where companies are exempt from import duties on raw materials and machinery used for production. Malaysia, for example, has established 20 Halal industry parks for companies engaging in the manufacturing of Halal food and non-food items. India operates Software Technology Parks of India (STPI) where companies benefit from full customs duty exemptions on the import of goods used for STPI operations in addition to full excise duty exemptions on the purchase of goods from Indian manufacturers to be used for STPI operations.
These programmes offer three main benefits for investors. First, tax exemption reduces costs and improves profitability for companies that do business in designated areas. Second, exemptions from duties and VAT payments on imports also improve cashflow, especially for companies that export the majority of their goods. Third, simplified administrative procedures reduce the costs associated with compliance.
VAT/GST is a multi-stage tax on consumption that applies to the supply of most goods and services at each stage of production, distribution and sale. It also generally applies to imports of goods (without the need for a transaction). As a tax on “consumption”, VAT/GST is generally borne by the final consumer, but it is collected and remitted by business entities that charge VAT/GST on their sales (output VAT) and recover VAT paid on their business purchases and overheads (input VAT).
An increasing number of emerging markets are adopting VAT/GST in preference to single-stage sales taxes or a range of local sales taxes. In January 2012, China launched a VAT pilot scheme in Shanghai with a view of eventually replacing its BT and VAT with a broad-based GST throughout the whole country. India is also undergoing reform in this area, recently finalising its “negative list” for service tax bringing the introduction of a new, centralized GST one step closer.
VAT/GST is generally considered to be cost neutral for businesses (as they offset tax paid against tax charged). In reality, VAT/GST can increase costs for business in three main ways:
1. Irrecoverable VAT/GST paid on business costs and overheads.
2. Cashflow costs from financing VAT/GST payments.
3. Penalties and interest related to mistakes in VAT/GST formalities and reporting.
The mechanism of charging and collecting tax from non-taxable persons using VAT-registered businesses makes VAT/GST a highly cost-effective form of taxation from a government perspective, but it places a heavy burden on businesses. They must report and remit VAT/GST payable to the tax authorities on a regular basis (generally monthly for large companies) with 100 percent accuracy. However, this task is complicated by the fact that each country has its own system with its own rules about how, when and where tax is charged. Documentation and reporting requirements also vary greatly between tax jurisdictions
A number of RGMs apply single-stage consumption taxes at the national, federal and municipal level, such as China's Business Tax. These single-stage taxes may apply at any stage of the supply chain, including production, importation, distribution and retail sales. Multiple single-stage taxes may apply in some jurisdictions. The main business drawback of single-stage taxes is that they generally are not creditable or available for offset, which means that they may add to the cost base. For goods that undergo multiple processes, single-stage taxes may apply at multiple stages, creating a cascading effect (as taxes paid at an earlier stage form part of the taxable base) that leads to very high effective tax rates.
Countries offer a variety of incentives to alleviate the burden associated with single-stage consumption taxes. For example, South Korea, as a part of its foreign direct investment (FDI) incentive package, offers qualified high-technology enterprises various incentives including a 100 percent exemption of local taxes for the first five years of operations and a 50 percent exemption for the following two years. In addition to this incentive, South Korea also offers these companies a consumption tax exemption on qualified imported capital goods.
VAT/GST generally applies to imports of goods at the time of importation. The amount due is generally based on the customs value and the tax is levied at the time of importation. VAT-registered taxpayers recover VAT/GST as input tax. The company representatives and Ernst & Young professionals that we spoke with identified a wide range of VAT/GST issues related to importation in RGMs, including the following:
• Multiple import taxes: In countries that impose state, local and federal consumption taxes (such as Brazil and India), several layers of consumption tax may apply to the importation of goods. Not only does this add to the administrative burden, it may increase the cost of goods as not all of the taxes imposed as importation are available for recovery or offset. In Peru, business importers have to pay an advance VAT in addition to customs duty and VAT on the imported goods. The VAT is an advance payment for the tax due on the later sale of the goods in Peru. The rate of advance VAT depends on whether the goods are new (3.5 percent), or used (5 percent) and on whether the goods are imported by a first-time importer (10 percent). The advance VAT payment is offset against the output tax due when the goods are sold. Although advance VAT is not an additional cost, it does have a negative impact on cashflow.
• Importer of record: As with customs duties, the fact that many RGMs do not allow non-residents to import goods has an impact on international structures. If a company establishes a local presence, VAT/GST registration and reporting obligations will also apply.
• Irrecoverable VAT/GST: Apart from the Czech Republic and Poland, none of the 25 RGMs listed in this report allow non-residents that are not established in the country to recover VAT/GST. Therefore, even if the RGM allows non-residents to import goods, it may not allow them to recover the VAT/GST charged on the import or on related local costs. Irrecoverable VAT/GST increases the cost of the goods, and given that VAT rates in some RGMs exceed 15 percent, this cost may eliminate the profitability of the structure, so that an alternative needs to be found.
• VAT recovery by residents - cashflow impact:In most RGMs, VAT/GST on imports must be paid at the time of importation to clear the goods through customs. As the input tax may not be recovered for several months, companies that import large quantities of goods, for example in a set-up period, or that are also frequent exporters may suffer severe cashflow impacts.
However, some RGMs (such as the Czech Republic) allow resident taxpayers to import goods without payment of VAT/GST at the time of importation. Instead, they account for the VAT/GST due on their periodic return, recovering the VAT/GST at the same time. This facility is sometimes referred to as “postponed accounting.” Although this facility may appear to impair the cashflow position of the customs authority, its availability can be highly beneficial to the overall economy, as multinational companies are increasingly looking to plan their trade routes to benefit from postponed accounting on importation where it is available, using those countries as a hub for regional distribution.
Many RGM economies rely heavily on exports of goods. VAT/GST does not generally apply to exports of goods, but VAT-registered taxpayers can recover VAT/GST on the purchase or import of the goods as input tax.
The company representatives and Ernst & Young professionals that we spoke with mentioned the following VAT/GST issues related to exporting goods from RGMs:
• Documentation: The VAT/GST treatment of a sale as an export -- no VAT charge but related VAT recovery, generally depends on proof that the goods have been exported and have not been sold on the domestic market. The documentation that is required varies between countries -- it may include customs documents, contracts, evidence of foreign exchange transactions, transport documentation and invoices. Multinational companies need to be aware of the local requirements and need to be able to provide the evidence to local tax authorities.
• VAT assessed on exports: Export sales represent a major area of VAT risk. If a VAT taxpayer cannot prove that the sale qualifies for export, the tax authorities may impose VAT/GST on the sale and may levy penalties and interest on the amount of tax they have assessed as due. This VAT/GST is likely to reduce the profitability of the sale as it can rarely be passed onto the foreign customer (who would, in any case, not be able to recover it and who would also have had to pay VAT on the same goods in the country of import).
• VAT “leakage”: Full input VAT recovery for exported goods is not a universal feature of the RGM consumption tax systems. In China, for example, exporters must calculate a VAT recovery percentage using a complex formula which may result in an automatic element of VAT cost.
Companies in the Czech Republic and Poland that sell to and buy from other EU countries need to account for these sales and purchases using the EU rules on intra-Community trade. Although these movements of goods do not attract customs duties or customs formalities, special VAT rules and reporting requirements do apply. In general, the system is straightforward and permits goods to be sold and purchased crossborder between businesses without payment of VAT, which can represent a major cashflow advantage in Poland, for example, compared with importing goods from outside the EU with VAT payment.
However, certain operational business models can create difficulties for intra-EU trade, including holding call-off or consignment stocks in a country where the supplier is not resident and chain transactions involving multiple legal changes in ownership of goods with physical delivery from one party in the chain to a later party in the chain (for example, parties ABC are involved in the sale, and delivery takes place from A to C). The EU has simplification rules for these situations, but their scope and implementation can vary between Member States. In addition, the rules do not deal with chains involving multiple parties, which may be common in industries such as oil and gas. Uncertainty may also arise relating to the treatment of chains involving intra-EU transactions and non-EU trade (for example, a sale from EU supplier A to another EU business B for sale to non-EU customer C with delivery directly from country A to C).
Most VAT/GST systems apply tax to supplies of services as well as to the provision of goods. This is one reason that VAT/GST has proved popular in many parts of the world as it allows consumption taxes to apply to a far wider tax base than many single-stage sales taxes have done in the past.
Until the late 20th Century, most services were rendered by service providers who were geographically close to their customers, so that VAT was charged by the supplier. Most “international” services related to discrete areas such as transportation or the international movement of goods or to the “management” services supplied by multinational companies to sister companies and subsidiaries.
But that situation has long since changed. Advances in technology have led to a rapid proliferation in services that can be supplied cross-border to both business and private consumers. They include telecommunications, data streaming, file sharing, computer gaming and cloud computing. This rise in the global trade in services presents several challenges to VAT/GST systems in all parts of the world, leading to the risk that cross-border services may be taxed twice (both in the supplier's and the customer's country), or not at all.
Tax authorities all over the world are struggling with how to charge consumption taxes on Internet downloads and cloud computing services. WTO members have agreed not to impose customs duties on electronic transmissions pending completion of a comprehensive work program. However, imposition of other indirect taxes is not restricted. The move to tax these services has been led by the EU. For several years, EU businesses have accounted for VAT on these services using the reverse charge and non-resident businesses have been required to account for VAT on B2C supplies to EU private consumers. Legislation in this area has been announced recently in South Africa, although the details are not yet clear. The Turkish Ministry of Finance has also recently announced its intention to ensure that tax is applied to the growing number of Internet downloads to private consumers. Other countries, such as China and India, have also been struggling to apply old consumption tax systems to new business models, and this difficulty is one of the spurs toward adopting new VAT/GST systems that tax services more broadly.
We hope that any new rules will not only protect RGM countries' revenues, but that they will also be clear and allow non-residents and their customers to comply with a minimum of additional administration. However, past experience indicates that this goal may be difficult to achieve, creating cost and compliance burdens for cross-border suppliers as they seek new markets.
Philip Robinson is Global Indirect Tax Leader at Ernst & Young, UK. He may be contacted by email at firstname.lastname@example.org
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