Customs and Export Control in China by Bundesverband der Deutschen Industrie e.V.

POSITION | FOREIGN ECONOMIC POLICY | CUSTOMS

Customs and Export Control in China. Legal Certainty and Business-Friendly Conditions: A Necessity Requirements Regarding Customs Inspections and Export Control Classification in China from the Perspective of German Industry

August 2020 Introduction 23. Oktober In the context of customs audits in China, there is currently no legal certainty regarding 2017 international World Customs Organization (WCO) or World Trade Organization (WTO) standards in China from a customs valuation perspective. Chinese subsidiaries of German enterprises are increasingly confronted with disproportionate demands for evidence and, in part, incomprehensible interpretation and tax assessment practices in the context of customs audits in China. In addition, the Chinese export control law is currently in the legislation process, which causes uncertainty for economic operators. Summary The Chinese customs authorities have been intensively examining customs valuation issues. A standardized procedure has been defined with regard to audit methodology, interpretation practice and duty determination for customs valuation in China. On the basis of the following examples, we consider the risk to be very high that, despite a comparable legal basis in China, the interpretation of certain facts may deviate from the usual assessment practice of WCO/ WTO standards and manifests itself for the future. For this reason, the following requirements for the audit behavior of the customs authorities in China are a fundamental prerequisite for the future activities of German companies in China. An improvement of the associated framework conditions is of central importance. ▪

The customs valuation should take current market conditions into account and accept the prices actually paid.

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Customs authorities should accept standard commercial practices to substantiate the order.

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The principle of proportionality should be respected when requiring evidence. Certificates from independent third parties should be accepted as evidence in the formation of transfer pricing.

Customs and Export Control in China. Legal Certainty and Business-Friendly Conditions: A Necessity

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When determining gross margins for customs purposes, transparent determination and timely communication should take place.

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The customs valuation of royalties should be examined in accordance with WCO/ WTO standards. Contractual content and written comments from third parties should be accepted as evidence.

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The customs valuation should consider the relevant WCO comments on indirect payments and accepted guarantee costs.

Background A key basis for determining customs duties is the so-called customs value for imported goods. In this context, the WTO has defined international standards on the costs to be taken into account for customs valuation. Based on this, China has also formulated a national customs valuation law. In the event of a customs inspection, the respective national customs authority will check whether the customs value requirements are being complied with by the importing company. In the course of the current customs audits at various companies in China, it can be ascertained that the procedure of the Chinese customs authorities – in terms of legal interpretation and inspection procedures and the associated acceptance of the evidence provided – differs from the approach of customs authorities of other countries. This leads to incalculable risks for the Chinese subsidiaries.

Facts and Appeals The following examples delineate the relevant facts and resulting general requirements for customs inspections as well as export control lists in China. 1. Assessment of Common Commercial Practices Generally accepted commercial practices are placed in a customs valuation context. This leads to the fact that, according to general assessment, facts not relevant to customs value are included in the assessment basis for customs duties. Example 1: The authority establishes the idea that the same goods are always sold at the same price for all customers and all markets, regardless of the number of units and the time of sale. They do not recognize different prices due to economies of scale, rationalization effects and free negotiations with different customers/ partners for instance due to the different market power of different customers. Appeal: Current market conditions (e.g. customer and country specific price differences, price fluctuations etc.) should be taken into account and accordingly the prices actually paid should be accepted. It cannot be assumed that the same goods will always be sold at the same price to all customers and all markets, regardless of quantities and time.

Customs and Export Control in China. Legal Certainty and Business-Friendly Conditions: A Necessity

Example 2: Contrary to common belief, the following actions are currently considered as a transfer of know-how relevant to customs value: ▪

The issuance of a specification sheet (character of a “wish list” and not a “construction manual”) with requirement criteria when ordering a machine without passing on manufacturing know-how.

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The issuance of a drawing/ material specification for the order of standard materials/ catalogue goods to specify standard measures or other quality assurance features without passing on manufacturing know-how.

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Change of dimensions/ measures Supplier has DIN screws M4*25mm in standard offer. M4*23 mm screws are ordered.

Appeal: Customs authorities should accept customary business practices to specify orders, allowing the possibility to make available specifications and specifications without IP. Accordingly, this should not be considered as transfer of manufacturing know-how for customs purposes without making any distinction. 2. Influence on Prices Through Affiliation Particularly in the case of purchases from affiliated companies, the correct calculation of the customs value of imported goods is regularly questioned. From a customs valuation point of view, it is crucial that the relationship between the seller and buyer of the goods has not influenced the price of the goods. This is ensured by compliance with the OECD standards, which follow the “arm’s length principle”. Example 3: As part of customs audits, companies are required to provide appropriate evidence. In this context, the respect of the principle of proportionality is of great importance. Currently, the Chinese customs authorities regularly request evidence of the correct transfer pricing at item number/ transaction level for the entire import volume of affiliated companies. With a high import volume and a significant number of part numbers, this can translate to years of manual checking on the company side. Furthermore, these verifications are only accepted to a limited extent, as they are created by the company itself. If independent certificates are presented (e.g. by external auditing companies), companies are faced with the requirement to have the correct TP and thus customs valuation for their complete import volume from affiliated companies verified by independent certificates on a case by case basis. Appeal: The principle of proportionality should be respected when requiring evidence. Certificates from independent third parties, such as opinions from external audit firms, in compliance with OECD standards should be accepted as evidence in transfer pricing.

Customs and Export Control in China. Legal Certainty and Business-Friendly Conditions: A Necessity

Example 4: In the context of imports from companies, in the case of particular industries the Chinese customs authorities also question whether there is any price influence due to affiliation. To investigate this matter, the Chinese customs authorities have been setting permissible gross margins for Chinese importers themselves since 2014. In our opinion, the procedure described below is not transparent and does not comply with WTO rules. Once a year, the Chinese customs authorities retrospectively determine the gross margins of all importers in certain industries in China (affiliated and non-affiliated companies, of which the affiliated companies are by far the majority) by means of a so-called “pricing investigation” and then set a range of “permissible” gross margins. If importers’ gross margins are below or within this range, the transaction values are recognized. If they are above the range, the transaction values are considered to be influenced – and therefore too low – until proven otherwise by the importer. Counterevidence of noninterference even if theoretically possible, can hardly be provided in practice and is hardly recognized by the authorities. We have the following serious reservations about this approach: ▪

The “permissible” gross margins are generated from a pool of largely related importers. Since the determination of margins is fundamentally different from the transfer price perspective (RoS determined from benchmark studies with only non-affiliated companies), there are logical conflicts here; a result that is appropriate from a tax/ TP perspective may still be too high from a customs point of view.

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The “permissible” gross margins are determined by customs in a non-transparent procedure (there are no studies by external consultants as in TP).

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The “permissible” gross margins are not announced in advance at the beginning of a planning period so that the margins/ prices can be controlled accordingly, but only after a closed period, when the corresponding imports have taken place.

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Whether or not an importer is confronted with a “pricing investigation” depends from year to year on the results obtained by other market participants. This means that even a conservative gross margin achievement may retrospectively be considered too high, if poor results of numerous other importers push down the margin average.

Appeal: The determination of gross margins for customs purposes by the Chinese customs authorities should be transparent, communicated timely (one quarter of the lead time) and be coordinated with the tax authorities. 3. Reference of Special Payments/ Offsetting on Imported Goods In the case of imports of goods in general, the question arises as to whether the price of the goods is complete at the time of import or whether the buyer of the goods has incurred further costs (e.g. development costs, license fees, etc.) which relate to the imported goods but are not included in the price of the goods.

Customs and Export Control in China. Legal Certainty and Business-Friendly Conditions: A Necessity

Example 5: Following WTO customs valuation rule on royalty payment, China Customs introduced their local customs valuation rules according to which the royalty fee is dutiable only when both of the below conditions are satisfied: 1) the royalty fee is related to the imported goods; 2) the payment of the royalty fee is a condition of the goods sold into China. However, the interpretation of the above rules by the Chinese customs authorities is not in line with the WTO customs valuation principle. Appeal: In assessing whether the paid royalty fee is a “condition of sale” for the goods imported by the licensee to China, China Customs should accept as evidence the contractual basis of the concrete transactions in question. Example 6: If the importing Chinese legal entity is subject to royalty payments, the question arises whether these payments relate to imported goods and are therefore customs value-relevant. As part of the checks carried out by the Chinese customs authorities to determine whether licenses paid are related to imported goods, ▪

a detailed price breakdown of imported parts and components is often requested. However, according to international customs law, price breakdowns are not decisive in determining whether there is a link with the imported goods. A written statement by the manufacturer that the goods were sold at full cost plus a certain profit margin is insufficient according to the Chinese customs authorities. We are critical of the sending of detailed price breakdowns from the company’s point of view and on the basis of existing antitrust law.

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it is intended that all imported goods should indicate for which goods technology or patents are embodied, irrespective of the requirement of licenses for those technology or patents. The compilation of such lists is very costly and disproportional for large import volumes, considering that on the basis of international customs law, this information is not relevant for indicating whether or not licenses are related to imported goods.

Appeal: The customs valuation of royalties should be examined in accordance with WCO/ WTO standards. Contract contents and written comments from third parties should be accepted as evidence. The principle of proportionality should be respected when requesting evidence. Example 7: The Chinese unit bears costs for extended warranties (due to national regulations in CN) and for compensations as a gesture of goodwill. According to WCO Commentary 20.1, these are not relevant for customs value. The Chinese customs authority is generally of the opinion that these costs are relevant to customs value.

Customs and Export Control in China. Legal Certainty and Business-Friendly Conditions: A Necessity

Example 8: In the replacement of a defective component in case of warranty by local retail company, the local retail company will be reimbursed for this by the Chinese wholesale distribution unit. The Chinese wholesale distribution unit is reimbursed for its acquisition costs by the principal in the third country under the guarantee agreement. The difference between the reimbursed acquisition costs and the reimbursement to the retail company (local sales price of the Chinese unit to retailers) is usually borne by the Chinese unit. According to the Chinese customs authorities, this difference in value is relevant for customs valuation. Appeal (for examples 7 and 8): The customs valuation should take the relevant WCO comments on indirect payments and guarantee costs covered into account: As discussed in example 7, according to WCO Commentary 20.1, extended warranties are not relevant for the customs value of goods. Accordingly, replacement deliveries should neither increase the customs value nor should they be charged with customs duties a second time when duties have already been charged for the initial deliveries. 4. Tariff Classification-related Issues Generally, companies pay special attention to the classification of goods and the use of correct tariff codes for imported and exported goods. A uniform application of tariff classification provisions worldwide provides a business-friendly environment and contributes to mitigating errors that have legal and fiscal implications, e.g. on customs and trade laws, customs duties, excise duties, import VAT, as well as import and export restrictions. The WCO and its rules and measures related to the Harmonized System (HS) play an essential role in this context. Example 9: It has been a constant challenge for companies to maintain a uniform use of tariff codes for their products in China. Although companies use one and the same tariff code for a specific product in several jurisdictions worldwide, many experienced complaints from Chinese customs authorities claiming the use of improper tariff codes, even in cases where a binding tariff decision of a competent authority in the EU is provided. The classification carried out by Chinese authorities conveys the impression that their interpretation is not based on the HS-rules and/ or the product compositions and properties since their decision process lacked transparency. In some cases, EU companies even suspect that the final classification indicates an advantage for Chinese products. Furthermore, it is unclear for many companies to what extend the disclosure of product-related sensitive data is required for classification purposes in China. Similar experiences have been increasingly reported in relation to cases in Russia, India, Thailand, and Malaysia. Appeal: Chinese customs authorities should define their tariff categories according to standards set out by the WCOâ&#x20AC;&#x2122;s Harmonized System. China Customs should establish a more effective system to help companies solve the classification deviations, reduce the threshold of the existing ruling application system, and increase transparency. A uniform, worldwide application of tariff classifications creates a businessfriendly environment and reduces administrative burdens.

Customs and Export Control in China. Legal Certainty and Business-Friendly Conditions: A Necessity

5. Export Control Classification The European Union integrates the control lists of the international non-proliferation regimes into its system for controlled items. For example, listings in the Wassenaar Arrangement will also be found in Annex I of the EUâ&#x20AC;&#x2122;s Dual Use Regulation. Each entry on the EU control lists consists of a 5-character code which corresponds to a tailor made and specific description of the regulated good. Most jurisdictions worldwide commonly use a similar system to classify controlled items. Example 10: China is still in the process of finalising its export control legislation. It is not yet clear which criteria will be used to create a list of controlled items. However, such details are usually not specified in the overall legislation itself but are regulated further on in the implementing regulations. These are often published gradually after the law has come into force. The fact that it remains unclear as to how China will uphold international export control standards creates significant uncertainty for economic operators and could provide ample opportunity for arbitrary implementation until a final list is established. This would harm Chinese economic interests, because economic operators will react to such uncertainty by trying to avoid the transboundary shipment of potentially controlled items altogether due to liability risks. Appeal: The Chinese Bureau of Industry, Security, Import and Export Control and Chinese customs authorities should use export control classifications similar to most other jurisdictions worldwide. For German industries a model resembling European standards would lead to virtually ideal conditions for reciprocal trade. This would reduce administrative burdens and liability risks for companies. Other systems, for example based on HS codes, would not be suitable for this purpose.

Customs and Export Control in China. Legal Certainty and Business-Friendly Conditions: A Necessity

Imprint Bundesverband der Deutschen Industrie e.V. (BDI) Breite StraĂ&#x;e 29, 10178 Berlin www.bdi.eu T: +49 30 2028-0 Authors Dr. Stormy-Annika Mildner T: +49 30 2028-1562 s.mildner@bdi.eu Anna Kantrup T: +49 30 2028-1526 a.kantrup@bdi.eu Katherine Tepper T: +49 30 2028-1499 k.tepper@bdi.eu Patricia Schetelig T: 49 30 2028-1532 p.schetelig@bdi.eu

Document Number: D 1224