• In a move to drive the transformation and upgrade of processing trade, increase resource utilisation efficiency and strengthen environmental protection, China announced in September that the tax rebates for certain export products with low value-added, high pollution, high energy consumption and resource consumption will be abolished or reduced. Moreover, all the products for which export tax rebates have been removed now come under the prohibited category.
  
  
• This policy change has dealt a hard blow on processing enterprises, especially those enterprises engaged in processing with supplied materials and the materials have now been included in the prohibited category. As they can no longer import the necessary raw materials for processing, these enterprises will be forced to stop production. Even though wholly foreign-owned and joint venture enterprises may import raw materials in the form of general trade, their production cost will soar due to the removal of tax rebates.
  
  
• The latest policy change is in line with the targets set for foreign investment utilisation under China's 11th Five-Year Programme. It can be expected that in order to upgrade the product structure of processing trade and to expedite the shift of foreign investment from simple processing and assembly activities to high value-added and high technology sectors, as well as raise the production level, China is set to further adjust its processing trade policy and expand the list of products under the prohibited and restricted categories.
  
  
• As China's industrial upgrade and transformation are imminent, efforts must be made by Hong Kong processing trade enterprises to change their operation mode, increase the value-added content of their production, implement clean production, and raise efficiency in resource and energy utilisation in order to avoid the fate of being eliminated.

Change in Processing Trade Policy

On 14 September 2006, the Ministry of Finance, National Development and Reform Commission, Ministry of Commerce, General Administration of Customs, and State Administration of Taxation jointly issued a circular on adjustments made to tax rebate rates for certain exports and the expansion of the prohibited category under export processing trade (Circular No.139 [2006]). Based on this circular, the Ministry of Commerce, General Administration of Customs and State Environmental Protection Administration jointly issued Circular No.82 on 3 November 2006, announcing the detailed list of products coming under the prohibited category in processing trade and for which export tax rebates have been removed (see Appendix). The newly revised list primarily covers high energy consumption and high pollution chemical and metallurgical products as well as products that consume large quantities of domestic resources.

The list further classifies products under the prohibited category into three sub-categories, namely "prohibited from export", "prohibited from import" and "prohibited from import and export". Among these, the 77 items prohibited from import are mainly products barred from import under international conventions and products causing serious pollution during processing. Examples include tiger bones, mineral ores, slag, and fibre waste. The 503 items prohibited from export are mainly primary raw materials used in deep processing, such as boards, sulphur, earth, stone and metals. Processing enterprises importing these raw materials are still entitled to bonded treatment. The 224 items prohibited from import and export are mainly low value-added, high energy consumption and high pollution products, such as mineral water, coal, asphalt, combustible gases and pesticides.

China has classified products into the prohibited, restricted and permitted categories in its processing trade management since 1999. Since 2004, the Ministry of Commerce, General Administration of Customs and State Environmental Protection Administration have jointly announced four batches of products that fall into the prohibited category, putting about 341 products in the list of products under the prohibited category in processing trade, covering high energy consumption and high pollution products such as used and scrap machinery and electrical products, chemical fertiliser, aluminium oxide and iron ore. Together with the new items listed in Circular No.82, the prohibited category now contains 1,145 (10-digit) products, accounting for 9.3% of the total tariff numbers.

According to Circular No.82, the list of products under the prohibited category in processing trade will be adjusted from time to time in line with the relevant policies of the state. The Ministry of Commerce will in future work with other competent ministries under the State Council to further improve the measures for the management of processing trade products by category in keeping with state policies on macro economic control, industrial development and environmental protection. Efforts will be made to establish a dynamic system for monitoring the list of industries and products granted market access, classifying step by step high energy consumption, high pollution, high resource consumption and low value-added products into the prohibited and restricted categories under processing trade, upgrading the product structure of processing trade, and raising the overall development level of processing trade. It is understood that the relevant government departments are in the process of studying and formulating a new list of products under the restricted category in processing trade, as well as revising the measures on the management of processing trade by category.

Impact of the Latest Change in Processing Trade Policy

Processing trade refers to the business activity of importing all or part of the raw and auxiliary materials, parts and components, elements, and packaging materials from abroad in bond, and re-exporting the finished products after processing or assembly by enterprises on the mainland. This activity includes processing with supplied materials and processing with imported materials. Under processing with supplied materials, the imported materials and parts are supplied by the foreign party and hence the processing enterprise does not have to make foreign exchange payment for the imports. The processing enterprise only charges the foreign party a processing fee, while the foreign party is responsible for selling the finished products. As for processing with imported materials, the processing enterprise (including both foreign-invested and domestic enterprises) not only makes foreign exchange payment for the imported materials and parts but also exports the finished products after processing.

Implications of Export Tax Rebate Adjustment

According to Circular No.139 [2006], the export tax rebates for certain resource consumption, high pollution, high energy consumption and low value-added products are either removed or reduced, while the export tax rebates for high-tech and high value-added products are increased.

The removal of or reduction in export tax rebates directly affects the costs and profits of export enterprises. Under the existing export tax rebate computation method, the difference between the tax rate and the rebate rate is not deductible. For instance, in garment processing, as the export tax rebate rate of textiles is reduced from 13% to 11%, the non-rebated tax amount will go up from 4% to 6% (amount of export tax not eligible for exemption, deduction or rebate = 17% - 11%). This difference has to be absorbed by the production cost.

For processing enterprises handling products with export tax rebates removed and put under the prohibited category, the impact is even greater as the increase in the costs they have to bear is much higher. Before the policy change, processing enterprises could import the necessary raw materials under processing trade contracts and enjoy exemption of customs duty and VAT. But with the implementation of the new policy, raw materials categorised as prohibited under processing trade can only be imported in the form of general trade. In other words, such imports are subject to customs duty and VAT. However, as the import-related VAT rebate rate is 0%, the finished products for export are not entitled to any rebate.

With the removal of or reduction in export tax rebate, enterprises have to raise their export price in order to maintain their profit level. However, given the keen market competition nowadays, enterprises must increase the value-added of their products in order to enhance their bargaining power.

Implications of the Expanded Prohibited Category

Since products which come under the prohibited category in processing trade can only be imported into China in the form of general trade, following the issuance of Circular No.139 [2006], mainland customs have stopped filing export processing trade contracts involving the newly added prohibited items. This has forced many processing enterprises to stop production because they can no longer import the necessary raw materials and parts and components or transfer them to and from another factory. As a result, upstream and downstream factories are also affected¹. Industries that are hardest hit include die-casting, machinery and hardware, fur, paper products and printing. However, the impact has been temporarily alleviated when certain commonly used raw materials are removed from the list under Circular No. 82.

The expansion of the prohibited category has dealt a particularly severe blow to factories undertaking processing with supplied materials. Under existing policy, such processing factories are not allowed to engage in domestic sale or general trade. Even if these processing factories are willing to pay import duties under normal trade terms for the importation of the necessary raw materials, customs will not grant approval. Thus, processing factories handling products newly put under the prohibited category have practically lost their licence to continue operation.

At present, processing with supplied materials still accounts for a certain share in processing trade and plays a significant role in the processing industry chain². Take the paper packaging industry for an example. Currently, over 90% of the factories in this industry operate in the form of processing with supplied materials, whereby processing contracts are executed by means of factory transfers among industry players. According to sources in the corrugated paper industry, the production of many factories have ground to a halt after the release of Circular No.139 [2006] which put corrugated paper products under the prohibited category. For instance, about 80% of the factories in Shajing have ceased production. In Dongguan, according to the rough estimate of the local foreign trade and economic cooperation bureau, about 1,000 factories processing with supplied materials in the city are engaged in processing activities using products classified under the prohibited category in Circular No.139 [2006]. When their processing contracts on hand are completed, these factories will have to cease production or close down. If these factories wish to continue their business, they must transform into foreign-invested enterprises.

Development Prospects of Processing Trade

Although the implementation timeline of Circular No.139 [2006] is rather short, the direction and objectives of the processing trade policy change contained in the circular can in fact be traced. When China announced its 11th Five-Year Programme, it clearly stated that great efforts would be made to achieve industrial structure upgrade, increased efficiency in utilising resources, and the building of a resource conserving and environmentally-friendly economy. The changes stipulated in Circular No.139 [2006] merely reflect the spirit of China's 11th Five-Year Programme.

In November 2006, the National Development and Reform Commission announced its 11th five-year programme on the utilisation of foreign investment, calling for a radical change from "quantity" to "quality" in the utilisation of foreign investment in China during the 11th Five-Year Programme period. Action will be taken to shift the focus of foreign investment utilisation from attracting more capital and foreign exchange to importing advanced technology, management expertise and high-calibre talent. Also, more attention will be given to ecological construction, environmental protection and conservation and comprehensive utilisation of resources and energy.

In its effort to achieve industrial structure upgrade, China will bring in more advanced technology and management expertise in a move to leverage on the strengths of foreign-invested enterprises to offer guidance to mainland enterprises. By so doing, China hopes to bolster its capabilities for innovation. Meanwhile, efforts will be made to upgrade foreign investment projects from simple processing, assembly and low-level production activities to new horizons such as R&D, sophisticated design and modern logistics. The objectives are to develop China into one of the world's leading manufacturing bases of high value-added products, and to channel foreign investment to the upgrading of the industrial structure and technological level of China.

In pushing ahead with resource conservation and environmental protection, China is determined to restrict foreign investment in low-end, high consumption and high pollution projects. Meanwhile, the utilisation of foreign investment in water, land and materials conservation, and in strengthening the comprehensive utilisation of resources will be encouraged. China will also encourage the introduction of applicable, advanced, energy-efficient techniques, technologies and equipment by means of foreign investment. In terms of implementation, China will:

• Formulate a sound system of market access standards in terms of energy consumption, water consumption and land usage for foreign investment projects. Enforce a mandatory system of eliminating those enterprises (including FIEs) which are high energy consumption, high water consumption, and using obsolete techniques, technologies and equipment.
• Strengthen supervision over all kinds of enterprises (including FIEs) regarding their environmental protection efforts. Steadfastly enforce the systems of clean production verification, eco labelling and environmental protection certification.
• Study and formulate a comprehensive incentive package in support of foreign investment in the environmental protection industry thereby speeding up the marketisation of pollution containment.
• Study and formulate a market access policy regulating foreign investment in mineral resources exploitation. Strict requirements will be set for foreign participation in mineral resources exploitation and development.
• Formulate and improve policies that encourage foreign investment in projects on water conservation, energy conservation and materials conservation, as well as projects that can further strengthen the comprehensive utilisation of resources and transfer of advanced technology.

It can be envisaged that the competent mainland authorities will continue to upgrade China's industrial structure by further adjusting the processing trade policy in order to achieve the targets set out in the 11th five-year programme on the utilisation of foreign investment. Efforts will continue to be made to encourage foreign investment to shift from simple processing, assembly and low-level production to high value-added, high technology and innovative activities. At the same time, in a bid to achieve environmental protection and resource conservation, the relevant authorities will continue to ban or restrict high pollution, high energy consumption and resource consumption processing activities, as well as formulate corresponding lists of products under the prohibited and restricted categories.