Processing trade compliance: Are you an unwitting smuggler?

When identifying customs affairs-related risks for enterprises, the author has found that certain processing trade enterprises have possibly commited smuggling offences without being aware. To prevent other similar enterprises from making the same mistake, there are three high-risk points to be aware of.

Setting prices of imported materials and parts arbitrarily

The processing trade is based on the principle of “importing raw materials from, and exporting finished products to, foreign countries”. In other words, providers of materials and parts, and purchasers of finished products, are all foreign entities. As they do not participate in business competition in domestic markets, processing trade enterprises are entitled to special preferential tax treatment.

In light of the original intention, no taxation issues are involved in the whole transaction, so the prices of materials and parts are not a focus of customs examination. Some enterprises thus believe that the declaration of the import prices of materials and parts is a mere formality, and consequently, the phenomena of “import at a high price and export at a low price” and “import and export at the same price” emerge one after another.

If an enterprise really “imports raw materials from and exports finished products to foreign countries”, there are no legal risks in such operations. However, in practice, if an enterprise sells defective products in domestic markets instead of foreign markets, or finished products in a domestic market as a result of shrinking foreign markets, it should pay a back tax calculated on the prices of the materials and parts fixed at the time of import.

In such cases, if an enterprise applies to customs for payment of back taxes based on the original under-declared prices of materials and parts, it may constitute smuggling. Therefore, a processing trade enterprise should reasonably set the import prices of materials and parts among its related enterprises, and should check the import prices of materials and parts in a timely manner before payment of back taxes.

If the prices are found to be under-declared, the enterprise should proactively disclose such information to customs, and adjust the amount of back taxes. Article 2 (3) of the Announcement of the PRC General Administration of Customs No. 59, 2018, specifies that: “If an enterprise proactively makes a supplementary declaration to customs in case of an emergencey on problems identified in its internal self-inspection and self-control, and provides timely control or corrective measures prior to the expiry of the account book verification period, customs will process such declarations collectively.” This provides a clear legal basis for self-declaration by an enterprise.

Returning defective products to a foreign country

Some enterprises return defective products, due to fault of their manufacture, to a foreign country without a declaration or payment of back taxes to customs, so that the Processing Trade Manual cannot be finally cancelled after verification and customs cannot perform verification in the Processing Trade Manual.

According to the Common Code Table and Description for the Customs Clearance System, there are no customs supervision methods for the re-export of defective products under processing trade. In other words, defective products made from imported materials and parts under processing trade shall not be re-exported, but shall be destroyed in China, or sold in domestic markets after paying back taxes. In fact, the above-mentioned returning of defective products to foreign countries by processing trade enterprises cause loss of national tax, and may constitute smuggling.

According to article 2 of the Decree of the General Administration of Customs No. 235: “Defective products refers to products (including finished and unfinished products) manufactured in the production process by a trade processing enterprise engaged in processing and re-exporting business, which cannot be re-exported due to their serious defects, or failure to meet the standard specified in an export contract.” This requires the quality control department of an enterprise to make an objective and accurate evaluation of product performance, and to not deliberately lower the acceptance standard for the purpose of bonded export.

Selling materials and parts supplied by foreign clients, or finished products in domestic markets, without customs approval

Article 1 of the Announcement of the Ministry of Commerce and the General Administration of Customs [2016] No. 45 specifies that the former requirement that processing trade contracts, and domestic sale of bonded imported materials and parts, or finished products under processing trade, are all subject to the approval of competent departments of commerce has been cancelled, and that competent departments of commerce at all levels shall cease to issue approvals in relation to processing trade.

Some processing trade enterprises now believe that the domestic sale of materials and parts supplied by foreign clients, and finished products made from such materials and parts, are no longer subject to customs approval. However, this is not the case. Announcement No. 45 only specifies that domestic sale of materials and parts supplied by foreign clients, and related finished products, are no longer subject to the approval of departments of commerce, but customs approval is still required.

Courts have also made a clear determination on the above-mentioned viewpoint. In Judgment (2017) No. 21, Erenhot City People’s Court holds that announcement No. 45 specifies that ‘the requirement that processing trade contracts, and domestic sale of bonded imported materials and parts or finished products under processing trade, are subject to the approval of competent departments of commerce is cancelled’, and ‘domestic sale of bonded imported materials and parts, or finished goods under processing trade outside the zone specially controlled by customs, are subject to paying taxes and tax-deferred interest levied by customs, by law’. Accordingly, domestic sale of bonded imported products is not subject to the approval of departments of commerce, but remains subject to customs approval, back taxes and tax-deferred interest. Therefore, such exhibit and supporting information are rejected.” The court finally ruled that the domestic sale of bonded materials, parts and finished products by the defendant without customs approval constitutes smuggling.

Under the new supervision model, customs shifts its focus from ex ante supervision to ex post facto supervision, so an enterprise has a much greater say at the time of the act, but if laws and regulations are understood only from the perspective of self-interest, legal risks will be higher. An enterprise should ask competent customs or legal advisers more often for help, so as to make an objective and accurate judgement on compliance.

Wang Yongliang is an associate at AllBright Law Offices