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China's war against oil tax fraud

A News and Analysis Feature

As Beijing tightens oil tax noose, will wily players escape again?

By Vandana Hari with Xiao Yi Zhou, Cindy Liang, Daisy Xu, Sebastian Lewis, and Song Yen Ling

August 20, 2014 - It's a 21st century remake of Tom and Jerry. The modern version of the classic cat-and-mouse chase has Beijing relentlessly plotting to develop a foolproof oil tax regime, to perhaps see devious market players stopping in their tracks every now and again. But only till they find new ways to outsmart the system.

This year, Beijing is tightening the consumption tax noose, a knot at a time, hoping to end the practice of oil market players illegitimately shaking down the state for "refunds." Armed with fraudulent invoices, some players routinely get tax reimbursements they are not entitled to, while others "recover" taxes they didn't even pay -- in other words, they tax the government.

The consumption tax, collected by the central government, is levied on all imports and production of luxury and non-renewable resource goods in China. It was introduced in the oil sector in April 2006, after nearly eight years of deliberations, as a means to encourage fuel efficiency and environmental consciousness. Some, at the time, also described it as a tax on the rich, who are bigger consumers of energy.

For oil products, the consumption tax is levied as a fixed yuan rate per liter. Current rates range from zero on crude, asphalt, LPG and MTBE, to Yuan 0.8/liter (13 cents/liter) on gasoil and a high of Yuan 1/liter on gasoline.

Analysis continues below...

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A new, more sophisticated invoicing system imposed on oil refiners in China from February 1 and extended to refined product wholesalers and retailers from August 1 has set the market abuzz, prompting some fear and uncertainty, and temporarily crimping the appetite of some of the companies that are known to rely on tax fraud to eke out margins, several sources said.

In order to weigh the chances of Beijing's latest measures succeeding and the potential for demand erosion from shrinking margins at some of the oil and petrochemical players, one needs to understand how the tax deception works and how the government hopes to stop it.

Massive web of taxes

At the heart of the problem is China's massive web of taxes on imports and domestic sale of oil and petrochemicals, which is further complicated by consumption tax waivers on certain feedstocks and products and refunds on others, as a means to incentivize their use and processing. While the tax breaks themselves can be a challenge to understand, keeping on top of all the changes being made to them every few months can be even harder.

There have been no less than 13 adjustments to the oil consumption tax policy since it was introduced on April 1, 2006.

Government restrictions on the import and processing of crude oil through a system of quotas and licenses, and controls on the sale of on-specification products in the domestic market adds an additional layer of complexity to the regulatory environment.

Not only are there a multitude of taxes to administer -- the country has 19 categories including value-added tax, consumption tax, and customs duty among others -- but their administration is split between the central government's State Administration of Taxation or SAT and the tax bureaus at the provincial, municipal and county levels.

Industry players and tax consultants point out that poor coordination between the central and local governments, the absence of a consolidated electronic data management system, and suspected widespread corruption in the local tax offices make it difficult to detect fraud and inconsistencies.

Brokering invoices

A lynchpin in the elaborate game of deception is the so-called "invoice broker," who finds counterparties willing to issue an invoice as per his client's requirements. The broker sells VAT invoices to buyers ranging from teapot refiners to blenders and wholesalers, for a fee. Until the introduction of the new invoicing system this year, the going rate for such invoices was typically in the range of Yuan 100-130/mt, according to market sources.

A regular VAT invoice, typically issued by the seller to the buyer, bears the seller's and buyer's names, the product name, quantity, price, and the 17% VAT levied on all crude and oil product sales in China. The invoice does not break down the consumption tax component, but serves as proof that this and all other applicable taxes were paid as part of the final amount.

The fraudulent VAT invoice has all the above information. It even bears the tax registration number of the issuing company, and a transaction-specific serial number generated by a USB device, issued by the local tax authority. The device is used in conjunction with tax authority-approved software, installed on a regular personal computer, to generate the invoice.

All these bits are authentic, unlike the commonly available counterfeit invoices, or "fapiaos" as they are called in Chinese, with fake names, serial numbers and seals, which can be bought for token sums to be used as receipts for the sale of goods or services that never happened.

Real invoice with fake sale

While the fraudulent VAT invoice is real, the sale declared in it is fake: the lot never changed hands between the two companies named in it. The company named as the seller in the invoice might have actually sold that product, or perhaps a related one, but it would have been to some other buyer or buyers, who agreed to forego the receipt.

Products are also commonly sold without a VAT invoice if they are of a specification the seller is not authorized to sell. The VAT on such sales might even be collected and submitted, but it comes from the real buyer, not the one stated in the fraudulent invoice.

Another racket cited by industry players, albeit somewhat murkier and believed to occur on a smaller scale, involves small tax-registered "trading" companies that issue fraudulent VAT invoices in their own name. These outfits, typically tucked away in rural interiors, don't actually deal in oil and also get away without submitting any taxes, thanks to an allegedly lax or corrupt local tax administration. These outfits tend to exist only for short time spans, to avoid detection.

The lack of reconciliation between information collected through the VAT invoices and consumption tax collections and refunds, sources say, is in large part due to local tax administrations that collect VAT not being bothered about the consumption tax, which is administered by the central government.

Thorough checking of the validity of consumption tax refund claims would also need national level coordination if the buyer and seller are located in different provinces.

Article continues: Ingenious ways of exploiting oil tax breaks in China

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