Many foreign investors, particularly investors from Hong Kong and Taiwan, have taken advantage of the Mainland's low production costs to engage in processing trade activities. However, numerous regulations promulgated by the various government authorities to strengthen their administration on the sector means it can be quite a challenge for investors to comply with PRC processing trade regulations and tax laws.

From a practical standpoint, lots of pitfalls await processing traders. For example, local administrations' regulations on processing trade activities may vary from area to area, such as how to deal with scraps, how to assess unit consumption and wastage rates, as well as how to verify cancellation of production contracts for both customs and foreign exchange requirements.

Due to regulations on contract processing trade activities, which prohibit products from being sold domestically and do not qualify for VAT refunds on local purchases, many foreign investors are considering changing their investments from contract processing to import processing.

There are a number of other areas that foreign investors should pay particular attention to if they are planning to go down this road, which are outlined below.

Selection of locality and form of processing trade

Regulations relating to customs, foreign exchange verification and cancellation, taxation as well as preferential treatment on processing trade investments for contract processing and import processing investments are all quite different. Such regulations may also vary from area to area. As such, companies should carefully make a comparison of how the differences will affect their businesses before making any changes regarding the location and type of processing trade that they are involved in.

Disposal of scraps

According to PRC business regulations, companies that sell scraps generated by their processing business domestically, without obtaining prior approval from the relevant government authorities, are liable to prosecution. However, certain transportation costs must be incurred if scraps have to be transferred out of the PRC in accordance with current regulations. Therefore, businesses need to carefully manage the amount of scrap produced and their disposal.

Assessment of unit consumption rate and wastage rate

If the unit consumption rate and wastage rate assessed by the relevant customs offices is too low, this may give rise to problems when performing verification and cancellation of bonded materials. It may also give rise to penalties imposed by the relevant customs offices. Businesses, therefore, need to pay close attention to the assessment unit consumption rate and wastage rate. It may also be necessary to negotiate with the customs office in-charge when and where appropriate to explain the situation.

Change in investment mode

Whether changing the investment mode from a contract processing arrangement into an import processing arrangement, businesses need to consider the PRC customs and tax implications of such a move as this will affect the transfer of bonded equipment, materials and inventories.