More than seven months after China's new consumption tax policies were supposed to take effect on Jan 1, 2013, little has happened and actions seem muted after much talking earlier on. Implementation seems still some distance away.

The market awaits further clarifications and actions from the State Administration of Taxation (SAT). Officials are pondering over the vague definitions and the difficulties in actual execution because of the extensive implications of the new policies. Another hurdle is the lack of national standards (Guo Biao in Chinese or GB) or industry standards for the many products covered under the scope of the new tax.

Challenging obstacles

"Difficulties in execution are beyond expectations," said an informed source. Local governments are protective of local enterprises due to economic development considerations. The new policies can be a serious blow to some local businesses. "There has been significant resistance from the industry and the government and tax authorities are mindful to protect responsible tax paying industry players," added the source. In China, most local refineries are privately owned.

The petrochemical chain is as complicated as you can imagine. The new policies involve many products and it is almost impossible to give a clear distinction on whether a product is a blend component or a chemical, a detail that contributes to the delay on execution. There are products that can be used as chemical raw materials and also for gasoline blending. Therefore the "one size fits all" approach does not appear feasible.

Some related petrochemicals lack national or industry standards. There may be internal standards that some corporations use though these cannot be used as a reference by the SAT. The absence of national or industry standards for some products is one of the obstacles hindering the implementation of the consumption tax.

New policies were designed to curb tax fraud

The latest policies widened the taxable scope for oil products to all liquid products produced or processed with crude oil or other materials. The policies triggered widespread concerns and strong reactions among petrochemical players after they were announced.

SAT released the "Announcement on the Issues Regarding the Consumption Tax - Related Policies (Announcement No. 47) on Nov. 6, 2012 to prevent intentional tax evasion and forged tax refund.

Since Jan. 1, 2009, China has levied on seven oil products -- gasoline, diesel fuel, naphtha, solvent oil, aviation kerosene, lubricants and fuel oil – but tax evasion remained rampant. Some refineries sell taxable gasoline under the name of tax-free chemicals, while some downstream enterprises are given tax refund for products that are not even taxed.

Milestones of China's consumption tax

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China's blueprint on the petrochemical industry goes hand-in-hand with the country's macro direction. The Twelfth Five-Year Plan wants the industry to adhere to the basic principles of "structural adjustment" through industrial consolidation, up- and down-stream integration, high-end production and strict control of small refineries from expanding capacity.

Policymakers are prudent to think twice. Announcement No. 47, if implemented, could have far reaching repercussions on traditional gasoline blenders and related chemicals producers. Chemicals being targeted are the major components in gasoline blending (such as MTBE) and these do not have any GB or uniform industry standards. The industry generally believes that components that are used as raw materials for chemical and petrochemical products should not be taxed.

Gasoline blending market faces reshuffle

Gasoline and diesel fuel produced by PetroChina and Sinopec refineries are all GB graded. Local refineries and blenders are also producing GB-graded gasoline and diesel fuel by blending with a high percentage of MTBE and BTX aromatics. These are the major sources of gasoline and diesel fuel in China until now.

The emergence of blended gasoline products on a large scale took place after the 2009 implementation of the refined oil pricing mechanism. Blenders add chemicals to off-grade gasoline and diesel fuel to attain GB level. These products are exempted from petroleum consumption tax, making blended gasoline cheaper by at least RMB 1,000/ton compared with their regular counterparts. The cost and price advantages are the reason why blended gasoline enjoys a vast consumer group despite quality concerns. Blended oil refineries have been depending on the price disparity to compete with PetroChina and Sinopec.

The expanded tax scope will undoubtedly impact blending margins. The enforcement of Announcement No. 47 will make prices of BTX aromatics (0.85 g/ml) and MTBE (0.72 g/ml) more expensive by RMB 1,176/ton and RMB 1,385/ton, respectively. Assuming 93 # blended gasoline is added with 25% BTX aromatics and 10% MTBE, its cost will increase by RMB 491/ton. At present, 93 # blended gasoline only enjoys a price gap of RMB 300-600/ton. The levy will deprive it of this price advantage.

Chinese GB gasoline consumption was about 82.8 million tons in 2012 against that of blended gasoline at about 12 million tons. A price increase will lead to a significant drop in demand for blended gasoline, which are produced and sold mostly by private refineries, further reinforcing the market dominance of Sinopec and PetroChina.

The new policies as they stand are expected to dent demand for MTBE as a blending component for gasoline. As a clean fuel component, MTBE is an important solution to replace the 'dirtier' gasoline components such as aromatics, olefins and benzene. By reducing the use of MTBE in gasoline, vehicle emission pollutants will likely increase, adding to the already poor air quality and PM2.5 in major cities.

Another major concern is that private blenders, in a bid to protect their margins, may replace MTBE with harmful and unauthorized chemicals and components to blend gasoline, potentially causing danger to human health, vehicle engines, and worsen air quality even further.

MTBE and BTX aromatics to see change in supply/demand pattern

The 2012 consumption of MTBE stood at some 5.2 million tons, of which about 90% was used in gasoline blending and 10% for the production of MMA, butyl rubber, isobutylene and other chemical products. The imposition of an MTBE consumption tax will increase MTBE's production cost, thus reducing margins.

Higher prices will lead to reduced demand from downstream producers, as they shun MTBE for cheaper alternatives. Thus, refineries solely producing MTBE may cut production or even close down; refineries with captive MTBE units will be impacted less. On balance, the tax adjustment could be counter-productive as these producers are responsible tax-paying companies; a potential reduction in taxable income will diminish the government's tax coffers.

Likewise for BTX aromatics - another non-GB group of liquid chemicals - producers will need to pay advance consumption tax for BTX aromatics, leading to the same scenario as MTBE. As a result, the production of BTX aromatics, a favorite of small refineries, may see a sharp drop in demand.

Industrial voices and reactions

In early February, Sinopec made public its guiding comments on the implementation of the "Issues of Consumption Tax-Related Policies." According to Sinopec's interpretation of Announcement No. 47, chemical materials used for producing chemical products do not fall in the taxable range. The document included a detailed list of 30 petrochemical products, including C5 and C9 that are not paying consumption tax at the moment.

PetroChina took a similar action in early March by issuing an internal announcement on the execution of the consumption tax. The announcement said that blending components remained a focus of consumption tax reform, but chemical products that are not used in producing taxable oil products are outside the taxable range. It also said that materials produced by PetroChina and sold to blending companies within the PetroChina group are exempted from tax. Although it did not provide a detailed list as Sinopec did, it produced a series of criteria for the taxable range, serving as a clear basis for the taxable products.

Understandably, the loudest voice came from local refineries as the new policies are seen as a serious threat to their survival. Some local associations and enterprises actively negotiated with SAT. Refining and Chemical Association of Shandong, for example, submitted to SAT an application for the development of relevant industry standards.

Over the years, multinational businesses are increasingly involved in almost the entire value chain of China's petrochemical industry, including downstream chemical products. European and American chemical giants expressed concerns their concerns over the implementation of the consumption tax, which will result in new taxes on previously untaxed products. They have joined forces to negotiate with SAT with the goal to be exempted from the implementation, requesting the SAT to specify what petrochemical products are subject to taxes and what are not, so that they can adjust their future development plans accordingly.

Based on past experiences, the two documents from PetroChina and Sinopec are likely to be used as a reference in actual execution. As the SAT work on the details of the new tax policies, the market has gradually resumed business-as-usual.

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