Why Do You Have to ”Pay Back Taxes” Even When You’ve Incurred a Loss?”

The VAT input tax credit chain is based on the assumption that ”goods continue to circulate and generate output tax.” Once goods are lost during circulation and can no longer generate output tax, the input tax credits previously claimed lose their corresponding tax base and must be reversed in accordance with regulations.

This is not a punitive measure, but a requirement for supply chain integrity. However, for cross-border sellers, unsold inventory in overseas warehouses, the destruction of returned goods, and shipping damage are all common occurrences. If they are not familiar with the rules, they may not realize there is a problem until their year-end tax settlement or a tax audit.

Distinguishing Between Normal Wear and Tear and Abnormal Losses

Under current Value-Added Tax regulations,Abnormal LossesThis generally refers to situations where goods are stolen, lost, or spoiled due to mismanagement, as well as cases where goods or real property are lawfully confiscated, destroyed, or demolished due to violations of laws and regulations. In contrast, there are normal losses incurred in the course of production and business operations; the input tax associated with the latter may be normally deducted.

The key lies in the four words ”mismanagement.” Even in cases of lost goods, the outcome may differ entirely depending on whether the loss resulted from natural disasters, goods that expired normally within their shelf life and were disposed of in accordance with regulations, or losses caused by disorganized warehouse management. The crux of the determination lies in whether reasonable management duties were fulfilled and whether supporting documentation can be provided.

How is the transfer of input tax calculated?

• For items that can be accurately allocated, the input tax actually consumed for that batch of goods shall be reversed;
• If the input tax amount cannot be accurately determined, the input tax to be deducted shall be calculated by multiplying the actual cost for the current period by the applicable tax rate;
• For abnormal losses involving real estate, construction in progress, and other items, the corresponding input tax amounts shall be written off in installments or in a lump sum, in accordance with the specific criteria.Subject to current regulations and the requirements of the competent tax authority..;
• Any additional tax deduction already recognized shall be correspondingly reduced in the period in which the input tax is reversed.

In practice, the most common mistake is to calculate the result directly by multiplying ”book cost by the tax rate,” while overlooking situations such as different tax rates applying to certain goods or input tax credits derived from invoices issued on behalf of small-scale taxpayers.

Four Common Scenarios

• Unsold items in overseas warehouses are destroyed locally. You must retain the destruction order, third-party proof of destruction, and confirmation records from the platform or warehouse operator. If you cannot prove that the items were actually destroyed, simply removing them from the books is generally insufficient to have the loss recognized.
• Cross-border returns cannot be resold. If goods returned to China are to be disposed of as scrap, it is necessary to determine whether the return was due to the buyer or a product quality issue, and to consider how to handle the taxes already paid on the goods during the import process.
• Damage and loss of packages during transit. For items involving the determination of carrier liability and compensation, compensation revenue must correspond to the treatment of losses; such amounts cannot be both recorded as compensation and excluded from the books.
• Samples, promotional items, and trade show exhibits. "Deemed sales" and "reversal of input tax" are two separate determinations; do not confuse them. The specific application depends on the substance of the transaction.

The chain of evidence must be established in advance.

Whether an abnormal loss is recognized ultimately depends on the supporting documentation. We recommend creating a standardized template for loss handling documentation, which should include: discovery and internal reporting of the loss; investigation of causes and determination of liability; third-party documentation (e.g., destruction certificates, loss reports, police report receipts); accounting vouchers; and tax calculation sheets.

These documents are required during annual tax settlements, tax audits, and even export tax rebate audits. If you wait until after the fact to prepare them, it is often impossible to reconstruct the original circumstances.

Qicaiying can assist cross-border businesses in establishing standardized procedures for handling inventory losses and input tax reversals, as well as in conducting tax compliance assessments and setting up document archiving systems. The specific criteria to be applied shall be subject to current regulations and the requirements of the competent tax authorities.