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EY Greater China Consumer Products and Retail Sector Journal

April 2017

Eric Chia

PartnerGreater China Consumer Products Sector Co-Leader

Arnold Sun

Partner

Greater China Consumer Products Sector Co-Leader

Dear EY friends,

Hope you’ve all had a wonderful Chinese New Year. It has been a while – and welcome to the Spring Edition of the

Consumer Products and Retail (CPR) Journal from EY in Greater China. In this edition, we have pulled together

three viewpoints to share with you.

Since late 2016, more scrutiny on the outbound investment process has been introduced in an attempt to slow

down the “buying frenzies” for China-based companies. Although already a critical part of the global mergers and

acquisitions (M&As) market, Chinese companies, many of which are players in the CPR industry, in general have

insufficient relevant experience in conducting cross-border M&As compared to their peers from developed

countries. A strategically aligned M&As plan can secure these companies with a more protected overseas M&As

journey. EY’s viewpoint “Strategy leads the way in overseas mergers and acquisitions in CPR sector”, by Jerry

Bao and Vivien Shan, provides not only step-by-step plans to help China entrepreneurs do overseas acquisitions,

but also supplements the theory with real business world evidence.

In the New Year, there will also be some new additions to the CPR Journal – we are now welcoming article

submissions from our Assurance colleagues. The article “The new leases standard – Consumer Product and

Retail”, by Lai Ting Wong, explains the latest changes in the accounting for leases by lessees and their

implications for CPR entities’ finances and operations. The new standard, IFRS 16, is effective for annual periods

beginning on or after 1 January 2019.

Last but not least, with regards to large retail chains in China, Alvin Kong analyzes the opportunities, impacts and

risks arose from the value-added tax (VAT) reform in the article “Challenges and analysis for large-scale chain

retailers during the post VAT implementation”. Since the implementation of the reform on 1 May 2016, there

has been increasing pressure on leading retailers to improve capabilities in practicing VAT. This article compiles a

to-do checklist and provides a set of follow-up procedures to help large retailers to leverage opportunities and

manage risks simultaneously.

Enjoy reading.

2EY Greater China Consumer Products and Retail Sector Journal |

Strategy leads the way in overseas M&As in the CPR sectorJerry Bao

Partner/Principal, TS-Corp Finance Strategy

[email protected]

Vivien Shan

Senior Manager, TS-Corp Finance Strategy

[email protected]

Chinese companies’ overseas CPR M&As continue to increase

In 1978, China introduced the monumental ‘reform and

opening-up’ policy. Fast forward just three decades and we

see, not only, a radically different China but also an explosion

in the number and size of both inbound and outbound merger

and acquisition (M&As) activity. By 2015, Chinese outbound

M&As into other regions reached a staggering USD59b (an

18% increase year over year). In the first four months of 2016,

Chinese buyers eclipsed 2015 volumes with the

announcement of over USD96b worth of outbound activity

(JP Morgan, 2016). Benefitting from an increasing number of

Chinese companies determined to become global players,

strong state support and an increasing supply of deals,

Chinese outbound M&As activities are not only expected to

continue – they are likely to accelerate from here.

In the past, the primary focus of Chinese outbound

investment had been on the energy and resources sector.

Since 2010 we have been seeing a shift towards a new

strategic focus – global market share growth and core

capabilities development across the Industrial, Technology,

Media and Telecommunications(TMT) and Consumer Products

and Retail (CPR) sectors. Increasingly,we are seeing more and

more Chinese companies actively pursuing outbound M&As to

access advanced products and strong-globally renowned

brands to not only open doors to new global markets, but also

as a means of elevating their own brand images in the Chinese

domestic market – a direct response to the sophistication of

domestic consumer behaviors. Key examples of this trend

include: the Sanpower Group acquisition of the House of

Fraser (2014), and more recently, the Biostime acquisition of

Swisse (2015) and the Qingdao Haier acquisition of GE

Appliance (2016).

Prior to 2010, the CPR sector represented a mere 2% of all

Chinese outbound activities. More recently, this figure had

risen to 12% (See figure below). And this might just be the

beginning.

In the January 2016 Issue of CPR Journal, we identified five

major trends that will shape strategies of consumer

products over the next three to five years. Collectively,

these trends point towards one clear conclusion – the rise of

the increasingly sophisticated ‘Chinese consumer’. What this

means for Chinese companies is that marginal competitive

advantages in brand, product quality or pricing will have an

increasingly amplified effect on corporate financial

performance. Technological advances have enabled

information and the consumer ‘voice’ to become

increasingly structured and available – serving as both risk

and opportunity for modern corporations. Outbound M&As

is often chosen as the preferred strategy for these Chinese

companies to rapidly acquire the necessary scale, brand

and/or core capabilities.

Despite the strategic importance of outbound M&As, we

have found that about 70% of M&As deals across all

industries in the 10 years to 2015 were not successful in

realizing their expected value. In pursuing overseas M&As,

Chinese companies have sometimes lacked a sufficient

rationale and execution plan in line with their visions. For

example, some enterprises were eager to expand and began

M&As activities in areas they were not familiar with. Some

entered a deal without a reasonable assessment of their

own resources and abilities and found themselves short of

the necessary core resources and execution power to

complete the overseas deals. Some did not have an orderly

execution plan and so their ‘going overseas’ strategies were

not given the required support.

To address these challenges and successfully complete an

overseas M&As deal, we believe that Chinese CPR

companies should formulate an M&As strategy in line with

their overall strategy and one that's proved to be effective.

They should have a plan before they make a move.


China outbound M&As by target sector

Plan before action – strategy leads the way in overseas M&As

An overseas M&As includes five major steps: formulation of an overseas investment strategy, screen and lock in an investment target, transaction and execution, post-M&As integration, and post-investment management and investment portfolio assessment.

A sound overseas M&As strategy should guide the company

when launching an overseas M&As, enhance its ability to

capture opportunities in the international economic

environment and respond to challenges, and help avoid

deviations from the established strategic line and failure as

a result.

To formulate an overseas M&As strategy, a company first

needs to review its vision and overall strategic objective –

to ascertain the objective of its overseas M&As activity.

Second, it must analyze the targeted region and industry,

and the investment in terms of market attraction and

investment feasibility. This is to identify the key region and

sector for its investment in light of the company's own

strategy and resource allocation. Third, the company

should look at the internal resources of the company and

assess the resources available for overseas M&As, and

analyze the potential synergies of an overseas M&As target.

Having formulated an overseas M&As strategy, the

company should also lay down a detailed execution

roadmap, build the supporting platform, and enhance its

own internal abilities to ensure they can support the

implementation of its overseas M&As strategy.

► Company vision and strategic objective

► An overseas investment strategy plan

The essay here discusses only the formulation of an overseas M&As strategy

Overseas investing strategy

1

Screen and lock in on an investment target

3

► Principles for screening

investing targets

► Long- and short-list of

investment targets

► Initial contacts with

investment targets

Transaction and execution

2

► Transaction documentation

► Detailed due diligence ► Risk analysis ► Valuation ► Deal negotiations ► Settlement

Post-acquisition integration

4

► Identify challenges to management integration

► Specify major areas of integration and methods

► Monitor and optimize integration plan

Post-investment management and investment portfolio assessment

5

► Identify key steps in assessing the investment portfolio

► Finalize execution methods for assessing investment portfolios

Case studies – the formulation of an effective overseas M&As strategy in CPR sector

As China’s middle class continues to expand and to create

more demand for a variety of consumables, overseas M&As

are needed as companies search for ways to maintain

revenue growth and profitability while expanding

production to fulfill increasing orders.

Therefore companies need to ascertain their development

objectives and direction through reviewing their vision and

strategy, armed with a full understanding of external

markets, competition, addressable customer base and its

internal resources.

Depending on companies’ business, market positioning in

the niche industry, and internal capabilities, there appear

to be three major strategic rationales for Chinese CPR

companies going overseas – to expand to become a truly

global company, to bring home and strengthen value

proposition in the domestic market, as well as to penetrate

into premium segments with more growth potential.

Rationale #1 – Becoming a global company

For a variety of reasons, Chinese companies are buying

foreign companies to enter international markets. Leading

Chinese companies are adopting outbound investment to

equip themselves with well-known global brands, overseas

distribution channels and a broader customer base.

Here is a good example of a company that embarked on a

series of overseas M&As to accelerate its globalization. A

Chinese household electrical appliances manufacturer

acquired a Japanese brand and its business operations in

2011 to enter into Japan and other countries including

Indonesia and Malaysia. Company revenue contributed by

the Japan market grew 450% in the next year. In 2012, the

company acquired a New Zealand-based appliances

company to enter into Australasian market, leading to an

over 70% annual growth for the acquired business in the

next three years.

In 2016, this company closed a landmark deal by acquiring

the home appliances division of a diversified technology

and financial services company. According to the

company’s Chairman, the US market is a core market for

growth and this transaction has allowed the company to

substantially enhance its global competitiveness.

The acquisitions of these recognized mainstream brands,

together with those valuable international resources, has

turned the company into a stronger global consumer brand

much faster.


Rationale # 2 – Creating a stronger China story

Chinese CPR companies are not just acquiring overseas

businesses in order to go overseas. Quite often, these

M&As enable Chinese companies to be more competitive in

the domestic market with more product offerings, better

quality and a stronger position.

Food safety issues have greatly influenced Chinese

consumer behavior. Middle class consumers prefer to pay a

premium for imported products with perceived better

quality. To address the unmet customer needs, a Chinese

leading dairy company formulated its overseas M&As

strategy to strengthen its industry chain, product portfolio

and brand image by constantly acquiring established

foreign brands in the past six years. The successful

acquisitions have provided strong competitive advantages

against its domestic rivals.

Rationale # 3 – Penetrating the premium segment with more growth potential

Another business motivation for Chinese companies’

ongoing overseas M&As is to enter a new and premium

segment. The transaction helps the company expand and

upgrade its competency by acquiring new capabilities,

specialized talents, valuable niche channels as well as a

strong footprint in a more promising market with higher

quality customer base.

A Shenzhen listed company specializing in corn oil

production, recently announced its 100% acquisition of a

Canada-based company that manufactures and sells

branded diet products primarily in the North American

market. This transaction will enable the Chinese company

to enter a much more profitable and fast growing nutrition

product markets from its existing relatively mature and low

margin corn oil business. It will also help the Canadian

company enter emerging and developing markets such as

China. After the purchase, the Chinese company will

develop products more receptive to Chinese consumers.

According to its Chairman, the company will strive to build

itself into a top brand in the high-end health food industry,

and will make use of its domestic business network to bring

premium products into the China market.

Conclusion

Based on our experience in assisting Chinese companies in

going overseas, Chinese companies sometimes have

insufficient relevant experience in conducting cross-border

M&As compared to peers from developed countries. If

Chinese companies are able to formulate a solid plan

before taking actions and have strategy-led M&As, their

overseas M&As journey will be more assured and protected.

These companies will steer clear of hidden reefs, in seeking

safe passage around the world.


The new leases products and retail

Lai Ting Wong

Senior Manager, FAAS

[email protected]

Overview

Consumer products and retail entities will

need to change certain lease accounting

practices when implementing IFRS 16

Leases, the new leases standard issued by

the International Accounting Standards

Board (IASB) on 13 January 2016. IFRS 16

significantly changes the accounting for

leases by lessees and could have far-

reaching implications for consumer

products and retail entities’ finances and

operations. The requirement for lessees to

recognise right-of-use assets and lease

liabilities for most leases may have a

significant effect on these entities balance

sheet metrics, given the number of leases

they typically have.


Lessor accounting is remained substantially the same as the

current accounting, requiring lessors to classify their leases

into two types: finance and operating leases. Lease

classification determines how and when a lessor recognises

lease revenue and what leased asset a lessor account for.

IFRS 16 requires lessees to recognise most leases on their

balance sheets as lease liabilities with corresponding right-

of-use assets. Lessees apply a single model for most leases.

Generally, the profit or loss recognition pattern will change

to interest and depreciation expense and is recognised

separately in the statement of profit or loss (similar to

today’s finance lease accounting). However, lessees can

make accounting policy elections to apply accounting similar

to IAS 17’s operating lease accounting to ‘short-term’ leases

and leases of ‘low-value’ assets.

For consumer products and retail lessees, this means

recognising assets and liabilities for most leases of stores

and distribution centres that they may currently account for

as operating leases. Recognising assets and liabilities could

have significant financial reporting and business implications.

Recognising a lease obligation for most leases may affect

certain key metrics, and the effect may be significant for

entities that lease a large number of stores and/or stores in

high-rent locations. Implementing the standard could also

require an entity to develop new processes and controls to

track and account for leases, including: (1) identifying a

lease; (2) initially and subsequently measuring lease-related

assets and liabilities; (3) identifying and allocating

consideration to the lease and non-lease components; and (4)

collecting and aggregating information necessary for

disclosure.

The new standard will be effective for annual periods

beginning on or after 1 January 2019. Early adoption will be

permitted, provided the new revenue standard, IFRS 15

Revenue from Contracts with Customers, has been applied

or is applied at the same date as IFRS 16. Lessees must

apply IFRS 16 using either a full retrospective or a modified

retrospective approach.

Illustrative examples relevant to consumer products and

retail entities are provided in IFRS 16.

1. Key Considerations

1.1 Definition of a lease

A lease is a contract (i.e., an agreement between two or

more parties that creates enforceable rights and obligations)

or part of a contract, that conveys the right to use an asset

(the underlying asset) for a period of time in exchange for

consideration. To be a lease, a contract must convey the

right to control the use of an identified asset.

1.1.1 Identified asset

An identified asset can be either implicitly or explicitly

specified in a contract and can be a physically distinct

portion of a larger asset (e.g., a store located in a shopping

centre). Even if an asset is specified, a customer does not

have the right to use an identified asset if, at inception of

the contract, a supplier has the substantive right to

substitute the asset throughout the period of use. A

substitution right is substantive if the supplier has the

practical ability to substitute alternative assets throughout

the period of use and the supplier would benefit

economically from exercising its right to substitute the asset.

If the customer cannot readily determine whether the

supplier has a substantive substitution right, the customer

presumes that any substitution right is not substantive.

Consumer products and retail entities enter into a variety of

supply arrangements that will need to be evaluated to

determine whether they involve the use of an identified

asset. For example, some contract manufacturing

arrangements require the use of an explicitly or implicitly

specified asset (e.g., an entire facility) or involve the use of a

portion of a larger asset (e.g., a production line within a

facility). Even if the arrangement specifies an asset, retail

entities will also need to carefully evaluate whether the

supplier has substantive substitution rights to determine if

there is an identified asset that may be a lease.


1.1.2 Right to control the use of the identified asset

A contract conveys the right to control the use of an

identified asset for a period of time if, throughout the period

of use, the customer has both of the following:

► The right to obtain substantially all of the economic

benefits from the use of the identified asset

► The right to direct the use of the identified asset

A customer has the right to direct the use of an identified

asset throughout the period of use when either:

(a) The customer has the right to direct how and for what

purpose the asset is used throughout the period of use

Or

(b) The relevant decisions about how and for what purpose

the asset is used are predetermined and the customer either:

i. Has the right to operate the asset, or direct others to

operate the asset in a manner that it determines, throughout

the period of use, without the supplier having the right to

change the operating instructions

Or

ii. Designed the asset, or specific aspects of the asset, in a

way that predetermines how and for what purpose the asset

will be used throughout the period of use

When evaluating whether a customer has the right to direct

how and for what purpose the asset is used throughout the

period of use, the focus is on whether the customer has the

decision-making rights that will most affect the economic

benefits that will be derived from the use of the asset. The

decision-making rights that are most relevant are likely to

depend on the nature of the asset and the terms and

conditions of the contract. The standard also says that if the

customer has the right to control the use of an identified

asset for only a portion of the term of the contract, the

contract contains a lease for that portion of the term.

Appendix A includes a flowchart that may assist entities in

making the assessment of whether a contract is, or contains,

a lease.

1.2 Identifying and separating components of a contract and allocating contract consideration

For contracts that contain the rights to use multiple assets

(e.g., a warehouse and equipment, multiple pieces of

equipment), the right to use each asset is considered a

separate lease component if both of the following conditions

are met: (1) the lessee can benefit from the use of the

underlying asset either on its own or together with other

resources that are readily available to the lessee; and (2) the

underlying asset is neither highly dependent on, nor highly

interrelated with, the other underlying assets in the contract.

For example, the lease contract for a warehouse and an

adjacent land parcel to be used for future development by

the lessee will generally be considered to contain two lease

components because the lessee could benefit from the

warehouse without development of the adjacent land parcel.

Many contracts contain a lease coupled with an agreement

to purchase or sell other goods or services (non-lease

components). For these contracts, the non-lease

components are identified and accounted for separately

from the lease component, in accordance with other

standards. For example, the non-lease components may be

accounted for as executory arrangements by lessees

(customers) or as contracts subject to IFRS 15 by lessors

(suppliers).

IFRS 16 provides a practical expedient that permits lessees

to make an accounting policy election, by class of underlying

asset, to account for each separate lease component of a

contract and any associated non-lease components as a

single lease component. Lessees that do not make an

accounting policy election to use this practical expedient are

required to allocate the consideration in the contract to the

lease and non-lease components on a relative stand-alone

price basis. Lessees are required to use observable stand-

alone prices (i.e., prices at which a customer would purchase

a component of a contract separately) when available. If

observable stand-alone prices are not readily available,

lessees estimate stand-alone prices, maximizing the use of

observable information.


Lessors do not have a practical expedient to account for

lease and non-lease components as a single lease

component. Lessors are required to apply IFRS 15 to

allocate the consideration in a contract between the lease

and non-lease components generally on a relative stand-

alone selling price basis. The stand-alone selling price is the

price at which an entity would sell a promised good or

service separately to a customer. When stand-alone selling

prices are not directly observable, the lessor must estimate

the stand-alone selling price. IFRS 15 also provides suitable

methods for estimating the stand-alone selling price.

Retailers’ store leases frequently include payments for

maintenance activities including common area maintenance

(CAM) (e.g., cleaning the reception area of a building,

removing snow from a car park for employees and

customers) and other goods or services transferred to the

lessee (e.g., providing utilities or trash removal). Under IFRS

16, payments for these activities are considered non-lease

components because they provide the lessee with a service.

In some leases, a lessee may also reimburse, or make certain

payments on behalf of, the lessor that relate to the leased

asset for activities and costs that do not transfer a good or

service to the lessee and would not be considered a non-

lease component (e.g., payments made for real estate taxes

that would be owed by the lessor regardless of whether it

leased the building and regardless of who the lessee is,

payments made for the insurance that protects the lessor’s

investment in the building and the lessor will receive the

proceeds from any claim). Under IFRS 16, such costs are not

separate components of the contract, but are considered to

be part of the total consideration that is allocated to the

separately identified components of the contract (i.e., the

lease and non-lease components).

For such payments that are allocated to the lease

component, entities will need to evaluate whether they are

fixed (or in-substance fixed) lease payments or variable lease

payments. Fixed lease payments are included in the initial

measurement of the lease asset and liability.

2. Lease classification

Lessors classify all leases in the same manner as under IAS

17, distinguishing between two types of leases: finance and

operating. Lessors are required to reassess lease

classification upon a modification that does not result in a

separate lease.

Lessees, however, apply a single accounting model for all

leases, with options not to recognise short-term leases and

leases of low-value assets on the balance sheet.

3. Lessee accounting

At the commencement date of a lease, a lessee recognises a

liability to make lease payments (i.e., the lease liability) and

an asset representing the right to use the underlying asset

during the lease term (i.e., the right-of-use asset).

Lessees measure the lease liability using the interest rate

implicit in the lease, if that rate is readily determinable. If

that rate cannot be readily determined, the lessee is

required to use its incremental borrowing rate. Lessees

measure the right-of-use asset at the amount of the lease

liability, adjusted for lease prepayments, lease incentives

received, the lessee’s initial direct costs (e.g., commissions)

and an estimate of restoration, removal and dismantling

costs.

Lessees are required to separately recognise the interest

expense on the lease liability and the depreciation expense

on the right-of-use asset. When the right-of-use asset is

depreciated on a straight-line basis, this will generally result

in a front-loaded expense recognition pattern, which is

consistent with the subsequent measurement of finance

leases under IAS 17.

IFRS 16 specifies the accounting for lease incentives (e.g.,

lessor reimbursement for a lessee’s real estate commissions)

when measuring a lease liability and right-of-use asset.

Lease incentives receivable from the lessor at the

commencement date are deducted from the right-of-use

asset. Lease incentives received at or before the

commencement date reduce the initial measurement of the

right-of-use asset. ‘Key money’, which is paid by an

incumbent tenant to an outgoing tenant to secure a prime

location, is not included in lease payments and, therefore,

not included in the lessee’s lease liability.


3.1 Short-term leases recognition exemption

Lessees can make an accounting policy election, by class of

underlying asset to which the right of use relates, to apply

accounting similar to IAS 17’s operating lease accounting to

leases that, at the commencement date, have a lease term

of 12 months or less and do not include an option to

purchase the underlying asset (short-term leases). Short-

term leases are not recognised on the balance sheet and the

related lease expense is recognised on a straight-line basis

over the term of the lease or another systematic basis, if

that basis is more representative of the pattern of the

lessee’s benefit.

3.2 Leases of low-value assets recognition exemption

Lessees can also make an election, on a lease-by-lease basis,

to apply accounting similar to current operating lease

accounting to leases for which the underlying asset is of low

value (low-value assets) in the amount of USD5,000 or less,

must be able to benefit from the asset on its own or together

with other resources that are readily available to the lessee

and must not be highly dependent on, or highly interrelated

with, other assets.

4. Lessor accounting

Consumer products and retail entities may be lessors if they

sublease assets or have supply or contract manufacturing

arrangements with a customer that are determined to

contain a lease.

IFRS 16 requires lessors to account for operating leases

using an approach that is substantially unchanged from IAS

17. That is, lessors continue to recognise the underlying

asset and lease payments are recognised as income over the

lease term, either on a straight-line basis or another

systematic basis that is more representative of the pattern

in which the benefits from the use of the underlying asset is

diminished.

Under IFRS 16, lessors are required to account for finance

leases also using an approach that is substantially

unchanged from IAS 17. That is, lessors derecognise the

carrying amount of the underlying asset, recognise a lease

receivable and recognise, in profit or loss, any selling profit

or loss.

4.1 Subleases – intermediate lessor accounting

It is common for retail entities to sublease retail space to a

third party. Under IFRS 16, an intermediate lessor accounts

for the head lease based on lessee accounting. However, an

intermediate lessor considers the lease classification criteria

with reference to the remaining right-of-use asset rather

than the underlying asset (e.g., building subject to a lease)

arising from the head lease when classifying a sublease as

finance or operating.

IFRS 16 requires the intermediate lessor to measure right-

of-use assets arising from leased property in accordance

with IAS 40 Investment Property if a leased property meets

the definition of investment property, the sublease is

classified as an operating lease and the intermediate lessor

elects the fair value model in IAS 40 as an accounting policy.

This represents a change from the current scope of IAS 40.

Under existing requirements, this is an election that is

available on a property-by-property basis.

An intermediate lessor generally accounts for a head lease

(as a lessee) and a sublease (as a lessor) as two separate

lease contracts. However, when contracts are entered into

at or near the same time with the same counterparty or

related parties of the counterparty, an intermediate lessor is

required to consider the criteria for combining contracts (i.e.,

whether the contracts are negotiated as a package with a

single commercial objective, the consideration to be paid in

one contract depends on the price or performance of the

other contract or rights to use the underlying assets

conveyed in the contract form a single lease component). If

any criterion is met, the intermediate lessor accounts for the

head lease and sublease as a single combined transaction.


5. Other considerations

5.1 Sale and leaseback transactions

Because lessees are required to recognise most leases on

the balance sheet, sale and leaseback transactions will no

longer provide lessees with a source of off-balance sheet

financing.

IFRS 16 requires seller-lessees and buyer-lessors to apply

the requirements in IFRS 15 to determine whether a sale has

occurred in a sale and leaseback transaction. If control of an

underlying asset passes to the buyer-lessor, the transaction

is accounted for as a sale (or purchase) and a lease by both

parties. If not, the transaction is accounted for as a financing

by both parties.

5.2 Variable lease payments

Variable lease payments that depend on an index or rate are

included in lease payments and are measured using the

prevailing index or rate at the measurement date (e.g., lease

commencement date for initial measurement). Variable

payments that do not depend on an index or rate, such as

those based on performance (e.g., a percentage of sales) or

usage of the underlying asset, are not included as lease

payments.

Variable payments that do not depend on an index or rate,

such as those based on performance or usage of the

underlying asset, are not included as lease payments which

is similar to today’s accounting. Lessees recognise an

expense in the period in which the event that triggers those

payments occurs. Although IFRS 16 does not specify the

lessor’s accounting for variable lease payments that do not

depend on an index or rate, given that the IASB decided to

substantially carry forward the lessor accounting model in

IAS 17, a lessor recognises such variable lease payments as

income in the period in which they are earned, consistent

with current accounting.

Under IFRS 16, lessees are required to remeasure the lease

liability under certain circumstances, including when there is

a change in future lease payments resulting from a change in

an index or rate used to determine those payments. The

lessee is required to remeasure the lease liability to reflect

those revised lease payments only when there is a change in

the cash flows (i.e., when the adjustment to the lease

payments takes effect). For example, if the contractual lease

payments change every two years and the change is linked

to a change in the Consumer Price Index (CPI) during the

two-year period, a lessee would reassess the lease liability

every two years when the contractual payments change, not

each time the CPI changes.


Next steps

► Entities should perform a preliminary assessment

as soon as possible to determine how their lease

accounting will be affected. Two critical first steps

include: (1) identifying the sources and locations of

an entity’s lease data; and (2) accumulating the

data in a way that will facilitate the application of

IFRS 16. For entities with decentralised operations

(e.g., an entity that is geographically dispersed),

this could be a complex process, given the

possibility for differences in operational, economic

and legal environments

► Entities will need to make sure they have the

processes, including internal controls, and systems

in place to collect the necessary information to

implement IFRS 16 (including making the necessary

financial statement disclosures)

► Consumer products and retail entities should

consider how they might communicate changes to

their financial reporting to investors and other

stakeholders

Appendix A: Extract from IFRS 16 B31 – Flowchart of lease definition

Is there an identified asset?

Yes

Does the customer have the right to obtain substantially all of the economic benefits from use of the asset throughout the period of use?

Does the customer, the supplier or neither party have the right to direct how and for what purpose the asset is used throughout the period of use?

Neither; how and for what purpose the asset will be used is predetermined

Does the customer have the right to operate the asset throughout the period of use, without the supplier having the right to change those operating instructions?

Does the customer have the right to operate the asset throughout the period of use, without the supplier having the right to change those operating instructions?

Yes

No

Thecontract

contains aleasec

Yes

No

No

No

SupplierCustomer

Yes

Thecontractdoes notcontain a

lease


Challenges and analysis for large-scale chain retailers during the post VAT implementationAlvin Kong

Manager, Indirect Tax

[email protected]

The final round of VAT pilot reform has

started nationwide from 1 May 2016 and

expanded to cover the construction, real

estate, finance and life-style service

industries. A number of circulars and

announcements have been issued regarding

the VAT pilot, with the aim to reduce the tax

burden for all industries. Under such

circumstances, it is important for large-

scale chain retailers to improve their VAT

management in order to enjoy the benefits

brought by the VAT pilot. Our analysis

below focuses on how large-scale chain

retailers should deal with the opportunities

and challenges from VAT management, VAT

filing and risk control during the stage of

post VAT implementation.


1. VAT opportunities for large-scale chain retailers

Most large-scale chain retailers have already became general

VAT payers before the final round of VAT pilot on 1 May

2016 and have been allowed for input VAT credit. After 1

May 2016, the scope of input VAT credit has been expanded

to include the input VAT incurred for renting immovable

property, the purchase of immovable property, decoration

services, renovation services, sales supporting services,

labor dispatch services, agency services, employee

accommodation, certain banking, insurance services and so

on. The expanded scope of input VAT credit is aiming for

leading a decrease on VAT payable and a relief on total tax

burden.

In addition, there are opportunities for large-scale chain

retailers to improve their business model during the post

VAT implementation. The traditional retailers could leverage

and benefit from VAT pilot by planning and separating sales

channels or service modules. For example, retailers could

consider to separate out the online and platform sales

channel from the traditional sales channel, or separate out

the sales supporting service and goods handling service from

the traditional sales service, with the purpose to achieve

maximum tax benefit under the current VAT system.

2. VAT challenges for large-scale chain retailers

After the VAT pilot, the traditional retail industry is facing

challenges raised from the evolving VAT system, the

complicated VAT related information and the VAT collection

and management requirements. Detailed analysis are listed

below:

Firstly, the traditional retail industry is having a higher a

compliance cost due to the continuously updated VAT rules

and regulations, as well as the inconsistent interpretations

from tax officials. In order to have a smooth transition

period, specific VAT requirements regarding the applicable

VAT rate, calculation method, VATable base and VAT invoice

issuance are designed differently based on the

characteristics of each industry, and local tax bureaus may

hold different opinions on the interpretation and

implementation at practical level. In this regard, the retail

industry should pay attention to the newly issued VAT rules

and practical requirements from their in charge tax bureau

to improve their level of VAT compliance.


Secondly, certain VAT practice requirements have brought

challenges on the operation model for the retail industry. For

example, the Announcement of the State Administration of

Taxation [2016] No. 53 has stipulated the requirements

regarding the VAT treatment and invoice requirements on

prepaid cards. The retail industry, which has adopted the

prepaid cards method for market development purpose

would be impacted significantly by these tax requirements.

The VAT requirements on prepaid cards could also bring

potential risks for retail industry on issues like deemed sales,

uncertain VAT rate applicable, input VAT recovery and VAT

invoice issuance etc. Chain retailers should consider taking

actions to mitigate these potential risks while maintain their

commercial interests.

Thirdly, the chain retailers may need to undertake significant

work load for VAT adjustment requirements. The final round

of VAT pilot started from 1 May 2016, tax and accounting

treatment for the business operations could be inter-

temporal on a quarterly, half yearly or yearly basis. Some

VAT rules require trace-back adjustments and chain retailers

would need to make adjustments accordingly. The workload

for large-scale chain retailers could be resource intensive

due to the scale of operation, large number of branches,

varying finance processes and moderate level of VAT

automation.

Fourthly, the retail industry would be impacted by the

development of e-invoicing. The downstream enterprises

would raise requirements on e-invoicing management for

their internal finance and reimbursement system, internal

recognition and control management etc. To meet the needs

from their customers, large retail industry would face

challenges from the improvement of e-invoice issuance and

management, including the solution to duplication and

identification issues.

Last but not the least, large-scale chain retailers need to

deploy significant resources on VAT filing. According to

prevailing VAT rules, it might not be practical for large-scale

chain retailers to have consolidated VAT payments at

national or even regional (cross city or town) level. In this

regard, the VAT filing could represent significant work load

for large-scale chain retailers with multiple VAT registration.

Especially after the final round of VAT pilot, the VAT returns

have been modified by the tax authorities and have been

updated to include nine forms. The co-relations between

these data are complicated as they are decided by the tax

authorities for automated tax risk management purposes.

When the data entered into the form meet the risk

assessment criteria, the system would raise alert to bring

the potential VAT issues to the attention of the in charge tax

bureau. In light of the above, large-scale chain retailers

would need to have capable and available human and IT

resources to ensure the VAT returns would be filed correctly

and timely.


3. Post VAT reform management of large-scale chain retailers

In view of comprehensive analysis of opportunities and

challenges faced by enterprises, we can find although large-

scale chain retailers are traditional VAT payers instead of

pilot VAT payers, significant changes are still happened

during VAT reform and noteworthy for chain retailers. From

a practical point of view, chain retailers should strengthen

internal control environment and improve VAT management

efficiency.

Firstly, enterprise should introduce periodic VAT health

check mechanism. With the roll-out of VAT reform, certain

regulators are carrying out investigations and inspections on

VAT reform implementation. In September 2016, SAT

announced Notification of Carrying out Special Inspection on

the Use of VAT Fapiao. The circular has set out the guidance

on undertaking targeted inspection on how VAT taxpayers

are using VAT fapiao (invoices), distribution of VAT fapiao

and cancellation of VAT fapiao. As an observation, the scope

and frequency of similar large and comprehensive inspection

are expanding and increasing. In this regard, undertaking

periodic VAT internal health check appears to be very

important. Effective health check can ensure VAT

compliance, mitigate VAT risks, discover VAT saving

opportunities, improve VAT compliance management

efficiency, assess VAT key control points, refine VAT

procedures and help taxpayers to have a clearer view on

how VAT is being managed across the different parts of their

organization. The final goal is to improve the compliance of

business activities, and build VAT risk control system.

Secondly, large-scale chain retailers should optimize their

business models. With the fast developing digital economy,

the traditional procurement arrangements, stock models,

sales channels, and delivery models for large-scale chain

retailers are facing significant impacts. Most large-scale

chain retails currently are considering the use of third party

internet platform to extend their reaches to the consumer

market. This revolution has caused chain reaction to

optimize the efficient on stock replenishment, sales and

delivery model. In view of multiple VAT rates under current

VAT system, and the existence of preferential treatment on

certain lifestyle service sector, large-scale chain retailers

should optimize business model (e.g. build effective supply

chain managing platform, financial service center, delivering

center and sales platform), and arrange effective operation

model, to increase overall tax efficiency.

Thirdly, large-scale chain retailers should consider investing

on information-based tax platform aiming to improve their

tax accuracy and efficiency. With the development of

technology, information-based tax platform has been

changed dramatically. Digitized VAT sensitive data can help

reveal features of which businesses can rely on to improve

the accuracy of VAT compliance by reducing the chance of

making errors. The following approaches are samples of

digitalizing VAT data:


► Electronic Fapiao

China has launched electronic fapiao pilot program from

May 2012. Until now, the pilot program has become

more mature. Currently, the SAT is accelerating the

progress of upgrading electronic fapiao. Associated data

pairing/matching measures have been released

continuously. From chain retailers practices point of view,

electronic fapiao has obvious advantages from costs and

operating efficiency perspectives. With the maturing of

electronic fapiao measures and full roll-out of VAT

reform implementation, it is observed that chain retailers

have adopted/ in the process of adopting electronic

fapiao as the cost and difficulties on issuing paper

fapaios have found to be increasing.

► Digitization of VAT Filing

Tax filing is one of the most essential components of VAT

management and can sometimes represent hurdles for

chain retailers. Tax filing often involves data pulled from

various internal IT system and if the data extractions and

handling are not being done automatically, it would be a

labor intensive process and the potential human error

could hinder the accuracy of the VAT filing. The first step

of automation on VAT management is often digitizing the

VAT sensitive data and there are readily available tools in

the market which can assist tax personnel with the VAT

return filing tasks.

Many digitized VAT return filing tools can realize

automated VAT data handling to a large extent which

involves data extraction, data population, reconciliation,

risk recognition and other VAT management functions.

An added benefits for adopting automation is that,

resources could be freed up to handle other value adding

matters within the company.

Fourthly, large-scale chain retailers should collect

requests of VAT associated policies and regulations. With

the implementation of VAT legislation, tax authorities are

refining/clarifying certain tax policies and regulations.

For example, on the VAT policy for consolidated VAT

filing for large-scale chain retailers head offices and

branches, due to certain requirements set by local tax

authorities in view of local financial interests, some

large-scale chain retailers head offices and branches are

having practical difficulties in utilizing consolidated VAT

filing.

On 2 November 2016, the General Office of the State

Council issued the Opinions of the General Office of the

State Council on Promoting the Innovative

Transformation of Physical Retail (Guo Ban Fa [2016] No.

78) and the circular has explicitly specified “enforce

associated policies and regulations on Enterprise Income

Tax and VAT consolidated filing of head offices and

branches”. Large-scale chain retailers should take

advantage of this principle set by the State Council and

this can be achieved by proposing reasonable and

practicable approaches (based on actual situations and

business model) on VAT consolidated filings.


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© 2017 Ernst & Young (China) Advisory LimitedAll Rights Reserved.

APAC no. 03004519ED None.

This material has been prepared for general informational purposes only

and is not intended to be relied upon as accounting, tax, or other

professional advice. Please refer to your advisors for specific advice.

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