A tax benefit hidden in the details
For smart hardware manufacturing companies, the immediate tax refund policy for embedded software value-added tax is an important tax incentive that encourages innovation. However, a key issue troubles many financial personnel in practice: should indirect costs such as labor costs and depreciation be included in the hardware production costs, in addition to direct materials?
This seemingly technical accounting issue directly relates to whether enterprises can fully enjoy the policy benefits, potentially leading to tax discrepancies in the millions.
1. Core of the Policy: Why Separate Accounting?
According to the “Notice on Value-Added Tax Policy for Software Products” (Cai Shui [2011] No. 100), embedded software products can enjoy a policy of immediate tax refund for the portion of the actual tax burden exceeding 3%.
The key premise for enjoying this policy is that taxpayers must separately account for the costs and revenues of embedded software products and computer hardware or machinery. This is because the sales amount of the hardware must be determined first to calculate the sales amount of the software.
The basic formula is:
Embedded Software Sales = Total Machine Sales Price – Hardware Sales
For the hardware portion, if there are no comparable prices from the same period for both your own and others’ products, the hardware sales amount must be calculated based on the composition taxable price:
Composition Taxable Price = Cost of Computer Hardware and Machinery × (1 + 10%)
Here, “cost” refers to the actual production (or procurement) cost of self-produced (or purchased) computer hardware and machinery. The cost profit margin is usually 10% (if the actual is higher than 10%, then use the actual).
In practice, most enterprises use the composition taxable price to calculate the income from hardware and software, as they generally do not sell hardware without software separately, and it is difficult to obtain prices from non-public companies.
2. Controversy Focus: Should Indirect Costs Be Included in Hardware Costs?
The core of the issue lies in how to define “hardware costs.” Currently, there are mainly two viewpoints:
Viewpoint 1: Strictly follow accounting standards and fully account for product costs
This viewpoint holds that hardware costs should adhere to enterprise accounting standards and include:
• Direct material costs: such as chips, circuit boards, and shells directly used in product manufacturing.
• Direct labor costs: salaries and benefits of production line operators directly involved in product assembly, welding, and debugging.
• Manufacturing expenses: including depreciation of production equipment, maintenance of specialized equipment, utilities for the production workshop, and salaries of workshop management personnel, which are indirect costs incurred for product production.
The rationale supporting this viewpoint emphasizes the integrity and authenticity of cost accounting, preventing enterprises from artificially allocating costs that should belong to hardware into software costs or period expenses, thereby exaggerating software sales and obtaining improper tax refunds.
Viewpoint 2: Align with the policy’s original intent, mainly accounting for direct material costs
This viewpoint argues that hardware costs should primarily cover direct material costs and should not excessively allocate indirect costs such as labor and depreciation. The reasons are as follows:
1. The policy’s original intent is to encourage software innovation: The establishment of the immediate tax refund policy for embedded software is aimed at alleviating the high actual tax burden due to the high value-added of the software portion but low deductible input tax, thereby encouraging software research and development and innovation. If a large amount of indirect costs is included in hardware costs, and then calculated at a 10% cost profit margin, it will artificially inflate hardware sales.
2. It leads to an underestimation of software sales: An inflated hardware sales amount means that the portion deducted from total sales increases, which naturally reduces the calculated sales amount of embedded software.
3. Ultimately weakens the tax refund strength: The software sales amount is the basis for calculating the tax refund amount, and its reduction directly leads to a decrease in the tax refund amount that enterprises can obtain.
4. Indirect costs correspond to less input tax: For example, labor costs correspond to very little input tax. Including these costs in hardware costs inflates hardware income, but this “inflated” income does not have enough input tax to offset, which may increase the overall tax burden for enterprises, deviating from the policy’s original intent.
3. Economic Downturn Intensifies Conflicts: Price Reductions and Rigid Costs
In recent years, the economic downturn has intensified this conflict: enterprises are forced to lower the prices of their end products, but labor and management costs cannot decrease proportionally.
• Pressure to lower product prices: Market competition is becoming increasingly fierce, and to secure orders, enterprises often need to offer more competitive prices to win projects. All industries are generally facing price pressure, and the decline in product unit prices drags down revenue and gross profit.
• Rigid costs: Indirect costs such as personnel salaries, depreciation of production equipment, and management expenses exhibit a relatively rigid characteristic, making it difficult to decrease in tandem with product prices.
• Vicious cycle: In this situation, if indirect costs that cannot decrease proportionally are included in hardware costs and calculated at a 10% profit margin, it will further inflate the calculated hardware sales amount, squeezing the sales amount of the software portion and significantly reducing the tax refund benefits that enterprises can enjoy.
This creates a vicious cycle of “the more the product price decreases, the more difficult it is to obtain tax refunds,” and it may even lead to situations where the hardware cost plus composition taxable price results in negative software income, contradicting the policy’s intent to encourage software innovation and reduce the burden on enterprises.
4. Real Dilemma: Inconsistent Execution by Tax Authorities Across Regions
Currently, there are indeed differences in the understanding and execution of this issue by tax authorities across the country.
Some regions require strict adherence to accounting standards for hardware cost accounting; others may focus more on the spirit of the policy, allowing for accounting methods that are closer to the value contribution of software. This uncertainty poses significant challenges for enterprises’ tax planning and compliance management.
5. Enterprise Response: How to Optimize Accounting and Mitigate Risks?
In the face of this dilemma, enterprises should not passively wait but should proactively plan:
1.Improve internal control and cost accounting systems
This is fundamental and crucial. Enterprises should establish clear rules for cost collection and allocation, and refine the separation of hardware and software costs as much as possible. Set up different cost centers or project codes for hardware and software to ensure accurate collection of all expenses. For common indirect costs, develop reasonable and consistent allocation standards (such as labor hours, area, etc.) and create written policy documents.
2.Contracts should clearly distinguish income, butmustbe reasonableand based on evidence
Clearly distinguish the income amounts for hardware and software in sales contracts, but this distinction must be based on reasonable and evidence-based foundations, not arbitrarily fabricated, and should comprehensively consider product value, market practices, and other factors. Otherwise, if the income for the hardware portion is excessively reduced, there is a motive and risk of artificially inflating software income to fraudulently obtain value-added tax refunds.
3.Strengthen communication with the tax authorities in advance
Before applying for tax refunds, proactively communicate with the tax policy management department of the competent tax authority to understand their specific execution standards and requirements for this issue. Attempt to explain the understanding of the policy’s original intent in a professional manner to seek the most favorable interpretation for the enterprise.
4.Prepare evidence to prove the value of software
Retain detailed research and development project reports, development process documents, labor hour records, information about the R&D team members, and labor contracts to demonstrate the core value and independent investment of the software, which will help in negotiating a more reasonable cost allocation method during communication.
5.Seek support from professional institutions
Given the professionalism of the issue, it is advisable to consult professional tax advisors or accounting firms. They usually understand the execution dynamics in various regions and effective communication methods with tax authorities, helping enterprises better prepare materials and respond to potential audits.
6. Returning to the Policy’s Essence: Calling for Calculation Based on Hardware Procurement Costs
Essentially, the immediate tax refund policy for embedded software is a structural tax reduction policy aimed at encouraging innovation and development in the software industry.
The design of its tax refund mechanism should more accurately reflect the true value and contribution of software. If the policy benefits are weakened due to issues with cost accounting standards, or if compliance costs increase due to inconsistent standards, it may deviate from the original intent of the policy to some extent.
The ideal situation is that, under the premise of complying with basic accounting principles, the cost accounting methods can better align with the policy’s direction, allowing the benefits to truly reach the entities that encourage innovation.
Therefore, we strongly call for:
Directly calculating the composition taxable price based on the procurement cost of hardware (or direct material costs) to avoid the problem of inflated hardware sales and underestimated software sales caused by including a large amount of indirect costs, so that the policy benefits can more accurately benefit the software R&D process and truly achieve the policy goal of encouraging innovation.
Directly calculating the composition taxable price based on the procurement cost of hardware (or direct material costs) to avoid the problem of inflated hardware sales and underestimated software sales caused by including a large amount of indirect costs, so that the policy benefits can more accurately benefit the software R&D process and truly achieve the policy goal of encouraging innovation.
For enterprises, deeply understanding the policy connotation, standardizing internal accounting, and strengthening communication and coordination are key to maximizing compliance and enjoying policy benefits in the current environment.
We hope that all enterprises dedicated to innovation can truly enjoy the support of national policies, making tax incentives a booster for enterprise innovation and development, rather than a challenging issue full of uncertainties.
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