Introduction
On May 1, 2016, China has fully implemented its VAT reform by replacing all business tax with value-added tax (VAT) after extending the policy to cover the construction, real estate, finance and consumer services sectors (Caishui [2016] No. 36 (“Circular 36”) jointly issued by the Ministry of Finance and State Administration of Taxation, March 24, 2016).
In this way, the red dragon of Asia has aligned its indirect tax policies with international practices, if we consider that more than 140 countries have already implemented a full VAT regime.
In fact, for years China has operated a dual system of indirect taxes, with VAT applicable to the sale and importation of goods, at the standard rate of 17 percent or, for some products, at the reduced rate of 13 percent, whilst most services were subject to business tax (BT) at rates of either 3 percent or 5 percent.
The reform removes completely the BT by introducing the VAT which taxes only the value added at each link in the production chain, and it avoids the double taxation of the BT regime, which is based on the gross revenue of a business, including the cost of input.
"The business-tax-to-VAT reform", together with the ongoing landmark tax reform, is expected to reduce burdens on all industries and to revitalize the real economy. Alongside the VAT reform, Chinese tax administration plans to implement reforms on other taxes including resource tax and environmental protection tax in order to support the country’s sustainable development and promote its economic transformation. In fact, the Chinese Government has also indicated that the final goal of the entire tax reform is to transform the nation from a production-based economy into a more service-oriented economy.
Consequently, a foreign company, in addition to align its business strategy to the new VAT system, has to assess whether these changes (taxation and new economic direction) will be favorable-profitable or not.
Background
Modernizing the taxation in China by the year of 2020 has become the common goal that all the Chinese tax officials have been working towards. Many works have achieved remarkable recognition in the process. One of the many important features of the modernized taxation was that it would consist of the “Six Systems”:
A comprehensive legislation system to ensure that tax laws are high in the legislative hierarchy and the implementation of the “tax governance by law” principle.
A mature institutional system to favor sound economic development, social fairness and equal treatments of market players.
A quality taxpayer service system in place to serve the strategic opening-up and economic development.
A technology driven administration system to improve the effectiveness and efficiency by incorporating the risk management techniques.
A powerful information system to collect and analyze information from all the taxes levies and the whole work process of taxation.
An effective organizational structure to nurture future leaders of Chinese tax administration.
A cross-the-board performance evaluation framework as a part of the effort to motivate the workforce and improve organizational efficiency.
Thus, the VAT system reform is just one of the many remarkable actions and measures taken across the recent years to implement the wider reform plan as above described.
The indirect tax system in China, with the purpose of unifying the Business Tax and the Value Added Tax, was launched in 1994 whilst the transformation from manufacture-based VAT to consumption-based VAT was in 2009.
Starting from 2012, the application of VAT has been gradually expanded to industries including transportation, postal service and telecommunication as well as seven modern service sectors including research and development and technical services, information technology services, cultural and creative services, logistics auxiliary service, tangible movable assets leasing services, authentication and consultation services, and broadcasting, film and television services.
As of January 1, 2015, the upgraded VAT Invoice Processing System was put into use. The upgraded system has several notable features. First, it is designed to collect all the information printed on the VAT invoices. Second, the information will be uploaded to the database once the information is collected. Last, the taxpayer invoice issuance process is monitored remotely and the information recorded will be stored in the database.
By compiling data from various types of businesses operating in diverse industries and different regions, the system can effectively identify and prevent tax evasion and tax frauds related to tax invoice. Above all, it can help inform the macroeconomics decision making. By the end of 2015, it is estimated that the reform has cut taxes by 641.2 billion yuan ($105.1 billion) and effectively reduced business costs for the taxpayers.
The final phase of the reform ushered in on May 1, 2016, has finally put all industries under a unified VAT regime by adding construction, real estate (with input taxes paid on the newly purchased property deductible), financial services and consumer services to its application scope. With that, the VAT has essentially taken the place of the BT in all the manufacturing and service sectors. This move was expected to slash taxes by over 500 billion yuan this year and reduce tax burden for all the industries involved.
The New VAT sector by sector
Construction services. Construction services include engineering, construction services installation (including equipment installation), renovation, interior decoration, repairs and other construction projects. The old BT was 3%, the new applicable VAT rate is 11% (General VAT payers) and 3% (Small-scale VAT payers).
Real Estate. Real Estate include sales of buildings and other structures built on land, assignment of land-use rights and natural resources use rights, real property leasing. The old BT was 5%, the new applicable VAT rate is 11% (General VAT payers) and 5% (Small-scale VAT payers). VAT at 5% during the transition period for General VAT payers.
Financial and insurance services. Financial and insurance services include insurance and reinsurance, banking and asset management, loan services, direct charge services, insurance and financial commodity transfers. The old BT was 5%, the new applicable VAT rate is 6% (General VAT payers) and 3% (Small-scale VAT payers).
Consumer services (lifestyle services). Consumer services include hospitality, tourism, food and beverage, education, healthcare and entertainment. The old BT was 5% (entertainment 5-20%), the new applicable VAT rate is 6% (General VAT payers) and 3% (Small-scale VAT payers).
Sale and importation of goods, logistic services, modern services, transportation, repair and processing services, asset leasing. These sectors were already subject to VAT before May 2016, with the standard applicable rate of 17 percent or, for some products, the reduced rate of 13 percent.
New compliance requirements
The implementation of VAT include additional compliance requirements compared with managing BT. Briefly:
Chinese companies in the financial, construction, real estate or lifestyle sectors should: - Assess the financial impact and adjust business model and pricing methods; - Review existing contracts and revise tax and pricing clauses (to reflect the change from BT to VAT) and price composition (include or exclude VAT depending on commercial situation); - Manage and upgrade internal financing system, implement control process for managing VAT compliance work, and conduct VAT training for employees; - Complete VAT registration, purchase VAT invoice machine and invoices, and be ready for first monthly VAT filing by 25 June 2016 (except financial institutions, which are subject to quarterly VAT filing).
Other Chinese companies that are already VAT payers should: - Review supply chain and supplier qualifications, follow up with suppliers on their VAT registration status, and obtain special VAT invoices to obtain more deductible input VAT for crediting purposes; - Review customer list, assess and determine whether to adjust the pricing mechanism for customers transformed from BT to VAT payers.
Foreign companies with Chinese operations should: - Understand the PRC VAT rules applicable to foreign companies and the VAT withholding mechanism; - Assess the potential tax impact on China-related transactions (e.g. sale or procurement of goods and services to/from China) and negotiate with Chinese counterparties regarding price adjustments; - Review and amend cross-border contracts to clarify the party responsible for VAT and VAT filing.
The "Circular 36" can guide companies to a correct adjustment-implementation of the new compliance requirements. It clarifies the current scope of taxable services and reclassifies certain taxable items such as:
Sale-and-leaseback, which was subject to 17% VAT as a “lease of movable assets”, and is reclassified as a “financial service” subject to 6% VAT.
Carrier business without vehicle, which was classified as “auxiliary logistics” subject to 6% VAT, and is reclassified as a “transportation service” subject to 11% VAT.
Parking fees and tolls are considered a “lease of immovable assets” subject to 11% VAT.
The scope of intangible assets is expanded to include “other economic interest”, such as operating rights for infrastructure, public utility concessions, quotas, franchises, memberships, domain names, naming rights, and club transfer fees. The transfer of such intangible assets in China will be subject to VAT at 6%.
The Circular 36 clarifies also:
General VAT exemption. The following activities are not subject to PRC VAT: - Provision of services and transfer of intangible or immovable assets free of charge for the public welfare (e.g. rail and air transport provided free of charge by State order); - Deposit interest; - Insurance payments to beneficiaries; - Special housing maintenance funds collected by real estate administrative departments, housing fund management centers, real estate developers and property management companies; - Transfer of buildings and land use rights as part of a business transfer (the assets and associated rights, liabilities, and workforce must be transferred at the same time).
In line with the State Council’s objective to reduce the tax burden, Appendix 2 of Circular 36 provides a comprehensive list of VAT-exempt items categorized by sector, including: - Preferential BT/VAT treatments for each sector before the VAT reform (e.g. qualifying educational services previously exempt from BT will continue to be exempt from VAT); - New exemptions for certain industries (e.g. certain types of interest income received by financial institutions).
VAT exemption on export service. Furthermore, exported services will continue to qualify for VAT exemption or be subject to a 0% VAT rate. Appendix 4 of Circular 36 provides a detailed list of such qualifying exported services. However, Circular 36 imposes a new requirement for certain types of exported services and intangible assets to qualify for VAT exemption. The provision of telecommunication, intellectual property, ancillary logistics, assurance and consultation, professional technical services, and advertising services for ads published outside China, as well as the transfer of intangible assets, will be exempt from VAT only if they are provided or transferred to overseas entities and fully consumed outside China. To be “fully consumed outside China”, the service recipient must be located offshore and the service must not be related to goods or immovable property in China, or the intangible asset must be used entirely offshore and not be related to goods or immovable property in China. This new requirement may limit the scope of eligible exported services and make it more difficult for VAT payers to provide sufficient proof that the services/assets were fully consumed outside China when applying for VAT exemption.
Input VAT deduction. Now that the real estate sector will be included into the scope of VAT industries, input VAT incurred on real property acquired on or after 1 May 2016 may be credited against the output VAT. Unlike the general input VAT deduction rule, which allows general VAT payers to immediately credit all input VAT indicated on special VAT invoices received from a seller, the input VAT incurred on newly acquired real estate must be credited over a two-year period, with 60% of the input VAT credited in the first year and the remaining 40% credited in the second year. This treatment does not apply to the projects of real estate developers or real estate acquired through financial leasing. As the granting of land use rights (“LUR”) is exempt from VAT, real estate developers cannot deduct input VAT on the purchase of LUR from governments. To reduce the potential tax increase on real estate developers caused by the VAT reform, real estate developers will be permitted to calculate their output VAT by deducting any LUR grant price paid to the government from their sales revenue.
Lessees may also credit any input VAT charged by their landlord on top of the rent for real property. Taxpayers may not credit the input VAT incurred on loan services (including input VAT incurred on loan interest, investment/financing advisory fees, commission charges, and consulting fees directly related to the loan borrowed by the taxpayer and paid by the taxpayer to the lender), catering services, daily residential services, and entertainment services against their output VAT.
Special sector rules. To ensure a smooth transition from BT to VAT, Circular 36 provides special rules for financial services, construction, sale and lease of real estate: - Financial services: special rule for calculating the output VAT tax base; - Construction: general VAT payers may opt for the simplified VAT taxation method for certain types of construction services; - Sale and lease of real estate: transition rules for the sale and lease of real estate before 1 May 2016.
How the new VAT system will affect businesses and China economy
Obviously it is still too early to assert if the new VAT system will bring real advantages to businesses and the expected results in China economy. We remember that the VAT reform is expected to directly help the tertiary industry (services sector boost), which makes up more than half of the Chinese economy and is critical to China’s economic transition.
Traditional manufacturing businesses stand to benefit too, as they enjoy more deductibles under the unified tax regime. Liu Shangxi, head of the Research Institute for Fiscal Science under China’s Ministry of Finance, said the VAT helps create a fairer market for business because “...the unified tax system covering the production, circulation and consumption of all goods and services is more neutral and provides a better tax environment for the market to play a decisive role in allocating resources...”.
Purchased services are deductible under the VAT scheme, which encourages firms to outsource more services rather than adopt a do-it-all business model, according to a report by China International Capital Corp Ltd, an investment bank.
A more socially significant impact of the VAT reform is that it eases tax burdens for small- and medium-sized enterprises (SMEs), which experts say will encourage entrepreneurship and boost job creation. SMEs used to pay a 5 percent or 3 percent business tax on sales, but they now only need to pay a VAT of 3 percent. Moreover, the business tax imposed on sales ignores the fact that some SMEs do not earn any profit.
Many multinational companies have already taken advantages from the new rules (in the sectors and areas where the VAT regime was introduced first as pilot program). For example, for the cross border services (intercompany service arrangements, transfer pricing arrangements, royalties for intellectual property rights, back office support services, management services and many more) the 5% of BT applied to most services which were either exported from, imported into China. Now exports of services, may be zero or exempt from VAT, whilst imports of services are subject to VAT withholding but recipient may claim an input VAT credit.
Businesses selling goods as well as importers (e.g. manufacturers, wholesalers, retailers), previously could not claim input VAT credits for the purchase of services because they were subject to BT. All service providers in China who register as general VAT taxpayers are now entitled to claim input VAT credits for the purchase of goods, fixed assets and services used in their business.
The Real Estate and Construction industry is perhaps the sector most affected (in negative) by the VAT reform. The VAT rates for the real estate and construction industry are substantially higher than the previous BT rates. The real estate sector, includes both sales and leasing, and it affects all major real estate categories, such as residential, retail, office, industrial, commercial property. The new VAT regime applies to all transactions related to real estate and construction, ranging from first sale of properties carried out by developers and secondhand sale by the public, to the full construction sector.
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