May 1, 2016, will be considered a significant milestone in the history of China tax law because that is the date business tax (BT) was replaced by Value-Added Tax (VAT) for all industries in China. Many changes are being implemented very quickly. With this landmark event, how do the changes affect your business?
Why is there a need to transition to VAT?
The State Council launched VAT reform to convert businesses subject to BT to VAT, starting with the transportation industry and certain other service industries in Shanghai as a pilot project in 2012. After that, the pilot was rolled out nationwide and expanded to more and more service sectors, including railway transportation, post and telecommunications. On May 1, 2016, other industries including construction, real estate, financial services and consumer services were also included within the scope of VAT, which effectively means all business in China is now within the scope of VAT.
The key aim of VAT reform is to resolve the double taxation issues under the BT scheme, to reduce the tax burden on taxpayers and to promote investment. According to Premier Li Keqiang, the tax reduction amount for this year is estimated to be around RMB500 billion as a result of the VAT reform.
Who is impacted?
In the VAT reforms of 2016, with construction, real estate, financial services and consumer services included in the VAT scope, the supply of construction services and the sale and leasing of real property in China will be subject to a VAT of 11 percent, while taxpayers are allowed to claim input on VAT credit on cost.
The new 11 percent VAT rate is much higher than the three percent (for construction) and five percent (for sales and leasing of real estate) BT rates. But the VAT rules allow taxpayers in these sectors to deduct subcontracting payments and land costs from the sales amounts to compute VAT in certain situations. It also introduced a mechanism whereby a provisional VAT was paid followed by a final settlement to solve the potential mismatch of input VAT and output VAT which could adversely impact real estate companies. On the other hand, transitional rules have been introduced in connection with old construction/real estate projects, allowing taxpayers to opt to pay VAT under a simplified taxation method similar to the current BT mechanism. These measures are expected to mitigate the potential negative impact of the increase in the applicable tax rates (e.g. from three percent or five percent BT to the current 11 percent VAT).
Financial and consumer services
China took a bold decision with a broad application of VAT to the financial services sector at the rate of six percent from May 1, 2016. The decision is bold because China is probably the first and only country to tax financial services so broadly. The current VAT rules largely follow the current BT rules including various BT exemptions (for example, exemption of interest from inter-bank transactions) and “net base” treatment where the taxable base (i.e. sales) is computed by deducting certain items from the gross revenue (for example, the sale of financial products).
The consumer service sector encompasses a number of industries that primarily focus on the supply of services to private individuals, so restaurants and hotels are now within its scope.
Taking into consideration the fact that taxpayers in these two sectors may claim input VAT credit after the reforms, it is generally expected that their overall tax burden will not be significantly impacted. It had been expected that the simplified taxation method could be applied to all taxpayers in the financial and consumer service industry sector after the reforms. But this treatment is not reflected in the final rules. So taxpayers in the financial and consumer sectors must apply for general taxation terms as long as they qualify for general VAT payer status. For these taxpayers, compliance costs may increase.
Taxpayers in other sectors are also expected to directly or indirectly benefit from the final rollout of the reforms. In particular, businesses will have the opportunity to get input VAT credit from vendors in the four sectors and reduce their own tax burden. The most eye-catching highlight in the final rollout program is the inclusion of newly-acquired real estate within the scope of input credit. There had been expectations among many that the credit period could be 20 years, with 5 percent of the input VAT on real estate being credited each year. But the final VAT rules provide for a two-year credit period, i.e. 60 percent of the input VAT can be credited in the first year, and the remaining 40 percent in the second year. This credit period is much shorter than was generally expected. It is obvious that the government is very determined to lower the tax burden on all sectors. It is expected that this policy will encourage investment in commercial real estate.
Although the full-scale rollout of the reforms is a very positive move, considering the complexity and fluidity of the economy and business activities, the newly-issued rules are still to be tested in business reality. Many taxpayers have focused on being ready for May 1, 2016, so many expect that the areas for improvement will be identified post-implementation. Also, although the Ministry of Finance (MOF) and State Administration of Taxation (SAT) have already issued several clarifications, there remain many more issues to be clarified by the authorities. In the meantime, there are multiple levels of VAT rates in the current system, which may limit the neutralization effect that the VAT regime is supposed to have. As a result, businesses should closely monitor further developments of the reforms.
Moreover, VAT is quite different from BT in terms of tax treatment and accounting booking. In this regard, new VAT payers would be wise to establish their own VAT compliance and control systems to accurately calculate VAT liabilities and manage the potential tax compliance risks. They are also recommended to study the new rules and explore preferential policies that can be enjoyed, for example, whether and how to adopt the transitional rules for old projects for construction and real estate taxpayers, whether to apply for VAT exemption or zero-rating treatments to reduce VAT burden, etc.
Lastly, how to manage commercial issues (e.g. pricing negotiations) as a result of the reforms is an imminent and crucial challenge for taxpayers. After BT is replaced by VAT, taxpayers need to perform a financial/tax impact analysis to understand the potential impact in terms of revenue, costs, profit and tax burden. On this basis, companies can revisit their pricing policy and communicate with suppliers and customers.
Commercial contracts and related legal documents should be amended to support the new pricing agreement and to protect the company’s interests to the greatest extent possible.
Candy Tang is a Director in the tax and business advisory services unit of Deloitte.