China VAT Reform

-       Big Challenges Ahead

By Jonas Jia He (CA)

China indirect tax system is facing a major storm. On 24^th March 2016, the Ministry of Finance and the State Administration of Taxation jointly issued Circular Caishui［2016］ No. 36 that provides the detailed rules on the full implementation of Value-Added-Taxes(VAT) to cover the last four big sectors - real estate, construction, financial services and lifestyle services. There are also modifications to the existing VAT rules. The new VAT rules take effect from 1 May 2016 and the traditional Business Tax (BT) will be abolished completely.   

For decades, China has been applying VAT mainly to goods sector and applying BT to services sector. BT was charged directly on the taxpayer’s taxable sales income without any input credit, it was a tax on businesses. VAT is a tax to be passed from businesses to the final consumers. Since 2012, the Chinese government has been carrying out a VAT Reform program (Chinese called it “BT2VAT”) in order to reduce the tax burden of businesses and promoting economic growth. Before the introduction of Circular No. 36, BT has been replaced by VAT in almost all the sectors except for the last four big sectors. Now, this shall be the final phase of the VAT Reform program. The table below summaries the new applicable rates to the four big sectors：

Generally speaking, the real estate and construction sectors will bear big tax rate increases. The financial services and lifestyle services sectors will expect more or less similar tax burden as in the past. Technically speaking, a direct comparison of the BT rates with the new VAT rates is not appropriate. Our evaluation shall be focused on the availability for input credits, transitional rules and special relief. Before analyzing the key impacts on the four big sectors, we need to understand some basic concepts of China VAT system:

· General VAT taxpayer – businesses with annual turnover > 5 million RMB

· Small scale VAT taxpayer – businesses with annual turnover < 5 million RMB and decide not to register itself as general VAT taxpayer.

· Simplified tax method – small scale VAT taxpayers shall apply this method with a low fixed VAT rate (typically 3%) on its gross income. However, taxpayers cannot claim any VAT input credit and may not issue or receive any VAT invoice.

· General VAT taxpayer may opt for the simplified tax method under certain circumstances.

· General VAT taxpayers can only issue VAT invoices on government authorized system.

· The land in China is not privatized; the purchase of land from the government contains no VAT input credit.

Net sales approach：Total VAT taxable sales = Total revenue received – certain direct costs (without VAT input credit)

Real Estate Sector

· Sales of real estates (B2B, B2C)  

Under the transitional rules, the general VAT taxpayer can opt for the simplified tax method to the real estates been developed or purchased before 1 May 2016(old real estate). The applicable rate is 5%. Under the simplified tax method, real estate developer cannot subtract the land cost from the taxable sales of the real estate. Non-real estate developer VAT taxpayer can subtract the original purchase costs of the real estate (not self-built) from the taxable sales amount (net sales approach).

If a real estate developer as a general VAT taxpayer does not opt for the simplified tax method. It can always subtract the land cost (no VAT input credit) from the taxable sales amount. Therefore, the real estate developers need to do internal calculations in order to make the right selection (a general tax method vs the simplified tax method) before selling the old real estates. The simplified tax method cannot be applied to the real estates been developed or purchased after 1 May 2016(new real estate) except for the small scale VAT taxpayers.

A key development is that when a general VAT taxpayer acquires a new real estate and records it as fixed asset for accounting purpose, the VAT input credits can be available for offsetting over a two-year period (60% 1^st year, 40% 2^nd year).  We think that a fair approach shall be that the full VAT input credits are available for offsetting within the same taxable period. A deferred offsetting approach is rare in other VAT systems. It seems that the Chinese authorities may have concerns about the potential VAT avoidance risk when taxpayers try to generate excessive VAT input credits from B2B real estate transactions. Two good solutions can be considered in this situation (a) Adoption of “Zero-rating” approach (b) Adoption of Domestic Reverse Charge mechanism.  

· Sales of real estates (C2C)

It’s interesting to see that the VAT will also be applied in the disposal of real estates by individuals. The rules are summarized as following:

(1)  5% VAT on gross sales will be applied to both residential and non-residential real estates, if the individual’s holding period < 2 years.

(2)  If individual’s holding period > 2 years, the real estates located outside of Beijing, Shanghai, Guangzhou and Shenzhen will be exempted for VAT. The residential real estates located in these regions will be exempted but not for the non-residential real estates.  

Personal income from the renting/leasing of residential real estates will be subject to 1.5% VAT.

The supplies of residential real estates between individuals are normally exempted for VAT purpose in other tax jurisdictions. A rational approach probably is that a Capital Gain Tax shall be adopted rather than VAT.

Construction Sector

The simplified tax method (3%) can be applied in the following circumstances:

(1)  A general VAT taxpayer does not purchase materials or only purchases auxiliary materials for the construction works. The taxpayer only charges labour service fees and management fees.

(2)  The project owner purchases all or part of the equipment, materials and energy set. A general VAT taxpayer mainly supplies labour services to the construction works. 

(3)  A general VAT taxpayer provides construction services to the old projects (commencement date before 1 May 2016)

(4)  A small scale VAT taxpayer.

The biggest problem in China construction industry is that many suppliers in this sector are not registered as general VAT taxpayers and they cannot produce VAT invoices. The other common issue is that labour costs accounts for a large percentage of the total costs. A typical cost model in China construction sector is:

(1)  Raw materials 60% (normally the suppliers of concrete and steel may provide VAT invoices that are about 45% of total costs).

(2)  Construction machinery 5% (VAT invoices available)

(3)  Labour costs 30% (no VAT)

(4)  Financing cost 5% (no VAT)

The costs with VAT invoices are only about 50% of the total construction costs. Obviously, the players in this industry will face short term tax burden due to the unavailability of sufficient VAT input credits. However, the new VAT rules will push all the construction companies to regulate its accounting and taxation systems. In the long term, only the players that follow the good industrial practices shall survive.

Financial Services   

The VAT on financial services is generally exempted in other VAT systems. China has taken a unique approach by imposing VAT on the following financial services:

· Loan services

· Direct charge financial services

· Insurance

· Financial commodity transfer (net sales approach available)  

The interest on deposit and the compensations from insurance payout will not be subject to VAT. There are certain incomes exempted for VAT:

· Interests from inter-bank lending, interests from uniformed borrowing and returning, interests from government debentures and local government debts etc.

· Earning from the trading in China stock exchange markets through “QFII”. Personal income from trading in financial commodity

· Income from the personal life insurance with duration of 1 year or more

·Income from the authorized credit guarantee services been provided to small-medium sized entities

· The liquidation transactions of a closed financial institution

A special clause is that the taxpayers cannot claim any VAT input credit on the loan interest and any other cost that is related to the lending service. Therefore, the VAT flow fully stops on the lender’s side.

By considering that the VAT input credits will be available for offsetting in the financial service sector, the 6% VAT rate seems not going to create more tax burden. We believe that the application of extensive VAT rules in financial service is a radical approach and it has subverted our traditional practice in this field. It will be also difficult to calculate the “value-added” amount in the complicated modern financial commodity transfers.    

Lifestyle Services

6% VAT will be applied to the following lifestyle services:

· Culture and sports service

· Education and medical service

· Tourism and entertainment service

· Catering and accommodation service

· Resident’s daily service

· Other lifestyle service

VAT exemption will be applied to the governmental authorized public education and medical providers. A general VAT taxpayer who provides culture and sports service may opt for the simplified tax method. The net sales approach is only available to the tourism operators. We found that the VAT flow is also blocked in the following circumstances:

(1) Taxpayers cannot claim VAT input credit on the purchased entertainment service

(2) Taxpayers cannot claim VAT input credit on the purchased catering service

(3) Taxpayers cannot claim VAT input credit on the purchased resident daily service

Due to the availability for VAT input credits, and many small scale VAT taxpayers may adopt the simplified tax method. We expect that the new VAT rules won’t have big financial impact on the lifestyle services.

After a quick review of the new VAT rules applicable to the four big sectors, we saw that the Chinese government had taken positive steps with commitment to minimize the tax for businesses. The replacement of BT with VAT is certainly a right approach. However, the new VAT system seems to be very complicated with uncertainties. Some rules are not consistent with the global VAT practices. The new VAT system still has some characteristics of the old BT regime. Further modifications and amendments will be necessary in order to make the new VAT system “pure” and “operable”.