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Tax Connect Flash | China moving forward to expand VAT scope with Shanghai as Pilot Region

Background of the reform

In China, there are two major kinds of turnover taxes, i.e. VAT and business tax ("BT"). They cover different scopes of transactions. The VAT system mainly covers import and sales of movable/tangible goods, while the BT system covers services, transfer of intangibles and immovable properties. A few exceptions are processing, repairing and maintenance services which are covered by the VAT system, not the BT system.

The BT system has been widely criticized for not having the input-output credit mechanism which is adopted in the VAT system. Such feature of the BT system means that BT costs are not recoverable by either party. Further, in case of subcontracting of services, the portion of the subcontracted service value will be taxed twice for BT purposes (once at the main-contractor and once at the subcontractor). In addition, due to the different tax rates and systems, the simultaneous operation of both VAT and BT systems has caused various administrative problems for both taxpayers and tax authorities.

To solve the above problems and to ultimately eliminate the BT system, the PRC government has recently taken actions to launch a pilot tax reform starting from 1 January 2012. For the time being, this reform is limited to Shanghai. However, ultimately, it is expected to be extended to all over China in the future. On 16 November 2011, the PRC State Administration of Taxation (SAT) and the Ministry of Finance ("MoF") jointly issued a notice regarding their general plan of replacing the BT system with the VAT system ("the Plan"). In accordance with the Plan, details of the Shanghai Pilot Program are provided under the Tax Circular Caishui [2011] No.111 ("Circular 111").

Main Content of the Shanghai Pilot Reform

1. Affected industries and taxpayers

Starting from 1 January 2011, tax payers registered in Shanghai shall pay VAT instead of BT for the following Taxable Services:

  • Transportation services (including road, water, air and pipeline transportation);
  • R&D, technology transfer, technology consulting, energy management contract and reconnaissance and prospecting;
  • IT technology services including software services, circuit design and testing, IT system services and business process management;
  • Design services; transfer of trademark, goodwill and copy rights; IP related services; advertisement; conference and exhibition services.
  • Logistics-related services such as warehousing, fright forwarding, customs agency services, etc;
  • Lease of movable tangible assets (including financial lease and operation lease);
  • Certification services, authentication services (including authentication services in the areas of accounting, tax, asset appraisal, law, real estate evaluation and project cost estimation) and consulting services (including consulting services in the areas of finance, tax, law, internal management, business operation and process management).

Foreign entities and individuals providing the above Taxable Services to tax payers in Shanghai shall also pay VAT (not BT) in China. In such case, the Shanghai service recipients shall withhold the VAT payable by the foreign service providers from the gross amount and remit it to the competent tax authority in Shanghai.

2. Applicable VAT rates and tax calculation

a) General VAT payers and small-scale VAT payers

VAT payers are divided into general VAT payers and small-scale VAT payers with different tax rates and calculation methods. A tax payer engaged in the above Taxable Services with an annual transaction value of above RMB 5 million is required to apply for the general VAT payer status. Small-scale enterprises with a transaction value below the threshold can also become general VAT payer upon application if they keep proper accounting records.

b) Tax rates for general VAT payers

A general VAT payer can issue VAT invoices and credit its input VAT against its output VAT. The applicable VAT rates for calculating output VAT are as follows:

  • 17% for lease of movable tangible assets;
  • 11% for transportation services;
  • 6% for other Taxable Services.

c) Small-scale tax payers

A small-scale VAT payer shall pay VAT at 3% on the gross amount for its Taxable Services and is not able to credit any input VAT. A small-scale VAT payer can not issue VAT invoices by itself but can ask the tax authority to issue VAT invoices for it.

d) Exportation of services

The Plan stipulates that a zero VAT rate or VAT exemption shall apply to exportation of services. Technically speaking, a zero VAT rate is different from VAT exemption. In case of a zero VAT rate, the input VAT attributable to the exported services is still creditable, while in case of VAT exemption, the relevant input VAT shall be excluded from the creditable input VAT. On 29 December 2011, the SAT and MoF issued the Tax Circular Caishui [2011] No. 131 ("Circular 131') concerning VAT treatments for exportation of services in the context of the Pilot Program. Circular 131 clarifies that for international transportation services, R&D services and design services, zero VAT rate applies. For exportation of other Taxation Services, VAT exemption applies.

3. Impacts of the tax reform

The tax reform is generally viewed as a tax reduction program. However, the exact impacts are complex and in some cases, the actual tax burden could also increase. To better understand the real changes in the tax burden, it is necessary to take into consideration various factors such as the VAT rate, the tax status of the customers (general VAT payer or not), the amount of input VAT available to the service provider, etc.

a) Taxable Services provided by Shanghai general VAT payers to general VAT payers (whether located in Shanghai or not)

The tax burden for such services will be decreased significantly. The service provider does not need to pay BT any more. It can charge the output VAT to its customers which can be recovered by the latter and is therefore not a real cost. In addition, the service provider can now credit its input VAT against its output VAT. Therefore, the overall tax burden will roughly be decreased by the sum of the BT amount (otherwise payable in the past) and the input VAT (otherwise not creditable in the past). In the end, such tax benefit may be shared by both the service provider and the customer depending on how the service fee is adjusted in response to the tax reform.

b) Taxable Services provided by Shanghai general VAT payers to small-scale VAT payers or BT payers

Since the Chinese customer is not a general VAT payer, it can not credit any input VAT. Therefore, the VAT costs can not be recovered and are real costs of the Chinese customer. On the other hand, the input VAT of the service provider now becomes creditable. As such, for such services, the change in the tax burden can be roughly calculated as follows:Change in the Tax Burden = Output VAT – Business Tax (otherwise payable in the past) + Input VAT of the service provider (otherwise not creditable in the past) The result could be either positive (increase) or negative (decrease) as the case may be. Therefore, the reform is not necessarily benefiting those companies which mainly provide Taxable Services to non-general VAT payers.

c) Taxable Services provided by Shanghai general VAT payers to overseas customers

In case tax exemption is adopted, no BT or VAT would payable for exportation of Taxable Services. However, technically speaking, the relevant input VAT would also be non-creditable. As such, the decrease in the tax burden equals to the BT otherwise payable. In case a zero tax rate is adopted, the output VAT is zero and the input VAT is still creditable or refundable. As such, the overall tax burden will roughly be decreased by the sum of the BT amount (otherwise payable in the past) and the input VAT (otherwise not creditable or refundable in the past).

d) Taxable Services provided by a foreign party to a Shanghai general VAT payer

Under the VAT system, the Chinese customer shall withhold the VAT payable by the foreign party and remit it to the Chinese tax authority. However, such VAT paid are not real costs since the Chinese customer can credit the same amount against its output VAT. As such, the decrease in the tax burden equals to the BT amount otherwise payable by the foreign party. Considering the above, the foreign party may wish to shift the VAT costs to the Shanghai customer.

e) Taxable Services provided by a foreign party to a Shanghai small-scale VAT payer or BT payer

The Chinese customer shall also withhold the VAT amount from the gross payment, which are real costs because the customer can not recover them by any crediting system. The change in the tax burden is (VAT – BT otherwise payable in the past), which represents an increase since the VAT rate is higher than the standard BT rate of 5% (applicable to the vast majority of services).

The above lit a) – e) are a simplified analysis of the changes in the tax burden. The real world is more complex and the actual results for a specific industry or transaction may differ from the general conclusion of the above analysis.

4. BT exemption

Generally speaking, VAT exemption is also granted to transactions which previously enjoyed BT exemption treatment, e.g. technology transfer, technology development and related technical services. The Plan provides VAT exemption for those transactions which enjoyed BT exemption under the BT system in the past.

5. Old Contracts

The Plan does not provide any transitional arrangements for old contracts concluded before 1 January 2012. However, as an exception, outstanding contracts for lease of movable tangible assets concluded before 1 January 2012 continue to be covered by the BT system until the termination of such contracts.

6. Circular 111 also covers various other topics such as mixed sales, consolidated VAT declaration, deemed sales of Taxable Services, conditions for creditable input VAT, non-creditable input VAT, consequence of not applying for the general VAT payer status, exchange rate, timing of VAT liability, tax declaration deadline, tax payment location, value threshold for individuals, issuance of VAT invoices, and a detailed explanation of the scope of Taxable Services, etc.

CMS suggestions

1. Tax payers located in Shanghai providing Taxable Services are advised to start applying for the general VAT payer status (where applicable) and prepare themselves to the VAT regime.

2. Group companies with entities in Shanghai may need to make an in-depth analysis of the changes in the tax burden, adjust their pricing where necessary and restructure business models where possible.

3. Foreign companies providing Taxable Services to customers in Shanghai shall also take the BT/VAT issue into consideration when concluding the relevant contracts.

Contact

Charlie Sun Senior Associate - CMS, China [email protected]