In 2016, the VAT, or value-added tax, became the primary indirect tax in China, phasing out the Business Tax of past few decades. China’s VAT regime is now unique in its broad coverage of industries including financial services and real estate. From the very beginning of China’s reform period until recently, indirect taxation in China was governed by a dual-system of the Business Tax and the VAT, which was complex and largely viewed as unfavourable for businesses. China’s VAT reforms are characterized as a supply-side reform intended to bolster the business environment.
The Chinese government is positioning VAT reform as a policy tool to foster China’s current economic transition. The main aspects of this transition include greater emphasis on domestic consumption as a component of aggregate output, a shift from low-end manufacturing to higher-end production, a shift from labor intensive to capital intensive production, and a more prominent services industry. Officially, the primary goals of China’s VAT reforms are to decrease the tax burden on businesses, aid institutional reforms, encourage innovation, boost job creation, facilitate entrepreneurship, and expand industrial chains. The government is also promoting China’s VAT reforms as a lubricant in the development of the Belt and Road Initiative, by reducing the tax burden on relevant businesses.
Businesses accustomed to the Business Tax regime (particularly financial services, real estate, construction, and lifestyle) will have to adapt to a new system, which, despite the alleged benefits, remains highly complex.
China’s VAT reforms began with a pilot program in Shanghai in 2012. It became a national effort in 2013 and gradually incorporated more industries, ending with most sensitive industries in 2016. By 2016, the Business Tax was nearly fully absorbed by the VAT system.
As of July 2017, the VAT comes in three tiers, 6%, 11%, and 17%. Determining the VAT rate can vary depending on types of transactions and industries.
VAT for SMEs
For small and medium enterprises (SMEs), the VAT is at a standard 3% and may not credit input VAT from output VAT. To qualify as an SME, annual sales must be under RMB 500,000 for industrial companies and RMB 800,000 for wholesale or retail enterprises. Large businesses, also referred to as general VAT taxable persons, are assumed to have robust accounting procedures that allow the authorities to undertake VAT audits.
The general calculation for VAT payable is as follows:
VAT payable = Current output VAT – Current input VAT
Output VAT is calculated much the same as a sales tax:
Output VAT = Sales volume x VAT rate
Impact of the Reforms
Though too early to get a complete reading of the impact of the reforms, there are a number of noteworthy results that appear to show the program has reduced the indirect tax burden on businesses. As of June 2017, the VAT pilot program saved business RMB 1.61 trillion, according to official statistics. 85.12 billion RMB in savings for businesses occurred between the program’s nationwide expansion in May 2016 and June 2017. The impact of VAT reform will likely vary greatly by industry, as the system provides different VAT rates by industry and transaction type. Additionally, industry specifics make the necessary steps forward for some companies more ambiguous than for others.
The financial services industry was one of the last industries to be incorporated into VAT reform and is the most controversial move of the reform effort. Businesses and tax professionals in the industry tend to characterize the VAT rules as inappropriate, given the complexities of the financial services industry. For VAT purposes, financial services firms are broken down into four categories: loan services, insurance services, fee-based services, and financial instrument trading. Categorizing financial services firms, however, is no simple matter. Industry analysts argue that the definitions of these services are ambiguous, which makes self-categorization problematic for companies.
In some areas, the VAT may increase the indirect tax burden on real estate business by comparison to the business tax. For instance, income from leased property is subject to 11% under the new VAT system while it was only subject to 5% under the business tax. Nonetheless, developers that pay the 11% rate are able to deduct the proceeds of purchased land usage rights from their VAT liability.
With the final phase of VAT reforms complete, China now has arguably the broadest VAT system among the 160 countries that levy VAT. While the impact of VAT reform will vary greatly depending on the business and industry, businesses should prepare to meet unique requirements of their local tax authorities, which are given some autonomy with regards to VAT collection. For instance, local authorities may have unique requirements to assess VAT fapiao allowances including registered capital and number of employees.
Due to ambiguous definitions in the VAT policy, businesses may have to face technical problems when adjusting to the new rules. For instance, small but high-growth organizations like technology startups might have difficulty deciding whether to self-select as a general taxpayer or small taxpayer. As another example, financial services companies whose service offerings are complex may have trouble determining which categories specified by the policy they fit into.