newsletter20120606

MWE China Law Offices lawyer, Lawrence Hu, authors cover story for May 2012 issue of China Law and Practice "Evolution: VAT reform changes in the economy"

This article previously appeared in the May 2012 edition of China Law & Practice and is re-published with the kind permission of its editors.

Evolution: VAT reform changes the economy

Over the past six months, Shanghai has adopted a full set of laws and regulations for its value added tax pilot programme. The move will help China’s economy evolve from a manufacturing hub and encourage the development of modern service sectors

China introduced value added tax (VAT) in 1994 as a single nationwide tax combined with business tax (BT). VAT is responsible for the added value generated in the sale, provision of processing, reparation and maintenance. These tax rates are 17%, 13% and 5% according to the nature of the taxpayer and of the goods concerned. In contrast, services in transportation, construction, finance, sports and culture and the transfer of intangible assets (including copyright, trademark, patent, know-how, goodwill, land and building titles) are subject to BT ranging from 3% to 5%, considering the turnover amount of the service or transfer. In order for VAT to impose the added value, the goods sold by VAT taxpayers is termed as output VAT and calculated by multiplying with the applicable VAT rate. Moreover, when purchasing raw materials and other VAT taxable items, the output VAT for the seller will be termed as input VAT for the VAT taxpayer (the buyer) and offset against its own output VAT, which is substantiated and processed though a VAT special invoice.

Problems with double taxation

As the country’s economy evolves, industries in China have expanded and no longer fit into simple categories covered by the previous taxation system. Companies have to focus on their core business and outsource some of their supporting departments. For example, manufacturers may choose to use a logistics company to deliver their goods instead of maintaining their own logistics team. Because of this trend the seemingly harmonious VAT and BT tax regime encounters two issues. For the VAT taxpayer, the purchase of the BT taxable services such as transportation or technology consulting may not be taxed as VAT, which cannot be treated as input VAT to offset its output VAT. For the BT taxpayer, the purchase of goods from equipments to computers, VAT corresponding to it cannot be offset because the BT taxpayer does not have output VAT. These non-offsetting situations are the essence of double taxation. This causes companies to reconsider whether to outsource their supporting functions and to some extent reverse the social division of labour. It is inevitable that VAT will replace BT resolving double taxation and unifying the tax regime. All industries will thus be subject to VAT and during transactions VAT may be offset in the future.

Timing is everything

China has been perceived as a manufacturing factory for the world, gaining little of the income generated. After almost 30 years of exponential growth, the pace of the world’s fastest manufacturing-driven economy has recently slowed down. China now has to transform its economic development model from manufacturing to a service economy. The implementation of the VAT pilot programme means companies in the service sector are willing to invest in equipment and resources, upgrading their capability as they can offset the corresponding VAT. They will also gain more business from service recipients, who no longer perform that service by themselves and may offset their own VAT by receiving a VAT special invoice issued by the service providers.

VAT for transportation

In addition to the service industry, the VAT pilot programme also covers the transportation industry for two reasons. Firstly, the transportation industry connects almost all other companies by delivering raw materials or final products. This close association means that if the transportation fee is subject to VAT then almost every company that receives the service can offset the corresponding VAT. Secondly, before the VAT pilot programme, the transportation fee had to be offset against the VAT through a transportation invoice (instead of a VAT invoice). This means that restructuring the VAT administration system is relatively easy for policy makers and enforcers.

Shanghai as a VAT haven

Shanghai was chosen to launch the VAT pilot programme because of its economic status in China. The city is home to some of the world’s largest multinationals all engaged in modern service and transportation industries. In addition, under the current tax administration regime, tax authorities are divided up into two categories. State tax authorities are mainly responsible for VAT and corporate income tax. Local tax authorities are responsible for BT, individual income tax and land value appreciation tax for local financial revenue purposes. However, Shanghai is an exception combining state tax authorities and local tax authorities into one. This means the change from BT to VAT will not lead to the replacement of tax officials between state tax authorities and local ones.

The VAT pilot programme involves twelve circulars from the Ministry of Finance, the State Administration of Taxation, and the Shanghai Tax Authority all detailed in figure 1.

Taxable services and tax rates

Under the VAT regime, VAT taxpayers are divided into two categories: general tax payers and small-scale tax payers. General taxpayers can issue VAT special invoices to the buyer and collect them from the seller to offset the VAT payable. Small-scale taxpayers can only issue VAT general invoices and are not able to collect VAT special invoices to offset their VAT payable. The tax rate for small-scale taxpayers and general taxpayers is highlighted in figure 2.

For general taxpayer status, if a company has a sound accounting system and is able to produce accurate tax data, they may elect to apply for the status. However, a taxpayer whose annual sales exceeds the required threshold must apply for the status as well. The thresholds for manufacturing taxpayers and trade taxpayers are Rmb800,000 ($126,884) and Rmb500,000 ($79,302), respectively. The threshold for service taxpayers under the pilot programme is Rmb5,000,000 ($793,036). This enormous difference means that the pilot programme gives much more flexibility for service taxpayers to elect to be small-scale taxpayers. This means they can not only enjoy the lower tax rate of 3%, but also circumvent the strict compliance procedures in issuing and recognising VAT special invoices.

Figure 1: Circulars implementing the VAT pilot programme

Circular No.	Name of the Circular	Main Content
Ministry of Finance, State Administration of Taxation
Caishui [2011] No.110	Notice for the Introduction of the Pilot Program to Convert BT to VAT	Outline of the Program, including the scope covered, the applicable rates; and the policy arrangement for the transition period
Caishui [2011] No.111	Notice for Converting BT to VAT in Transportation and Certain Modern Service Sectors in Shanghai	The detailed implementation rules, including the tax payable calculation period and explanation of taxable items
Caishui [2011] No.131	Notice on Application of Zero Rate and Exemption Treatment on Certain Taxable Services	Detailed explanation of tax items entitled to zero rate or exemption treatment
Caishui [2011] No.133	Notice on Several Policies for Converting BT to VAT in Transportation and Certain Modern Service Sectors in Shanghai	Specific issues, including the tax implications of used fixed assets, the cross-year business and etc.
State Administration of Taxation
Gonggao [2011] No.65	Announcement on Recognition of General Taxpayer Qualification in VAT Pilot Program in Shanghai	Recognition of General Taxpayer
Gonggao [2011] No.66	Announcement on Certain Issues of Adjustment on VAT Declaration	Specific issues regarding preparing the VAT filing form
Gonggao [2011] No.74	Announcement on Start of Using VAT Invoices in Transportation Industry	Pages of Invoices and their respective usage; Sample of Transportation VAT Invoice
Gonggao [2011] No.77	Announcement on Certain Issues of Tax Administration in VAT Pilot Program in Shanghai	Use of VAT Special Invoice and Invoice Issuance Machine
Shanghai Tax Authority
Huguoshuihuo [2011] No. 45	Opinions on Implementation of Pilot Program of Converting BT to VAT in Shanghai	Steps to introduce and orientate the Pilot Program and different sectors to be established to facilitate the Program
Gonggao [2011] No.3	Announcement on Recognition of Taxpayer and Relevant Administration Issues	Detailed implementation rules regarding the recognition of General Taxpayer
Gonggao [2011] No.4	Announcement on Transitional Policies for Converting BT to VAT in Shanghai	Transitional Policies for certain reduced or exemption preferential treatments
Gonggao [2011] No.5	Announcement on Certain Issues of Adjustment on VAT Declaration	Summary of VAT filing materials
Hucaishui [2012] No.5	Notice on Transitional Financial Subsidy for Converting BT to VAT in Shanghai	Financial subsidy for taxpayers whose tax burden is increased by the VAT Pilot Program

Figure 2: Taxable services and applicable tax rates

Industry	Content	Current VAT Rate	Original BT Rate
Transportation	Road, water, air and pipeline transportation	11%	3%
Certain Modern Service Industries
R&D and Technology services	Transfers of technology and technology consulting	6%	5%
Information and Technology services	Software related services; circuit design and testing services; IT system service and process and procedure management services
Creative Culture Services	Design, transfers of copyrights and trademarks; service related to IP rights; advertising, conference and exhibition services
Logistics-Related Auxiliary Services	Dockage service, forwarding service, customs declaration, storage service, loading & unloading service
Attestation and Consulting Services	Recognition, witnessing and consulting service (including legal ,tax, accounting and management )
Leasing of Movable and Tangible Assets	Operating leasing and financial leasing	17%

Figure 3: Taxable services in and out of Shanghai

	Location of Service Provider	Location of Service Recipient	Tax Implications of Service Provider	Tax Implications of Service Recipient
Cross-District Taxable Services (Shanghai)
1	Inside	Outside	Subject to VAT; may issue VAT Special Invoice if the recipient is a VAT General Taxpayer	VAT Special Invoice may offset its own VAT
2	Outside	Inside	BT	Non-deductible
Cross-Border Taxable Services (China)
3	Onshore	Offshore	Zero Rate or Exempt	N/A
4	Offshore	Onshore	Subject to VAT but exempt if the service and leasing assets are located offshore	Obliged to withhold VAT if the provider has no presence in China; and such VAT is deductible

Compliance

It is essential for taxpayers engaged in BT before the VAT pilot programme to accommodate changes to their tax administration because VAT is far stricter than BT, especially for purchases and issuing VAT special invoices. They also have to decide whether general taxpayer status or small-scale taxpayer status best applies to their business. If annual sales volume exceeds the threshold then they have to apply for general taxpayer status. Otherwise, they may choose small-scale status at their discretion, after fully considering the pros and cons of each. There are three steps a business should consider to ensure compliance under the pilot programme:

1. Make sure the appropriate VAT invoice may be purchased and that the invoice issuance machine has been correctly installed and works smoothly;

2. Specify a certain person in charge of VAT-related matters such as VAT filing and the recognition of VAT Special Invoices received;

3. If anything related to VAT invoices and filing is in doubt, promptly report to the tax authority or consult tax professionals given that the strictness of VAT administration and the seriousness of VAT violation acts.

Tax planning

It is advisable for VAT taxpayers to choose Shanghai service providers under the VAT pilot programme. The VAT special invoice issued by Shanghai service providers may offset the former’s VAT, reducing its total tax burden. See figure 3 for applicable taxable services by area.

If a taxpayer outside Shanghai has business in Shanghai, establishing a branch or even a subsidiary entitles them to the benefits of the VAT pilot programme. Even if they have limited business in Shanghai, it is still advisable to do so because Shanghai branches can file their VAT in Shanghai for the business it conducts, no matter where the business takes place. Shanghai branches can issue VAT special invoices, which are favourable for VAT taxpayers.

Concerning group companies, especially multinational companies that have subsidiaries or a presence in different jurisdictions, now is a good time for them to restructure their business on a China-wide or even Asia-wide basis. It is common for a multinational company to establish a regional headquarter to provide its affiliated entities with supporting services such as IT, legal, finance and even procurement.

Before the VAT pilot programme, the regional headquarter had to file BT for these services. What is worse is that BT cannot be deducted by its affiliated entities, resulting in double taxation. While under the VAT pilot programme, the services subject to VAT can be offset by the service recipients if they are VAT taxpayers. Therefore, multinational companies should choose or even establish a company in Shanghai to serve as the regional headquarter.

It is better for regional headquarters to cover the multinational companies’ presence outside of China if it is also an Asian regional headquarter. This is because before the VAT pilot programme, such services might have been subject to BT if either a service provider or a service recipient is located in China. While under VAT pilot programme, if a regional headquarter located in Shanghai provides services to its affiliated entities outside of China, such service fees are exempt from VAT.

It is also advisable to combine the function of the regional headquarter with the multinational company’s original principle business, especially if such principal business is periodic. The functions of a regional headquarter are talent-centred business, which generates high added value (or profit) and incurs high VAT payable accordingly. If combined with its principal business, the high VAT corresponding to the regional headquarter’s function could offset the principle business’s VAT in the period concerned, deferring the total burden in the long run.

Nationwide reforms

Since the launch of the pilot scheme in Shanghai, there are rumours that Beijing, Guangzhou, Qingdao, and Tianjin are also considering taking part. Despite the pilot scheme being well received in Shanghai, the government is cautious of implementing these policies too quickly. Shanghai is being used as a testing ground. China’s great VAT reform has created a window of opportunity for consumers using services in Shanghai. The overall plan is to implement VAT nationwide, until then companies can enjoy favourable tax opportunities in China’s most populous city.

Lawrence Hu, MWE Law Offices, Shanghai

Evolution: VAT reform changes in the economy

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