China: VAT Reform Pilot to Launch in January

According to a November announcement from the executive committee of China’s State Council, Shanghai will spearhead a pilot VAT reform initiative on January 1, 2012. The program is part of an effort to ease the significant problem of indirect taxation in China and incent the services industry (in particular) by reducing the tax burden.

The pilot is part of a system-wide change scheduled for implementation in 2013. Initially, changes will be rolled out in certain regions and industry sectors, with a goal of gradually replacing business tax with VAT, while improving the VAT deduction chain.

China currently utilizes two separate, and very different, systems of indirect taxes: value added tax (VAT) and business tax (BT). VAT is applied at the standard rate of 17% to the sale of goods in China, the provision of repair, processing and replacement services, and the importation of goods into China. It taxes the ’value added’ by allowing business taxpayers a credit for the tax embedded throughout the supply chain.

BT, by contrast, is a turnover tax which is levied on the business turnover obtained by institutions and individuals engaged in the construction, finance and insurance, postal and telecommunications, cultural and sports, entertainment, and services sectors, as well as in the transfer of intangible assets and sale of immovable property. Rates range from 3% to 5 %, but are as high as 20% for the entertainment sector.

The maintenance of two tax systems has created ambiguity, uncertainty and, in some cases, double taxation, a situation the VAT reform program intends to ease. Though details are not fully clear, the Shanghai pilot is expected to apply to services currently subject to Business Tax, including transportation but excluding financial services and real estate.
As part of the new program, the current VAT rate (applied at the standard rate of 17% and a lower rate of 13%) will be augmented by two new, reduced rates of 11% and 6%.

During the trial implementation period, as business tax is replaced by VAT, VAT revenue will belong to the pilot location. Existing business tax preferential policies for pilot sectors will be extended, but adjusted based on the specific features of the VAT system. VAT credit will also be available to taxpayers included in the VAT pilot in accordance with the relevant provisions.

Logistics, distribution and services industries should benefit from a lowered tax burden and increased profit, as many related costs down the supply and consumption chain will be now claimed for deduction.

Key Impact
The reforms will affect business models designed to minimize the cascading of Business Tax, as well as processes involving contracts, invoicing, and IT, so we encourage you to take advantage of the time before the program is implemented to consider the impact. We outline some thoughts on the changes below:

• Previously, BT appears as Cost of Sales in the BT payers’ P&L. Therefore, this change will likely reduce the indirect tax liabilities for BT payers which are impacted by the change. Since the input VAT incurred will now be creditable, the BT which they previously had to pay will become VAT which they will collect from their customers.
• The pilot program is limited to Shanghai, so the impact on the customers and suppliers of the entities involved cannot be fully ascertained, particularly if those customers and suppliers are based outside Shanghai. More importantly, the impact on the customers/suppliers’ counterparts downstream (both inside and outside Shanghai) will make the pilot more complex to implement.
• With every major regulatory change come necessary alterations to the people, process, technology and financial reporting involved. Companies will need to consider the following:
  • employee retraining re the new requirements;
  • revamped transaction data collection processes;
  • retooled information systems and applications to collect the necessary information from customers to issue VAT invoices;
  • when and how to issue VAT invoices and credit notes;
  • how accounting and financial reporting teams will report and account for VAT.