Value-added tax (“VAT”) is a general tax on consumption that is levied on the value added to goods and services at each stage in the production and distribution chain and is borne ultimately by final consumers.
The history of VAT in the People’s Republic of China (“China”) is not long. VAT was first introduced in 1979 as an experiment conducted only in certain provinces, and was officially imposed in 1984 when the State Council promulgated The Regulation on VAT (Draft) effective as of 1 October 1984. Since then VAT has been contributing a substantial portion to the tax revenue of the state. The first VAT reform was undertaken in 1993 whereby The Provisional Regulation on Value-Added Tax (“VAT Regulation”) officially codifying Chinese VAT system was promulgated by the State Council on 13 December 1993 and came into force as of 1 January 1994. Furthermore, The Detailed Rules for the Implementation of the Provisional Regulation on Value-Added Tax (“VAT Implementation Rules”) was issued jointly by the Ministry of Finance (“MOF”) and the State Administration of Taxation (“SAT”), following the promulgation of the VAT Regulation.
The most recent VAT reform took place in 2008. During this reform, the VAT Regulation was amended and re-promulgated on 10 November 2008. At the same time, the VAT Implementation Rules were amended as well. Following the coming into force of the amendments to the VAT Regulation and to the VAT Implementation Rules on 1 January 2009, Chinese businesses are permitted to deduct the input VAT on fixed assets, for instance, transportation vehicles, machinery or equipment purchased as capital goods, and Chinese VAT has been converted from a production-based tax (which explicitly prohibits deduction of the input VAT on fixed assets purchased) into a consumption-based one.
According to Article 1 of the VAT Regulation and Article 2 of the VAT Implementation Rules, sale and/or importation of goods, and/or provision of processing, repair and/or components-replacing services in connection with goods within China are subject to VAT. For other transactions, for instance, transfer of intangible assets, supply/transfer of immovable property, and provision of services other than processing, repair and/or components-replacing services, a different tax, business tax (“BT’) at the rate of 5%, is levied based on the turnover generated by businesses. However, these transactions are supposed to fall within the scope of VAT based on the nature of VAT being a general tax on consumption. It is clear that the current scope of Chinese VAT only covers a limited area of consumption. Thus Chinese VAT currently in existence is not considered a real VAT, but a quasi-VAT.
China has been planning to promulgate a VAT law (“Chinese VAT Law”) , which entails a through VAT reform to be conducted to merge BT with VAT and turn the current quasi-VAT system into a real VAT system (“Chinese VAT Reform”). The Chinese VAT Reform as planned will be implemented nationwide as of 1 January 2013. The Chinese government has consulted both domestic and foreign (in particular, European) experts specializing in indirect tax for the implementation of the Chinese VAT Reform and the draft of the Chinese VAT Law. As a first step a pilot scheme will be first launched to test the water.
An Executive Meeting of the State Council was held on 26 October 2011 during which it was decided that the pilot scheme for the Chinese VAT Reform (“Pilot Scheme”) would be first launched in Shanghai. On 16 November 2011 the MoF and the SAT jointly issued The Pilot Scheme for Merging BT with VAT (CaiShui-2011-No. 110, “Circular 110”) following the approval of the State Council. On the same day the MoF and the SAT jointly issued The Circular on the Implementation of the Pilot Scheme for Merging BT with VAT on Transportation and Chosen Modern Services Sectors in Shanghai (CaiShui-2011-No. 111, “Circular 111”) to circulate The Rules on the Implementation of the Pilot Scheme for Merging BT with VAT on Transportation and Chosen Modern Services Sectors, The Regulation on Relevant Matters with respect to the Pilot Scheme for Merging BT with VAT on Transportation and Chosen Modern Services Sectors, and The Regulation on the Transitional Policy with respect to the Pilot Scheme for Merging BT with VAT on Transportation and Chosen Modern Services Sectors (collectively “Pilot Scheme Implementation Rules’). In Short the Circular 110 serves as the guidance on how and when the Pilot Scheme will be implemented, first in pilot regions for transportation and chosen modern services sectors, then nationwide for some of these sectors, while the Circular 111 and the Pilot Scheme Implementation Rules serve as the detailed rules for implementing the Pilot Scheme, in particular, in Shanghai as of 1 January 2012.
Businesses and Sectors Affected
According to the Circular 111 and the Pilot Scheme Implementation Rules, as of 1 January 2012 businesses registered in Shanghai and engaging in the following sectors (“VAT Taxable Services”) will be affected and will be subject to VAT instead of BT:
General Taxpayer & Small-scale Taxpayer
To simplify the VAT collection procedures and reduce the costs incurred by tax authorities and by taxpayers with respect to the collection and payment of VAT, the same as for the VAT Regulation, the Pilot Scheme Implementation Rules differentiate between two types of taxpayers for VAT purposes, i.e. general taxpayer and small-scale taxpayer. A general taxpayer is granted the right of deduction and is eligible to issue VAT Fapiao that is, in principle, required for deduction of input VAT, while a small-scale taxpayer has no right of deduction and is not eligible to issue VAT Fapiao. By default all taxpayers for VAT purposes are considered small-scale taxpayers unless they are recognized by tax authorities as general taxpayers. To file an application with tax authorities for recognition as a general taxpayer, taxpayers should either reach certain turnover thresholds or have maintained sound and accurate books of accounts.
We note that general taxpayers that engage in sale and/or importation of goods, and/or provision of processing, repair and/or components-replacing services in connection with goods, and in the meantime also engage in the VAT Taxable Services, need not re-apply to be recognized as general taxpayers in order to enjoy the right of deduction and issue VAT Fapiao for the VAT Taxable Services.
The turnover threshold for businesses engaging in the VAT Taxable Services to be recognized as general taxpayers within the framework the Pilot Scheme is currently set at RMB5 million per year, subject to adjustment by the MOF and the SAT. We estimate that most (if not all) small businesses are not eligible to be recognized as general taxpayers due to the foregoing high threshold.
Impacts on Businesses
For businesses (mostly small businesses) that do not reach the turnover threshold therefore do not qualify as general taxpayers, the tax burden on them is alleviated (tax changed from 5% BT to 3% VAT) except for businesses in transportation sectors (tax changed from 3% BT to 3% VAT).
For businesses that are already recognized or are eligible to be recognized as general taxpayers, the overall tax burden on them is supposed to be alleviated, but to what extent the taxes payable can be reduced varies from sector to sector depending on how much deductible input VAT will be accumulated by such businesses.
We believe that for businesses engaging in consulting services, the provision of which does not require the utilization of expensive hardware and software, or part (or the whole) of which will not be subcontracted out, for instance, law firms, it is more beneficial to remain a small-scale taxpayer than a general taxpayer. However, as stated in the Pilot Scheme Implementation Rules businesses are obliged to apply to be recognized as general taxpayers in the event that their annual turnover reaches the threshold.
Moreover it is notable that the Circular 110 states that the treatment of importation and exportation of the VAT Taxable Services is similar to that of the importation and exportation of goods, i.e. importation of the VAT Taxable Services is subject to import VAT, while exportation is either zero-rated or exempted. This indicates that when foreign businesses provide the VAT Taxable Services to businesses registered in Shanghai, the latter will be obliged to pay VAT on such VAT Taxable Services, and when businesses registered in Shanghai provide the VAT Taxable Services to foreign businesses, no output VAT will be levied on the payment received for such services . In the Pilot Scheme Implementation Rules this is not further specified though.
To ensure that BT incentives currently applicable to the VAT Taxable Services will continue to apply after the Pilot Scheme is launched, the Pilot Scheme Implementation Rules state that taxpayers engaging in the VAT Taxable Services within pilot regions will enjoy certain VAT-exemption policies within an indefinite period, or within a specified period where applicable. Such VAT-exemption policies cover, among others, transfer / licensing of patented or unpatented technology, and entrusted development of technology (inclusive of technical consultancy and technical services in connection with such transfer or development, in order to help the transferee or the entrusting party to master the transferred or developed technology), subject to recognition by Technology and Science Committees at provincial level.
New Concepts and Conclusion
Even though the rules with respect to collection and payment of VAT provided in the Pilot Scheme Implementation Rules are, in general, similar to those provided in the VAT Regulation and the VAT Implementation Rules, we note that there are new concepts that we assume are borrowed or derived from the European Union (EU) VAT system, for instance, non-economic activity and VAT grouping.
Under the EU VAT system, there are concepts of taxable person and economic activity. Taxable person refers to any person who independently carries out any economic activity, whatever the purpose or results of that activity, and economic activity refers to any activity of producers, traders or persons supplying services. Economic activities fall within the scope of VAT and are subject to VAT, and taxable persons are responsible for paying VAT due on the economic activities which they engage in to the revenue department. In contrast, non-economic activities fall outside the scope of VAT and are therefore not subject to VAT, and persons engaging in non-economic activities are non-taxable persons. Non-economic activities refer to, among others, activities in which government authorities and other bodies governed by public law engage as public authorities, even where they collect dues, fees, contributions or payments in connection with such activities.
The Pilot Scheme Implementation Rules state that the provision of transportation and chosen modern services during non-economic activities does not constitute provision of the VAT Taxable Services.
The VAT grouping scheme utilized in the EU VAT system refers to the scheme of treating a number of independent (but often affiliated) businesses that are closely bound to one another by financial, economic and organizational links as a single taxable person for VAT purpose. Internal transactions within the group are eliminated for VAT purposes, and the profits and losses of the members of the group can be offset against each other, which is one of the most important benefits granted by the VAT grouping scheme. Such scheme is usually introduced for purposes of reducing administrative and compliance cost and minimizing the opportunity for VAT evasion.
The Pilot Scheme Implementation Rules only briefly state that two or more taxpayers may be taxed as if they were one taxpayer, subject to the approval of the MOF and the SAT. This means that in order to implement such VAT grouping scheme within pilot regions specific regulations need to be drafted and issued.
If the Pilot Scheme is proved successful, the Chinese VAT Reform will be implemented nationwide, as planned. Eventually China will abolish the VAT Regulation, the VAT Implementation Rules, the Pilot Scheme and the Pilot Scheme Implementation Rules, and promulgate the Chinese VAT Law to completely abolish business tax in all sectors, and convert Chinese VAT into a real VAT. We believe that the to-be-promulgated Chinese VAT Law will have similar features and concepts of VAT to those under the EU VAT system, and like the EU VAT system there will be special schemes for small businesses, and for farmers, etc. However the Chinese VAT system after the promulgation of the Chinese VAT Law would still be a lot simpler than the EU VAT system given the special status of the European Union, an economic and political union containing 27 member states.