China's VAT Reform Hits Delay

Mark Melnicoe
Bloomberg BNA

China's value-added tax (VAT) reforms have hit a temporary delay, with the final and most significant revisions to its VAT regime not expected to be implemented until later this year—at the earliest.

The government's 12th Five-Year Plan (2011-2015) on VAT calls for reforms to rid the services sector of the existing business tax and replace it with VAT, in an effort to boost the country's service industries. The reforms began as a pilot in Shanghai in January 2012 and additional geographic locations and economic sectors have been rolled out on a fairly regular basis since. Under the plan, the changes are to be completed by the end of 2015.

Recent state media reports said the final stage of the VAT reform—affecting the real estate construction, financial services, and consumer services industries—would be imminent. However, three attorneys with ties to the relevant Chinese ministries told Bloomberg BNA the reforms are being delayed, with no revised timetable given.

I. Implementation before Year-End in Question

“We understand there has been a delay with the VAT reform implementation,” Lachlan Wolfers, partner at KPMG in Hong Kong, told Bloomberg BNA in an Aug. 14 e-mail. “We are operating on the working assumption that an announcement is likely to be issued by the end of this year,” he said.

However, another tax attorney, who wished to remain anonymous, told Bloomberg BNA in an Aug. 14 telephone interview that the final stage of reform will not happen until sometime in 2016. Furthermore, he said that an announcement about the delay from the Ministry of Finance and the State Administration of Taxation (“SAT”) is unlikely “because there is no concrete timetable and they don't have to be accountable to the public.”

Meanwhile, Henri Ji, associate at DLA Piper in Beijing, told Bloomberg BNA in an Aug. 16 e-mail that he believed the final stage of VAT reform could be “very difficult to achieve within this year.” Putting the odds at 50 percent, Ji cited five factors, including the complexity of the remaining industries, the administrative burden to the state tax bureau due to the huge number of taxpayers in those industries, a likely reduction in tax revenue to the government, the tough balancing of interests between the central and local governments, and the ongoing objection of some large state-owned enterprises as the reform will potentially increase their tax burden.”

II. Fears of Higher Taxes, less Government Revenue

The potential higher tax burden has many companies fearing that, even with the tax write-offs that VAT will provide, they could still emerge with the short straw. In particular, the real estate and construction sector is likely to see an 11 percent VAT once the new regime comes into force, which could lead to higher taxes for those companies and for consumers.

Local governments have also expressed concern because business tax is a local tax, whereas 75 percent of VAT revenue goes to the central government. However, Wolfers noted that the central government has agreed to different revenue-sharing mechanisms with local governments to make up for the shortfall.

One of the main advantages of a VAT is that unlike the business tax, companies can deduct it from their taxes due when they sell their products up the distribution chain. VAT has long been used for goods in China, alongside the business tax for services.

Still, fears remain among companies about higher net taxes, even though more than 95 percent of taxpayers who have come under the VAT reform so far have benefited. During the first half of this year, business taxes were reduced by more than 110 billion yuan ($17.2 billion), according to the SAT.

“For multinational companies, these reforms may bring some short-term challenges, but in the longer term the replacement of business tax with a VAT is generally a good thing,” said Wolfers, who has advised China's central government ministries on the reforms. “That is because business tax is a tax on businesses, whereas VAT is a tax which is collected by businesses, but is ultimately intended to be passed on to the end consumer.”

III. Plan Likely to Tax Real Estate, Construction Higher than Other Sectors

A brief draft plan released recently by the finance ministry suggested that an 11 percent VAT would be levied on the real estate and construction sector, while the finance and consumer-services industries would see a VAT of 6 percent.

Because real estate and finance are so complex and impact so much of the economy, they are considered the most difficult areas to reform, particularly in a transition period, Wolfers said. “If VAT applies at an 11 percent rate from say July 1, 2016, then if someone sells a property in say August 2016 it may not be fair for them to pay 11 percent tax on the entire sales proceeds, given that most of the ’value added’ occurred before the VAT even commenced. Also, that same person would not have been claiming input VAT credits on most of their development costs because the work would have pre-dated the VAT commencing. So the challenge is in ensuring fair outcomes which deal with these transitional arrangements,” Wolfers explained.

IV. Other Countries to Watch China's Financial Services VAT

Another complication, Wolfers said, is China's plan to include financial services, which he noted have not traditionally fallen under VAT/GST systems in most countries.

“The reason for this has been that it is difficult to measure the value added on a transaction-by-transaction basis,” he said “Most countries have chosen to exempt financial services from a VAT, especially where the bank derives a margin rather than a specific fee.”

“China is different—they are proposing to tax practically all financial services under a VAT, and that is very challenging to implement. They will be among the first countries in the world to do so. If China is successful in applying a VAT to the financial services sector, you can expect other countries will watch this development closely and may follow suit.”

V. Multinational Companies Need to Change Plans

Multinational companies operating in China in the sectors due to be included in the VAT regime have many tasks to comply with a change to VAT, Ji said.

“First, review the current supply chain to see if there are new tax planning opportunities under the new VAT regime,” he said, adding that firms should then strengthen their invoice management to guarantee the new VAT deductions and seek potential government subsidies, among other steps.

“To prepare for the VAT reforms, multinational companies need to be aware that this is not simply a tax change—this is a business change,” said Wolfers. “The VAT reforms have a number of different impacts on business, in areas such as contracts, pricing, IT systems, supplier and customers relations, and on finance function processes.” He noted that once this final piece of the VAT reforms is in place, the business tax “will have been fully subsumed by the VAT.”

However, “this is not the end of the indirect tax reform process,” he stressed. “Over time, it is expected that China will try to move towards a single rate VAT system (for all goods and services), and also introduce other changes like electronic invoicing.”