A new tax revolution

A transforming reform

The core element that saves most VAT payers money is the transformation of a production-based system to a consumption-based system. This is a turning point in the PRC's tax system history.

“In the old days, when a company purchases equipment, they will have to pay 17% VAT on the purchase. But this 17% VAT couldn't be credited in the future when the company sells the finished products. The VAT becomes a pure cost for the company, almost like adding 17% to the price,” says Julie Zhang, partner at JSM. After the reform, the tax can be deducted when companies purchase fixed-assets such as machinery and equipment.

In fact, the consumption-based system is commonly applied worldwide. According to Zhang, of more than 140 countries that have the VAT system, most do not adopt the production-based regime. Given the fact that the economy in the PRC is now affected by the global economic downturn, the reform could be a huge favour to some enterprises.

“Taxpayers are experiencing financial difficulties, so a tax cut will help them to deal with the problems,” says Yongjun Peter Ni, partner at White & Case. “The government now has no choice because of the economic crisis. They have to do something.”

Expansion expected

After January 1, manufacturers' VAT on newly-purchased equipment can be credited immediately once the consumer pays the VAT for the final products made with the equipment. Consumers will bear the tax responsibility. As enterprises can then purchase cheaper technology and recover the tax much faster, tax specialists expect to see company expansion after the reform.

Fuli Cao, partner at Jones Day, says that expenses and costs are always crucial factors for companies when it comes to decision-making and any tax reduction or incentives will certainly have a positive impact on companies' expansion. “Ultimately, the government's goal is to see the country's economy moved to upstream high-value-added product-oriented, rather than seeing the PRC as always making shoes, toys, or toothpaste,” he says.

But the tax benefits will undoubtedly reduce the government's revenue – a cut of over Rmb120 billion has been projected. Ni says that this was one of the challenges and concerns that had deterred the government from nationalising the rules earlier. According to PricewaterhouseCoopers, VAT revenue in 2007 made up 33.9% of the total tax collection, while business tax and consumption tax accounted for 14.4% and 4.8%, respectively. But, since the reform aims to bolster the economy by increasing investments, tax specialists expect the transformation should eventually bring the government back its lost revenue.

Discouraged Enterprises

So who will enjoy tax benefits from the reform? The regulations apply to all VAT payers including those in the mining, manufacturing, production and mineral sectors, and all sources of high-value-added IT industries. Domestic companies, in particular, will gain more tax incentives that were previously absent. But for some foreign enterprises the story will be a little different.

After January 1, foreign invested enterprises (FIEs)² that are classified as Encouraged according to the Foreign Investment Industrial Guidance Catalogue (外商投资产业指导目录)³ will no longer enjoy certain favourable policies. During a press conference held by the Ministry of Finance and the State Administration of Taxation on November 11, it was announced that benefits such as import VAT exemption and refund for domestic purchases of equipment would be abolished.

For example, if a FIE wants to purchase machinery worth US$100, under the production-based system, it must pay 17% VAT on top of the price. But FIEs can enjoy the benefit of import exemption: they can also get a 100% VAT refund from the competent tax authority for the input VAT they have paid for the domestic purchase of equipment (although the application for the refund could be time-consuming in practice).

Nevertheless, the government is creating a more level-playing field for both domestic and foreign companies, requiring all of them to pay VAT. Although it can be credited once the final products are sold, FIEs will have to make the tax payments upfront. And that could create cash-flow issues.

“There will no longer be any VAT relief for exports or fixed-asset purchases,” says Cecil Leong, managing director of Bryan Cave International Trade. “[FIEs] still rely somewhat on a lot of purchases of raw materials and intermediate products. There would be definitely cash-flow output, and that's a serious concern for enterprises,” he says.

Qiong Yu, attorney to Delphi Asia-Pacific, says that as an FIE, Delphi imports a lot of equipment from overseas.

“Cash flow will be directly impacted for our [type of] company which imports a lot of overseas machinery. In the old regime, VAT is directly exempted, but now you need to pay first and then get the recovery. But most of the time recovery could not be made immediately, especially for a project start-up period,” he says.

Delphi Asia-Pacific is already experiencing serious cash-flow pressure, and its parent company filed for US Chapter 11 bankruptcy protection in October 2005. For companies like this, the reform will only prolong and worsen their situation.

While some FIEs will be affected, the majority of enterprises will be neutral to the reform. As the rules only apply to VAT payers, any FIEs or domestic companies in the business services sector will neither lose nor gain any benefits after January 1. However, some business taxpayers might be disappointed by the fact that they will not get any benefits at all.

“Many business services enterprises' investments on capital and fixed assets are huge. Like China Mobile or Bank of China, they spend a huge amount of money on telecoms equipment or IT systems. I think the government … will be given pressure from those big players,” Ni says.

Research and development FIEs will be in a particularly bad position after the reform. These companies are engaged in the services industry and are not covered by the VAT system. They now enjoy the same tax benefits as other Encouraged FIEs, but the cancellation of the VAT exemption and refund policies will have significant impact on them. When they purchase fixed-assets, they will have no output VAT to credit the purchase against. The tax they pay for the machinery will therefore become a pure cost. Alan Wu, China national leader of indirect taxes at PricewaterhouseCoopers, says that the government is considering whether to grant the affected enterprises a grandfather period. More Circulars are expected to be published soon.

Adding to the pressure, the VAT payment can only be recovered by crediting against the output VAT at some later time when the final product is sold. Charlie Sun, senior tax consultant at CMS Shanghai Office, says that for FIEs at the construction stage, such cash recovery may take a long time since they are not expected to have sufficient output VAT in the near future. In the present critical economic situation, this may add to financing problems of some FIEs.

Ironically, companies such as FIEs and domestic manufacturing enterprises that do not enjoy Encouraged status will benefit direct from the reform, and non-Encouraged enterprises are now more encouraged to expand, says Sun.

Calls for clarity

Tax and legal specialists are waiting for more clarification on several areas in the regulations which are critical to enterprises. While it is clear that the VAT exemption for Encouraged enterprises will be cancelled, it is uncertain whether the exemption of customs duty will be abolished. If it is, FIEs will face an additional cost burden.

The definition of “fixed assets” will need to be further explained, too. At the November 11 press conference, the scope of fixed-assets was said to include equipment, machinery, means of transport and other equipment, tools and utensils related to production and operation. However, tax specialists find this explanation unclear.

“Does it mean only limited to production type equipment? Or does it also expand to tables and chairs and everything?” asks Wu. “This is a place to be clarified by the detailed implementation rules.”

A rethink needed

It is also unclear whether there will be changes to reporting procedures and supporting requirements. Wu suggests that businesses might need to have new housekeeping measures, just to handle the new reporting requirement procedures.

The success of the stimulus plan is not yet known. But the cash-flow issue will be a concern for FIEs and impact their business decisions; the PRC Employment Contract Law (中华人民共和国劳动合同法)⁴ has already made many FIEs see the country as less favourable for investment. For FIEs that are considering establishing a branch in the PRC, the tax reform could make them sit down and recalculate the costs and benefits.

Wu suggests that companies will need to modify their procurement plans, rethink their supply chain model and keep an eye on developments regarding grandfathering or special concessions.

FIEs that are already in the PRC will need to adjust to the new situation and account for any losses that may be incurred as a result of the VAT reform. If they cannot do so, then they may need to reconsider their position.

“The government might as well be saying that [those FIEs] might not be competitive enough in the Chinese market,” Leong says.

Endnotes

1. See Implementing Regulations for the PRC Enterprise Income Tax Law in CLP February 2008

2. See Foreign Investment Industrial Guidance Catalogue (Amended in 2007) in CLP December 2007

3. See Foreign Investment Industry Catalogue: New Revisions & Alignment in CLP December 2007

4. See Implementing Regulations for the PRC Employment Contract Law in CLP October 2008

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