Evolution: VAT reform changes the economy

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.

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: