Opinion: VAT goes nationwide

November 13, 2012 | BY

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The VAT Programme has expanded rapidly since it started in Shanghai this year. For the first time, it allows companies to offset taxes when using external service providers. Lawrence Hu considers how tax reform affects companies

At the beginning of the year, in a widely publicised move by the PRC government, Shanghai was chosen to launch the Value Added Tax (VAT) Pilot Programme. Six months later, on July 25, the Programme was extended to other areas including: Anhui, Beijing, Fujian, Guangdong, Hubei, Jiangsu, Ningbo, Shenzhen, Tianjin, Xiamen and Zhejiang. Then on October 18, Li Keqiang, the likely candidate to be the next prime minister, held a meeting announcing his decision to extend the Programme to new jurisdictions and industries. Mail, telecommunications, railway and construction were the industries to be targeted. The unification of VAT and Business Tax (BT) is expected to be completed during the 12th Five-year Plan.

Shanghai as a tax magnet?

The purpose of the Programme is to resolve double taxation, which occurs under the current regime of both VAT and BT. Considering the long term goals, if implementation was restricted to Shanghai, the effects would not only be limited but also negative. If Shanghai became a tax haven, an increasing number of VAT taxpayers would purchase from Shanghai, allowing them to offset their output VAT. In addition, some BT taxpayers would relocate their business to Shanghai, allowing them to have their output VAT deducted from the input VAT received from sellers. Essentially, the economic balance between Shanghai and other areas would be broken, devastating certain industries in other jurisdictions.

Strengthening the division of labour

By extending the Programme to new industries and jurisdictions, the effect on China's economy will become increasingly pronounced. Before implementation, in order to avoid double taxation, multiple companies choose a business model spanning several stages of the economic value chain. For example, they might have their own logistics team in addition to their core business of manufacturing, avoiding the tax burden of using a third-party logistics provider. Under the Programme, companies can outsource such support functions to external professional service providers.

This specialisation process is an inevitable and natural trend towards the division of labour, which will deepen and may cause a boom in third-party service industries. Currently, the service industry accounts for only 43% of GDP in China, far below the 70% in developed countries or even the 45% in developing countries. It is expected the percentage of the economy based on services will rapidly increase as the Programme expands to more jurisdictions and industries.

Another round of reform

In the meantime, the extension of the Programme may initiate another round of reforms to the tax system. The system was established nearly 20 years ago in 1994. Under it, local governments keep all the revenue from BT and VAT revenue is split between the central and local governments, ranging from 75% to 25%. As VAT eventually replaces BT, local governments will lose a major source of revenue. If the Programme had only been launched in Shanghai, it would have limited the effect on the country's tax revenue allocation system. However, the Programme is already being extended, especially in weaker economic areas.

Before BT is fully replaced, the central government has to consider how to allocate the VAT revenue between itself and local governments. Otherwise, a dramatic shift in tax revenue for the local governments will occur. The Programme is not only a starting point for restructuring the economic development model, but it will also strengthen tax reforms.

Gaining momentum

A company cannot be expected to succeed in every industry, as was the case before the Programme. Some companies, especially large state-owned enterprises, were forced to operate businesses in several different industries to avoid double taxation. Before the announcement of the Programme, companies were hesitant about adjusting their business models. However, as the Programme has extended, the trend of VAT replacing BT has gained momentum and become a near certainty. Considering the clear direction of the tax regime, companies should consider focusing on their core businesses and splitting off everything else.

Lawrence Hu, MWE China Law Offices, Shanghai

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