How law firms should prepare for the new VAT rules

The Chinese government has an ambitious tax reform agenda to replace business tax (BT) with value added tax (VAT). The reforms began with a pilot programme in Shanghai on January 1 2012 and has progressively expanded nationwide from August 1 2013.

The provision of consulting services, which includes legal services, is considered to be part of what is called the "modern services" industry, for which VAT now applies at the rate of 6%. This 6% VAT rate replaces the previous 5% BT rate. While in theory this may seem like a minor change, in reality it has a number of important implications for law firms.

VAT categories

Under the VAT pilot programme, law firms with an annual turnover exceeding Rmb5 million (US$802,000) are required to register as general VAT taxpayers. Registration as a general VAT taxpayer is optional for businesses with a turnover lower than the Rmb5 million threshold, but those who wish to register must maintain a proper system of accounting and remain as a general VAT taxpayer for at least three years.

Registration as a general VAT taxpayer entails a number of obligations as well as benefits:

• VAT applies to legal services provided within mainland China at the rate of 6%;
• Input VAT credits can generally be claimed for expenses incurred in relation to the law firm's operations - for this purpose, special VAT invoices need to be obtained and validated with the tax authorities;
• Special VAT invoices may be issued to clients who are also general VAT taxpayers (to enable them to claim an input VAT credit for the legal services).

Small scale VAT taxpayers are those with a turnover below Rmb5 million and do not voluntarily register as general VAT taxpayers. These law firms pay VAT at the rate of 3%, but they can neither issue nor receive special VAT invoices and are therefore precluded from claiming any input VAT credits.

The VAT treatment of foreign law firms which operate through representative offices in mainland China has been a source of considerable confusion. In the early stages of the VAT reforms, a number of local tax officials took the view that foreign representative law firms were unable to register as general VAT taxpayers. This was based on the belief that representative offices of foreign law firms are not eligible to provide services to, or derive revenue from, third parties - a mistaken belief as foreign law firms are an exception to this general policy under PRC law. Consequently, we have assisted a number of representative offices of foreign law firms in obtaining registration as general VAT taxpayers. Foreign law firms with corporate clients typically prefer to register as such so as to facilitate their clients claiming input VAT credits for the legal services.

VAT accounting tips

There is a common misconception that VAT need only be accounted for when the client is issued with a special VAT invoice. But, in fact, law firms are required to account for output VAT as soon as they issue an invoice or bill to the client and when they are paid by the client. Technically, the obligation to account for VAT arises when there is a right to receive payment under the contract, and in practice, that will ordinarily be when a bill is issued to the client.

A useful commercial practice advisable to law firms is to only issue special VAT invoices to clients upon receipt of the full amount set out in the client's bill. This has a number of advantages. First, it overcomes the need to issue so-called "red letter invoices" which happen when there is a reduction in the price (for example, a renegotiation of the fee with a discount) after the special VAT invoice has been issued. Instead, initially issuing a normal commercial bill and a special VAT invoice to the client upon payment vastly reduces the volume of red letter invoices and consequent administration. Secondly, once a client receives a special VAT invoice they are entitled to claim an input VAT credit, assuming they are a general VAT taxpayer. Deferring the issuance of the special VAT invoice until payment provides the client with an incentive to pay up. In other words, if the client is issued with a special VAT invoice before payment is made, what reason is there for the client to pay quickly

However, not all clients will accept this approach, such as larger institutions which require special VAT invoices to be issued prior to payment. A degree of flexibility is therefore prudent.

In terms of claiming input VAT credits, law firms can only include such amounts in their VAT return if they hold a special VAT invoice, which is validated with the tax authorities. At present, law firms typically incur relatively minor amounts of input VAT credits, for instance when they replace their IT systems, purchase or lease photocopiers and other equipment, engage couriers and other postal services and outsource certain tasks to their overseas offices. The major expenses of most law firms are rent and salaries, neither of which is presently subject to VAT. However, it is expected that from early 2015, VAT will be expanded to the real estate industry, whereupon rental of office space should become subject to VAT. The policymakers are considering adopting a VAT rate for the real estate industry that is as high as 11%, although this has yet to be formalised.

Contracting for VAT

The general principle under both the VAT regulations and PRC law is that if the contract is silent as to VAT, the price is deemed to be inclusive of VAT. Therefore, if the law firm's intention is to pass on the VAT liability to the client, explicitly stating this in the contract is crucial.

The range of drafting options which may be used to achieve this is virtually limitless, though the key is to stipulate in clear and unambiguous language that VAT may be added to any fees, hourly rates, disbursements and other charges payable under the engagement contract. This may be achieved as simply as "plus VAT", although much depends on how the engagement contract has been drafted.

Tax advisors are often asked whether law firms should instead draft their engagement contracts to reflect their fees being inclusive of VAT. But this is generally undesirable, given that if those fees have been determined on the assumption of the VAT rate being 6%, what happens if the rate increases to 11% In such circumstances, the law firm will be left to bear the additional irrecoverable VAT liability.

Finally, local taxes and surcharges (which differ slightly from city to city), continue to apply as a percentage of the VAT payable. The only difference from the previous BT position is that the local taxes and surcharges apply to the net VAT payable, rather than the gross BT payable.

Disbursements and outlays

A common source of confusion for many law firms is how to deal with the VAT in relation to disbursements or outlays where the costs are passed on to the client - specifically, whether this results in a double VAT liability and how this should be disclosed on a bill to the client.

In a simple example, a law firm's fees to a client are Rmb50,000 plus disbursements, and in providing services to the client, a lawyer needed to travel from Shanghai to Beijing for meetings and negotiations. Figure 1 sets out the disbursements incurred by the law firm as well as the suggested VAT treatment. Figure 2 lays out the subsequent bill to the client.



Representing overseas clients

One of the biggest hurdles of these reforms is the VAT treatment of exported services provided to overseas clients. Circular Caishui [2013] No 106 provides that consulting services, including legal services, are exempt from VAT if they are provided to overseas entities and the services do not relate to goods or real estate in China.

The challenges of interpreting and applying these vague concepts have been exacerbated by the inconsistent implementation rules issued by the different local tax authorities. For instance, the rules for implementing the VAT exemption for exported services in Shanghai differ from those in Beijing.

It should firstly be noted that, to qualify as an exported service, the services do not necessarily have to be performed outside of mainland China. Rather, exemption may apply if the services are performed inland but provided to an overseas client.

Secondly, legal services may qualify as an exported service if the overseas client is in a special administrative region of Hong Kong or Macau.

Thirdly, these provisions have largely been borrowed from those of comparable countries such as Australia, New Zealand and Canada. The concept of a legal service relating to goods or real estate in those jurisdictions typically requires a close connection between them. For example, a legal service which consists of a conveyance of real estate in China would not qualify for exemption. By contrast, a legal service which consists of advising a client on the establishment of a new wholly foreign owned entity in China that manufactures goods is unlikely to create a sufficient connection with goods so as to disqualify entitlement to the exemption. The practical issue is that many real life cases fall between these extremes, such as due diligence services in connection with proposed M&A activity where the client manufactures or sells goods, or holds significant real estate assets.

Zooming in on details

While the technical requirements for claiming exemption from VAT under Circular 106 are relatively straightforward, as with many things in China the devil is in the details of implementation. The following cases require attention to specifics:

• The VAT exemption may be disallowed where payment for the legal services is made by the overseas client's local Chinese entity, or even in some cases denied where payment is made by another overseas related party of the client;
• There is a need to transfer out or deny input VAT credits which relate to exempt revenue, and a determination of that amount may be complex to apply;
• There is a need to provide the tax authorities with translated copies of engagement contracts and various other documents which can be very cumbersome for larger law firms with hundreds or thousands of such engagements;
• Many international law firms which are part of a network and provide legal services from their Chinese entity or representative office under inter-firm types of engagements can qualify for exemption from VAT but only if the documentation is properly prepared; and
• Given these uncertainties and the fact that exemption from VAT can be disallowed as a result of circumstances beyond the control of the law firm, many firms have debated whether to charge VAT on these engagements and then refund upon approval of exemption. This can help manage the risk to the law firm if the exemption is not satisfied.

Legal assistance from overseas

In reverse, a law firm in China may obtain assistance from an overseas provider (potentially another law firm) when a Chinese client seeks assistance in multi-jurisdictional matters. Figure 3 illustrates the contracting position in this instance.



In this situation, VAT will apply to the entire fee rendered by the Chinese law firm to its client in China, including disbursements. As for the subcontracting arrangement, if the overseas law firm has neither a permanent establishment nor other tax presence in China, it will not levy Chinese VAT. Instead, the Chinese law firm is required to withhold VAT at the rate of 6%. However, the Chinese law firm should be eligible to claim an input VAT credit upon receiving clearance for foreign exchange settlement.

The VAT withholding system is designed to overcome the problem of Chinese tax authorities collecting the VAT from the overseas party. It is somewhat akin to the so-called "reverse charge" system which applies in many other countries with VAT, but the Chinese withholding system is unique in that the Chinese law firm is required to withhold 6% of the fee it pays overseas. This means the overseas law firm is underpaid, unless both parties agree to gross up the fee to counteract the withholding effect. Unfortunately the system entails accounting complications as the overseas party's accounts will continue to show an outstanding liability of 6% of the fee, and may require a bad debt adjustment to correct the imbalance.

Lower burdens but higher complexities

While the transition from BT to VAT may seem on the surface like a simple tax change from 5% to 6%, for many law firms the VAT reforms signify changes to their engagement contracts, billing systems and processes as well as their compliance obligations. On the other hand, this results in a reduction in the overall tax burden for law firms and their clients, due to the ability to claim input VAT credits and to potentially exempt engagements with overseas clients from VAT.


Lachlan Wolfers and Christine Li, KPMG, Hong Kong


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