China's VAT reform crosses the finish line

The mechanism allows taxpayers to offset:

A: their VAT paid on raw materials, parts or components and/or services (and under certain types of VAT systems, that paid on production equipment and other fixed assets as well) (Input VAT), against

B: the tentative VAT payable computed based on the total sales amount from the sale of products and/or provision of services (Output VAT), thereby effectively eliminating double taxation on the same value added.

For example, if in its initial VAT period, a manufacturer of lower end automobiles in China had only the following transactions:

Purchased raw materials, parts and components by paying its suppliers Rmb500,000 and VAT aggregating Rmb85,000 (Rmb500,000 * the applicable VAT rate at 17%);
Manufactured and sold four automobiles at Rmb250,000 each, generating a total sales for the tax period in the amount of Rmb1,000,000;

The VAT payable by the auto company would then be calculated as follows:

VAT Payable = Output VAT – Input VAT

= Rmb1,000,000 * 17% (the applicable VAT rate) – Rmb85,000

= Rmb85,000

As can be seen from the calculation, VAT was only imposed on Rmb500,000 value added by the company.

In contrast to other turnover taxes, VAT is neutral with respect to the number of passages there are between the producer and the end consumers. Other indirect/turnover taxes are levied on the total value added at each stage, resulting in double, and potentially multiple, taxation of the same portion of value added.

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Types of VAT systems

Based on the treatment of Input VAT paid for fixed assets purchased for self-use, VAT systems have been commonly classified into three types:

production-type;
revenue-type; and
consumption-type.

Under the production-type VAT system, Input VAT paid on fixed asset purchases cannot be used to offset Output VAT, and as a result the VAT taxable base would be equivalent to the gross national product of a country. Production-type VAT has the biggest VAT taxable base, but creates the worst double taxation of the same portion of value added.

The VAT taxable base under a revenue-type VAT system equals to the national income of a country and is smaller than that under a production-type of VAT system, but larger than that under a consumption-type. Under the revenue-type system, only Input VAT paid on purchased fixed assets in proportion to the value of the fixed assets being depreciated in the current year can be used to offset against the Output VAT.

Under a consumption-type, the VAT taxable base equals to the total value of goods and services consumed in the country where this is implemented, and the taxable base is the smallest among the three types of VAT systems. A consumption-type would completely do away with double or multiple (indirect) taxation of the same value added.

The majority of the 100+ countries that impose VAT has adopted the consumption-type system.

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Evolution of China's VAT system

Until the late 1970s, China had imposed the Industrial and Commercial Tax (ICT) on domestic enterprises and the Consolidated Industrial and Commercial Tax (CICT) on foreign-invested enterprises (FIEs). Both ICT and CICT were a typical tax imposed on business turnover.

China began experimenting with VAT in 1979 by breaking the ICT up into four different taxes applicable to domestic enterprises—one of which is VAT. After several years of trial implementation on select products in a few industrial cities such as Shanghai, the State Council promulgated the PRC Regulations on Value-added Tax (Draft) and their implementing rules in September 1984. This was the prototype of China's VAT system. However, VAT was only imposed on state-owned enterprises and a limited range of products, and the method of calculating VAT payable was rudimentary at best.

China's current VAT system was introduced in 1994 when both the government and taxpayers increasingly felt the need to do away with the double and potentially multiple (indirect) taxation of the same value added resulting from turnover taxes. That year, the State Council issued new versions of the PRC Tentative Regulations on Value-added Tax, PRC Tentative Regulations on Business Tax and the PRC Tentative Regulations on Consumption Tax. The ICT and CICT were repealed, and all three new tax regulations applied to both domestic and foreign enterprises (VAT and BT were mutually exclusive, while Consumption Tax is imposed on specified luxury goods on top of VAT).

The system introduced in 1994 was a production-type VAT, where Input VAT paid on the purchase of fixed assets can't be used to offset Output VAT. There were several reasons for the move, including weak infrastructure and pillar industries; limited supply of energy, transportation and raw materials; imbalanced investment and industrial structures and economic development; and excess investment in small-scale iron and steel, textile and cigarette factories. The aim was to discourage over-investment in fixed assets.

The issue of VAT as a trade irritant came up in 2005 as well, with criticism from the U.S. forcing China to end VAT rebates for local computer chip companies. This came after the U.S. filed a complaint with the World Trade Organization, with groups representing companies such as Intel Corp. arguing the rebates curbed their exports to China.

On November 5, 2008, the State Council issued the revised Tentative Regulations on Value-added Tax (Revised VAT Regulations), which took effect on January 1, 2009. These did away with the provision that prohibited enterprises from using the Input VAT they paid for their fixed assets to offset Output VAT computed on sales of finished products or services. This was a major change and helped stimulate fixed asset investments. It boosted economic development and helped the country sail through the global financial crisis triggered by the U.S. sub-prime crisis.

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Consumption-type VAT

As with every new mechanism introduced in China, trial of the consumption-type VAT system was first made on a step-by-step and region-by-region basis. In almost all pilot regions, enterprises were permitted to use the Input VAT paid on equipment purchases to first offset against VAT payable by the enterprises, and then the amount payable that was in excess of their respective VAT paid in the previous year. And if there was still a balance of Input VAT paid on the purchased equipment at the end of the year, they were allowed to carry the balance forward to the next fiscal year for offset purposes.

The trial laid the foundation for the nationwide implementation of consumption-type VAT.

From January 1, 2009, under the Revised VAT Regulations, an enterprise's Input VAT payments for acquiring fixed assets (i.e., machinery, mechanical devices, transportation means and other equipment, tools and devices related to production and/or business operations) could be used to offset its Output VAT.

However, real estate was not included in the VAT definition of fixed assets, and therefore Input VAT, if any, paid in respect of real estate could not be entered into the equation. Also, in order to prevent taxpayers from abusing the system, passenger cars, motorcycles and sail boats that are not directly related to enterprises' business operations have been specifically excluded from the definition of equipment.

As part of its continued reform, China also eliminated the VAT-exemption policy that had allowed FIEs and domestic enterprises to import self-use equipment free of import VAT and the VAT-refund policy that had allowed FIEs to obtain a refund for their purchase of domestically-manufactured equipment. The import VAT exemption policy was adopted under the former production-type VAT system to encourage foreign investment in certain sectors and bring in advanced technology from overseas. The VAT refund policy was also adopted under the then production-type system and as a supplement to the import exemption. The government ceased implementing these two policies as it no longer considered them necessary—under the Revised VAT Regulations, Input VAT paid on purchased equipment could be offset against the Output VAT imposed on the sale of products or provision of services.

The Revised VAT Regulations also reduced the VAT rate applicable to small-scale taxpayers from 6% to 3% for industrial taxpayers and 4% for commercial taxpayers, in order to lessen the burden of those unlikely to benefit from the reform of the production-type to the consumption-type VAT system. In 2014, the two rates were combined and reduced to 3%.

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Circular 36

Circular 36 addresses various practical issues regarding the implementation of VAT across the board, in particular, how the scheme will be applied to revenue generated from activities in the remaining industries which were, as of April 30, 2016, still subject to BT.

The Implementing Measures of Circular 36 clarify the following major issues:

- Who VAT taxpayers are, and who pays the VAT when an enterprise is leased to a third party or allows third parties to use the VAT taxpayer's name in business operations (Article 2);

- The circumstances in which a taxpayer qualifies as a general VAT taxpayer (and thus allows for offsetting its Input VAT against its tentative Output VAT) (Article 3);

- The scope of taxable transactions, with a cross reference to the Notes on Sale of Services, Intangible Property and Immovable Property (an attachment to the Implementing Measures of Circular 36);

- The scope of transactions that would not be deemed to have occurred in mainland China, thereby exempting such transactions from VAT (Article 13);

- When a transaction not involving payment of money for services rendered or tangible/intangible property transferred to another party would be deemed as a sale subject to VAT (Article 14);

- Zero-rated cross-border transactions (Article 1 of the Provisions on Applying Zero VAT Rate or Tax Exemption Policy in Respect of Cross-border Taxable Acts released under Circular 36); and the party responsible for withholding VAT from payments to non-residents that do not have a business establishment in mainland China, but nonetheless provided taxable services in mainland China (Article 6);

- The applicable VAT rate where a taxpayer has engaged in a mix of sales involving products and services subject to varying rates (Article 40 & 41);

- The different VAT rates for taxpayers (ranging from 6% to 17%), the levy rate for small-scale VAT taxpayers (3%) and the simplified VAT rate (5%) for small-scale VAT taxpayers, as well as for taxpayers who derive revenue from providing construction services or transferring or leasing real property acquired (i.e., developed or purchased by the taxpayers) on or before April 30, 2016; and

- Transitional tax collection arrangements, to guarantee seamless collaboration among the SAT branches and corresponding local tax bureaus and that there will be no increases in taxpayer burdens.

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The new regime

May 1, 2016 marked the end of China's reform of replacing BT with VAT, and the beginning of a full-fledged VAT system covering all of China's manufacturing, sales, services, as well as the transfer of tangible (including real estate) and intangible property.

BT was regressive in that it was imposed on each turnover, thereby resulting in multiple indirect taxation of business transactions. And the more parties were involved in a series of economic activities, the greater the BT burden on the entire chain, thus discouraging collaboration and economic efficiency among players. Furthermore, BT paid by a taxpayer could not be used to offset against its Output VAT.

No doubt the imposition of VAT across the board will—in all cases other than those involving small-scale payers—eliminate double or multiple indirect taxation of the same portion of the value added. This significantly reduces the unnecessary burden of all taxpayers and their suppliers once subject to BT. It is anticipated that this new tax regime will greatly facilitate the supply-side economic reform promoted by the PRC central government and China's overall economic development.

David Dingfa Liu, FuJae Partners, Shanghai

Under the State Council's mandate, on March 7, 2016, the PRC Ministry of Finance and State Administration of Taxation (SAT) issued the Circular on Comprehensively Launching a Pilot Project for the Levy of Value-added Tax in Place of Business Tax, or Caishui [2016] No.32 (Circular 32). This instructed all SAT branches and provincial tax bureaus across the country to expand the application of value-added tax (VAT) to the remaining industries still subject to business tax (BT), a gross turnover tax that co-existed with VAT as of April 30, 2016.

Pursuant to Circular 32, the SAT will levy VAT on revenue generated by taxpayers from the construction, real estate, banking and financial service sectors, as well as services relating to people's daily life, from May 1, 2016. Subsequent to Circular 32, the Ministry of Finance and/or the SAT issued a series of notices to implement the collection of VAT in place of BT on taxpayers in these remaining industry sectors. This includes the Implementing Measures for the Pilot Project for Levy of Value-added Tax in Place of Business Tax and other documents released under Caishui [2016] No.36 (Circular 36), released on March 23.

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How VAT works

VAT first came into existence in 1954, when France was reforming its sales tax system with the intent to eliminate double and sometimes multiple (indirect) taxation due to the many layers of economic activities. The country's introduction of VAT effectively abolished the redundant taxation caused by the previous system, which was a significant obstacle to economic development.

After France's successful implementation, other countries in Europe, Latin America and Asia followed suit. Currently, more than 100 countries have a VAT system of one type or another in place.

The core feature of VAT, which sets it apart from other indirect/turnover taxes, is that it is ultimately, under an ideal scenario, only imposed on the actual value added in the entire chain of economic activities, although the basis for computing VAT payable is the gross sales amount realized from the sale of goods, provision of services or transfer of tangible or intangible property.