On 24 March 2016, the Ministry of Finance and the State Administration of Taxation (the "SAT") jointly issued Caishui 2016 Circular No. 36 (the "Circular 36"), which marks the overall replacement of Business tax (the "BT ") with VAT as the sole indirect tax in China, starting from 1 May 2016.

The previous VAT regime in China was established in 1994 and applied to the sale of goods, processing and repair services, whereas co-existing BT applied to transactions of other services, intangible assets and real estate.

As part of the efforts made to reform China's state-centralised tax system, Circular 36 implements VAT reforms which were first introduced in Shanghai in 2012 as a trial programme and as from 2013 in other municipalities.

Circular 36 is a series of systematic regulations upgrading the previous VAT reforms and expanding them to new industries as from May 1st, 2016: construction, real estate, financial services and consumer services.

The main measures of Circular 36 are summarized below, as well as a comparison of the resulting VAT regime with BT's.

               ​ 1. Key issues of the VAT reform

 The main purpose of the VAT reform is to create a general tax system applicable without distinction to manufacturing and services industries, as well as avoiding double taxation mechanism by implementing the VAT credit mechanism.

                 1.1  Taxation principle

The main principle governing BT is that its amount is included in the price of the transaction so that it is never recoverable by the service provider or the asset transferor.

On the contrary, the VAT system allows for the tax payable to be recovered and the price of the transaction will be mentioned both VAT included and VAT-free.

Moreover, the system rests upon the generalisation of regular invoices delivery. In this respect, it has now become recommended for contractual parties to provide VAT invoices and to make a connection between the invoice and the payment.

                 1.2 Generalisation of the reverse charge mechanism

 In order to prevent tax fraud due to false VAT invoices, the SAT enacted the "Announcement of State Administration Taxation on Issues Relating to Tax Administration of Value-added Tax (Guoshuifa No. 192 [1995]).

Such regulation provides that companies that receive a goods, services or transportation fee must be the companies who issue VAT invoices to the counterparties in order to be able to claim a VAT credit for their purchase.

In principle the parties (provider and receiver) for cash flow (supported by the bank statement), invoice flow (supported by the information on the VAT invoice, such as issuer or receiver) and goods flow (or service flow) should be the same with each other although practically speaking, some discrepancy will be allowed based on reasonable commercial arrangement.

                 1.3 Improve the internal control and enhance in-house VAT invoice administration

 Under China VAT, fraud will be severely fought, so that the issuer of a false invoice might face criminal charges while not being able to deduct its VAT credit. The implementation of stricter rules than the ones governing the collection of BT will necessarily have to be taken into account by companies while setting up their internal control policies.

                1.4 Questions under the transitional period

 Going forward, lawyers should be aware of the impact of the VAT Reform and advise clients to take proper measures, including analyzing any future transactions and obtaining the axcertificate of the special purpose vehicle (SPV). For example, in view of the input VAT credit for newly acquired real estate, companies may encounter large amounts of input VAT. Lawyers should remind companies to take this impact into consideration when making relevant purchasing or selling plans. To optimize the tax burden, it is feasible to target the timeline of the transaction (in advance or after the event) by revisiting the payment and invoicing terms. Companies should also consider negotiating the contract changes with counterparties during the transition period where necessary.

Many practical transaction arrangements involve a SPV. After VAT Reform, the registration of a SPV as a general taxpayer should be finalized as quickly as possible. Otherwise, the VAT invoice issued by the SPV cannot be deducted and the tax burden of the transaction will increase.

The industry specific rules under the VAT Reform are critical; for example, the different calculating methods for interest income and financial commodity transfers in the financial services industry, the general and simplified levying and collection of VAT in the real estate industry and the VAT impact on the consumer business industry. The details of this are beyond the scope of this article, however will be explored in future articles.

              2 General comparison of BT and the new VAT

 The notable differences are summarised below.

Click here to view the table.