Reforms to China’s value-added tax raise issues that landlords should consider when designing leasing structures and negotiating rental terms.
On May 1, 2016, China’s value-added tax (VAT) replaced the business tax in the real property sector and in various other industries. According to the VAT reform regulations, for qualified property leasing, landlords may opt to pay either 5% VAT or 11% VAT; for the leasing of other properties, 11% VAT will be applied.
This LawFlash analyzes the effect that VAT reform has had on China's real estate leasing business and raises important issues for landlords designing leasing structures and negotiating rental terms.
OVERVIEW OF THE NEW RULES
Before China’s VAT reform, the business tax was applied to real property leasing and was assessed on the basis of all rental income received by landlords from leasing. The business tax rate for property leasing was 5%. After VAT reform, VAT now applies to real property leasing. VAT rates and calculation methods would be applied to different types of properties for different types of taxpayers, as follows:
Please click here to view table.
General and Small-Scale Taxpayers.
Based on the amount of a taxpayer’s annual taxable income, Notice No. 36 places taxpayers into one of two categories: (i) small-scale taxpayers who have taxable income of no more than RMB5 million per year; and (ii) general taxpayers who have more than RMB5 million of taxable income per year.General and Small-Scale Taxpayers.
Companies that meet the criteria for a general taxpayer should register with local tax authorities as a general taxpayer. If a company fails to register, it will not be allowed to deduct the input VAT from the output VAT and will have to pay VAT based on the total amount of rental income it receives.
General Method vs. Simplified Method.
There are two different VAT calculation methods, the general method and the simplified method.
- Under the general method, VAT equals output VAT minus input VAT. Output VAT is calculated based on landlords' taxable income and the applicable VAT rate. Input VAT is the VAT that has already been included in the purchase price when taxpayers acquire goods or services. The general method is based on the concept that VAT is levied on the value that is added to commodities or services as they pass through the supply chain.
- Under the simplified method, however, VAT equals the taxable income of the taxpayer multiplied by the applicable VAT rate (i.e., 5% for property leasing); input VAT is not deductible when the simplified method is used. The simplified method is similar to the approach used to calculate business tax before VAT reform.
Old Projects vs. New Projects.
For the purpose of collecting VAT on leased property acquired by landlords, Circular No. 16 categorizes properties into two types:
- New Projects, which include properties that landlords acquired after April 30, 2016; and
- Old Projects, which include properties that landlords acquired on or before April 30, 2016.
"Acquire" means that a property has been acquired by purchase, donation, as a capital contribution, or due to debt repayment, etc.
For properties that are developed and then leased by real property developers, Old Projects refer to construction projects (i) in which the Construction Permit (Construction Permit) indicates that construction commenced on or before April 30, 2016; or (ii) when there is no Construction Permit, or the Construction Permit does not indicate a construction commencement date, and the construction contract indicates that construction commenced on or before April 30, 2016.
5% vs. 11%.
For small-scale taxpayers, the applicable VAT rate is 5% and the simplified method always applies. General taxpayers who lease Old Projects choose either the simplified method and apply the VAT rate of 5% or the general method and apply the VAT rate of 11%. General taxpayers who lease New Projects are required to use the general method and the VAT rate of 11%.
Two-Installment Deduction of Input VAT.
For general taxpayers who use the general method to calculate VAT, input VAT may be deducted in two installments: up to 60% in the first year and 40% in the second year. If a balance remains after the first two years' deductions have been applied, the balance may be used in the following years until the input VAT amount is reduced to zero.
POST VAT REFORM: THINGS TO CONSIDER DURING LEASE NEGOTIATIONS
The Simplified Method Is Ideal for Leasing Old Projects.
Landlords should apply the simplified method when leasing Old Projects. This method is straightforward and similar to the old business tax approach, and it does not require extensive revisions of standard rental terms that were used under the business tax regime.
If the landlord chooses to use the simplified method, assuming that the rent remains the same, the landlord's tax liability under the new VAT regime will remain approximately the same as under the business tax regime. Even better, if the landlord and tenant agree that the VAT tax is included in the amount of the lease, the VAT tax should be excluded from lease proceeds in order to determine the taxable income (i.e., taxable income = rent / (1+5%)). In this situation, landlords actually pay less VAT tax than they paid business tax under the old regime.
Applying the General Method May Reduce Landlords' Income from Leasing Old Projects.
If the landlord chooses the general method, its rental income might be reduced significantly under existing leases.
Although one advantage of choosing the general method is that landlords are allowed to deduct input VAT from output VAT, in certain circumstances landlords might not be able to realize this advantage. When the general method is used, landlords are required to use special VAT invoices when they claim deductions of input VAT from output VAT. For Old Projects acquired before April 30, 2016, however, landlords did not receive these special VAT invoices, and thus they are not able to deduct input VAT from the acquisition price. One lesson for landlords acquiring New Projects is that they must make sure to obtain a special VAT invoice before making payment for the property.
Furthermore, prior to VAT reform, lease agreements usually stipulated that each party paid its own taxes and expenses in connection with the lease. Landlords typically included grossed-up business taxes in the rental amount in order to realize the desired rental income. In theory, as a result of VAT reform, if the lease agreement is silent on the question of which party bears the tax burden, the output VAT should be deemed to have been embedded in the nominal rent. When the 11% rate applies, landlords will be placed in a financially unfavorable position, as they will receive considerably lower net proceeds.
To avoid a deduction in rental income, landlords applying the general method should revise their rental terms to ensure that the invoice amount covers two separate items:
- Net rental income that the landlord seeks to realize
- Grossed-up VAT amount that corresponds to the 11% rate
However, if tenants do not agree to revise the existing lease agreements, it is not advisable that landlords choose to apply the general method—for the reasons mentioned above.
Landlords Leasing New Projects Should Make Sure to Include VAT in the Rent.
While landlords operating Old Projects have two options, landlords leasing New Projects should always apply the general method. Thus, it is also important for them to be sure to include both (i) the net rental income that the landlord seeks to realize; and (ii) the grossed-up VAT amount that corresponds to the 11% rate in their standard rental terms.
If standard terms are drafted in this way, under the general method, the net income anticipated by the landlord will not be reduced. Better still, input VAT for deductible items like operating expenses may also be deducted from the output VAT on the rental income. Using this approach, the landlord's tax treatment after the proper deductions have been made will actually be more favorable than that under the old business tax regime.
One complication is that the total nominal rent will rise after the 11% VAT has been factored in. Thus, the tenant's costs will increase a corresponding amount. When the landlord negotiates rental terms, however, he could point out that the tenant may deduct such grossed-up VAT amounts as input items against its own output VAT and that the tenant's actual tax burden would therefore not be greatly increased. In fact, if the tenant fully deducts the grossed-up VAT from its own output VAT, the cost of the tenant's lease will be effectively reduced by approximately 5%. This is clearly a win-win situation, as both landlord and tenant benefit.
With the introduction of VAT reform, some technical questions require further clarification. It is not always clear which kinds of input items may be deducted from output VAT, and questions remain regarding the deduction of input items. Under the current legislation, it appears that daily operating expenses like daily maintenance fees or routine capital expenditures fall within the scope of deductible items, while employee costs and interest on mortgage payments do not. Furthermore, it is not entirely clear whether land premiums may be categorized as input items and, if so, over what period of time they may be amortized against output VAT.