After running pilot programs in different parts of China, the State Council has approved Value-Added Tax (VAT) reform jointly submitted by the Ministry of Finance and the State Administration of Taxation. With the issuance of Order of the State Council No. 538, the central government has announced that the revised People’s Republic of China Tentative Regulations on Value-added Tax (VAT Regulations) is now the law throughout China. The revised VAT Regulations became effective on January 1, 2009. The crux of this reform is to permit VAT deduction for the purchase of fixed assets.

In the short term, VAT reform will most likely have a significant and immediate impact on China’s fiscal budget. According to statistics released by the Ministry of Finance, revenue from VAT accounts for approximately 31% of China’s overall tax revenue. The Ministry of Finance estimates that VAT revenue to be collected under the revised VAT Regulations will be reduced by more than 120,000,000,000 Yuan – approximately 17 billion U.S. Dollars.[1]In the long term, VAT reform will eliminate double taxation, which was a major drawback associated with the production-based VAT model.

Value-Added Tax Coverage

VAT is a tax that is levied based not on a taxpayer’s income but on the turnover of certain goods and services that have been “touched” by each taxpayer. Any person engaged in any VAT taxable economic activities is responsible for VAT. Taxable economic activities covered under VAT are broad and include the sale or import of goods. Article 1 of the VAT Regulations broadly defines goods to include all items that can be moved.

Calculation of VAT Payable

The amount of VAT payable is based on a formula: VAT payable equals output VAT deducted by input VAT. The output VAT equals the product of the “sales value” multiplied by the applicable VAT rate, and the input VAT equals the VAT payable on the purchase of goods or services. Unless a business is classified as a “small-scale taxpayer,” the VAT rate for fixed-assets purchases is 17% under Article 2 of the VAT Regulations.

Although a deduction of input VAT against output VAT is the general rule, there are exceptions. Article 10 of the old rules listed six categories of items for which input VAT cannot be deducted against output VAT. What impacted the manufacturing enterprises the most was the exception governing fixed-assets purchases. Before January 1, 2009, taxpayers could not deduct the amount of input VAT associated with the acquisition of fixed assets against output VAT. In effect, the old rules raised the cost of every equipment acquisition by the VAT rate.

Models of VAT Collection

In broad terms, VAT collection could be divided into two models: production-based and consumption-based. Under the production-based model, VAT is collected at every link of the production cycle. A key characteristic of the production-based model is that the VAT included in the purchase of fixed assets is not deductible against output VAT. In contrast, under the consumption-based model, VAT included in the purchase of fixed assets is deductible.

Before this reform and with the exception of some parts of China that were operating under the pilot program, China had been following the production-based model since 1994.[2] With the full implementation of VAT reform, China has switched to the consumption-based model of VAT collection.

Double Taxation Under Production-Based VAT Model

In the context of product manufacturing, one major drawback of the production-based VAT model is double taxation on goods produced. This phenomenon stems from the fact that VAT is included in the sales price of goods. When a manufacturer acquires capital equipment, the cost of that equipment includes VAT (or input VAT). But under the old law, the input VAT (included in the purchase price of the equipment) was not deductible against output VAT associated with the finished goods. The manufacturer paid VAT when it purchased the equipment, and the consumers indirectly pay VAT again for the same equipment in the form of higher sales price. In other words, the sales price of the final goods included two payments of VAT for the same equipment purchased to make the goods, hence double taxation.

Double taxation drives down demand and leads to a slower pace of capital investment. The negative effect of double taxation under the production-based VAT model is magnified in the manufacturing of sophisticated, high value-added products that often require heavy capital investment. By switching to the consumer-based VAT model, the new law eliminated the drawback of double taxation, and the VAT policy is now in step with China’s aspiration to develop its high-end manufacturing capabilities.


After the full implementation of VAT reform on January 1, 2009, input VAT associated with the purchase of fixed assets is now deductible against output VAT. The timing of VAT reform comes at an opportune time as China seeks to grow its economy in a challenging global economic climate. Enterprises looking to invest in fixed assets will benefit from VAT reform because they can recover their investments faster. The switch from production-based VAT model to consumption-based VAT model eliminates double taxation, which should result in lower prices for consumers and encourage more investments in high-end manufacturing capabilities.