On January 1, 2012, the trial of the value-added tax ("VAT") Transition from business tax to VAT ("VAT Transition") for transportation and certain modern service industries was implemented in Shanghai. It is a landmark event in Chinese tax reform. In July 2012, the State Council further decided to expand the pilot area to Beijing and seven other provinces and municipalities in stages: Beijing is expected to complete the VAT reform by September 2012; Jiangsu and Anhui provinces are expected to be complete by October 2012; the conversion deadline for Fujian and Guangdong provinces is November 1, 2012; and the deadline for Tianjin Municipality, Zhejiang Province and Hubei Province is December 1, 2012. Furthermore, the VAT Transition pilot areas will continue to be expanded next year and certain industries will be selected as pilots for VAT Transition nationwide.
The VAT Transition will result in changes to the tax burden for taxpayers of relevant industries, and may even have significant impacts on their operations and pricing models. In this article, the authors will introduce the background of the VAT Transition; analyze the impacts of the VAT Transition on related industries; compare the differences between the Shanghai scheme and the new pilot scheme ("New Scheme"); and finally make suggestions to taxpayers about how to deal with the reform properly.
- Background of the VAT Reform
The current goods and services tax system is mainly a turnover tax which consists of VAT, business tax, and consumption tax(1) etc. Currently, except for the VAT Transition pilot areas, the provision of services, the transfer of intangible assets and the sale of real estate within China are treated as taxable activities of business tax, while the sale of goods, the service of processing, repairing and replacing, and the import of goods within China are treated as VAT taxable activities, as per relevant tax laws and regulations. Unless otherwise provided,(2) business tax is levied based on the gross operating income. Consequently, concerns of double taxation may arise in multi-levels of services. On the other hand, the key character of VAT is its deduction mechanism, i.e. in calculating the VAT payable, the input VAT for purchasing goods and taxable services during the process of operation is deductible against the output VAT for sales, and thus could effectively avoid the double taxation issues.
The VAT Transition will effectively crack the bottleneck of the current tax regime which restricts the development of modern service industry, and will help to solve the double taxation issues of business tax, thereby reducing companies' tax burden, promoting the industrial division-and-collaboration among taxpayers, and continuously optimizing the industrial structure.
- Impacts of the VAT Reform
- Major Contents of the VAT Transition
According to the "Ministry of Finance and State Administration of Taxation: Circular on Carrying out the Pilot Collection of the Value-Added Tax in Lieu of Business Tax on Transportation Industry and Part of Modern Services Industry in Eight Provinces and Cities including Beijing (Circular Cai Shui  No. 71)", the implementation plan in Beijing and other pilot areas is largely consistent with that in Shanghai. Both adopt the same pilot scheme, the same pilot industries and the same policy arrangements. The VAT Transition program mainly involves the transportation industry and parts of modern service industries. The VAT tax rate is 11% for the transportation industry, 17% for the tangible property leasing services industry, and 6% in the remaining modern service industries. Meanwhile, VAT is imposed on import of services in the domestic process, while zero tax rate or exemption is applicable to exports.
Comparison of the tax rates before and after VAT Transition in the transportation industry and modern service industries is summarized as follows:
Click here to view table.
The above VAT rate is applicable to general taxpayers; for small-scale taxpayers, the rate is 3% and no input VAT is deductible.
- Impacts of the VAT Transition on Main Industries
- Transportation Industry
From the above table, it can be seen that in the pilot regions the tax rate for general taxpayers in transportation services except the pipeline transportation service has increased by 8%. Although the input VAT from the purchase of transportation equipment, fuel, and other purchase activities is deductible against the output VAT arising from the transportation services, many taxpayers have a small amount of deductible input VAT in the short term as most of the transport equipment was purchased before January 1, 2012. Moreover, because the VAT Transition only applies to certain limited industries, not all input VAT for purchased services is deductible against the output VAT. For example, road tolls which make up a large share of transportation costs are not yet deductible. For the above reasons, the turnover tax burden of transportation companies will increase in the short term after the VAT Transition. After implementation of the VAT Transition program in Shanghai, a survey by China Logistics and Purchasing Federation showed that the actual VAT paid for 67% of companies in the logistics industry has increased to some extent in January this year.
The Shanghai scheme provides that taxpayers engaged in highway and inland river freight transportation, as long as they issue invoices, are all treated as general taxpayers and pay VAT at the rate of 11% regardless of whether sales amount reaches RMB 5 million. However, the New Scheme repeals this provision, which means that taxpayers in highway and inland river freight transportation with annual sales amount of less than 5 million shall be treated as small-scale taxpayers and pay tax at the rate of 3%. This will bring huge benefits for small-scale enterprises. This is also the biggest difference between the Shanghai Scheme and the new Scheme.
- Modern Service Industry (Leasing Industry Excluded)
As can be seen from the above table, the tax rate has increased by 3% for some logistics auxiliary services, and 1% for other modern services. However, results may be different as to whether taxpayers' actual tax burden will increase. For consulting companies, the major costs are labor cost, rental, property management fees, transportation, and mail and telecommunications expenditures, which are not within the scope of input VAT deduction, and therefore the actual tax burden may increase. Furthermore, if the taxpayers render R&D services and design services to overseas enterprises, a zero VAT rate may be applied. Similarly, if the taxpayers provide services such as technology transfer services, technical advisory services, contract energy management services, software services, circuit design and testing services, information system services, business process management services, trademark and copyright transfer services, intellectual property services, logistics and ancillary services (except warehousing services), certification services, authentication services, and consulting services to foreign enterprises, the taxpayers will be exempt from the VAT. For companies in which the services income for the above services accounts for a relatively large ratio of the total service income, their tax burden would be reduced substantially.
- Tangible Assets Leasing Industry
For financial leasing business, the pilot program provides "refund upon collection" treatment for the part of the actual VAT that exceeds 3%, so theoretically speaking, the actual VAT tax rate will be 2% less than the business tax rate. Meanwhile, the lessee may deduct the input VAT if it can obtain the VAT special invoices from the lessor. It is expected the VAT Transition will promote the development of the tangible assets finance leasing business.
For operating leasing business, the tax rate increases by 12% under the pilot program. Although operating leasing companies can deduct the input VAT for purchasing of the leased equipment, the available amount of the input VAT deduction in the short-term may be small if the major leased equipment was purchased before the pilot program was launched and there is no recent large procurement plan. Moreover, if operating leasing companies cannot pass the tax burden effectively onto their service recipients, their actual tax burden will be even greater in the short term, which may constrain the development of this industry.
In response to the above problems in operating leasing companies, the Ministry of Finance and State Administration of Taxation jointly issued Cai Shui  No. 53, which stipulates that, since July 1, 2012, general taxpayers in pilot areas that provide operating leases services with tangible assets that were purchased or self-manufactured before implementation of the pilot program can choose to apply for the simplified tax method (i.e. applicable tax rate of 3% with no input VAT deductible) to calculate the VAT. This provision will lessen the tax burden of leasing companies who made a large number of procurements prior to the implementation of the pilot program.
- How to Cope with the VAT Transition
VAT may be an unfamiliar concept for many taxpayers which are engaged mainly in business tax related activities. Relevant taxpayers should pay close attention to the latest changes of the policy, and cooperate with relevant departments to ensure that the companies' IT and accounting systems are able to accommodate the tax reform and changes. Taxpayers should also assess in details the impacts of this reform on the companies' operating structure, business model, sales price, sales demand, procurement costs, cash flow and market competitiveness, and make timely adjustments accordingly.
VAT collection and management is more mature and strict. Therefore taxpayers should put special focus on the following areas of VAT compliance issues in order to reduce the risk of non-compliance:
- Verification of the VAT general taxpayers. It shall be noted that, where the sales amount of a taxpayer exceeds the threshold for the small-scale VAT payer, even if it fails to apply for verification of the general taxpayer, the VAT payable shall be computed based on the sales amount and the VAT tax rate (generally at 17%), while no input VAT may be credited against the output VAT. In addition, this taxpayer cannot issue the special VAT invoices. Enterprises should try to avoid such situations.
- The issuing and using of the VAT special invoices shall strictly comply with the relevant provisions. Illegal issuing and using of the VAT special invoices may lead to more serious consequences than that of violating the rules for ordinary invoice, and may involve criminal liability.
- Verification of the VAT special invoices. VAT invoices should be verified by tax authorities within 180 days from the date of issuance. The taxpayers shall file with the tax authorities in charge for deduction of the input VAT in the following month upon the verification of the VAT invoice. As for imported goods, taxpayers should file for the application of check and comparison of the import VAT invoices to competent tax authorities within 180 days from the date when they obtain such invoices. Failure to seek verification/check of the VAT invoice in time may result in ineligibility of input VAT deduction.
- The companies that enjoy the VAT exemption or zero rate should learn more about applicable preferential criteria, procedures and documentation requirements, and avoid failure to apply the preferential treatments due to non-compliance with standardized procedures or incomplete documents.
- Tax calculations: business tax is the tax included in the price, which means that the tax is borne by the seller. Therefore, tax payable = sales revenue * tax rate. VAT is the tax excluded in the price, which means that the tax is borne by the purchaser, and the sales revenue for sellers contains the purchase price and the VAT tax. Therefore, tax payable = (sales revenue/ (1 + tax rate)) * tax rate. Taxpayers should pay attention to the calculation method difference between business tax and VAT, and reasonably determine the sales price.
In addition, when companies outside of the pilot areas purchase from service providers in the pilot areas, they should learn more about the service providers, including whether the service providers are VAT general taxpayers and whether they can issue VAT invoices. Companies outside pilot areas should also comprehensively evaluate factors such as the purchase price and amount of the input VAT.
- Trend of the VAT Reform
Currently, business tax has nine tax items: transportation, construction, finance, insurance, mail and telecommunications, culture and sports, entertainment, service, transfer of intangible assets and sale of real estate. The current pilot industry of VAT Transition only covers the transportation industry and some modern service industries. Along with the participation of the eight provinces and municipalities, and the increase of the pilot industries, more and more taxpayers will be affected. According to the macroeconomic forecast, during the 12th Five-Year period (2011-2015), the VAT reform will expand to the whole nation and VAT will eventually replace the business tax nationwide. Consequently, there will be a new turnover tax structure with the general collection of VAT as the major tax and the special adjustments of consumption tax as the supplemental tool.
It is noteworthy that under the financial system in China, VAT is shared by central and local governments with the ratio of 75:25; for business tax, except where a few companies pay directly to central government, all other tax revenue belongs to local governments as local tax revenue (comprising about one-third of the overall revenue). In order to protect the interests of the local treasury, the current VAT (i.e. previous business tax) revenue still belongs to the local governments after the VAT Transition. However, regarding the collection of VAT, the national tax bureaus will take charge. In the short term, the VAT Transition does not affect the allocation of the central and local tax revenues, but this program is, after all, contradictory with the current tax distribution system. In order to solve the problem fundamentally, more comprehensive financial solutions may be needed to adjust the problem of partitioning fiscal revenue between local and central governments. It can thus be predicted that the VAT reform will also promote and accelerate more general financial system reform.