SAT: Latest developments in China’s VAT reform

China’s roll-out of VAT has been impressively quick and efficient

The Chinese government has launched a series of VAT reforms over the past few years to align its VAT system with internationally accepted principles, and to adapt to the economic development in China and the world at large, with an aim to modernise the country's governance system and administration capabilities. On July 1 2014, the multiple VAT rates of 6%, 4% and 3% (for small-scale VAT payers) were simplified and unified into a single rate of 3%.

On May 1 2016, the Business Tax (BT)-to-VAT reform was rolled out nationwide wherein BT on taxable services was replaced by VAT, such that input tax credit could be fully available along all cycles of value chains in order to avoid the cascading effect of BT. On July 1 2017, the four-tier VAT system with rates of 17%, 13%, 11% and 6% were simplified and unified into the three-tier VAT system with rates of 17%, 11% and 6%. All the above measures were made to continuously develop a simpler, clearer and more scientific VAT system.

In 2018, the Chinese government deepened the VAT reform with three significant measures.

• First, from May 1 2018, VAT rates were appropriately lowered from 17% and 11% to 16% and 10% respectively, resulting in a three-tier VAT rate structure comprising VAT rates of 16%, 10% and 6%.

• Second, the annual turnover thresholds of RMB 500,000 ($77,000) and RMB 800,000 applicable to small scale VAT payers engaged in manufacturing and trading respectively were unified and increased to a single threshold of RMB 5,000,000.

• Third, the scope of excessive input tax refund was extended. More specifically, the current scope of the excessive input tax refund for qualifying sectors and enterprises has now been extended to qualifying enterprises engaged in modern services (eg. research and development) and advanced manufacturing, such as equipment manufacturing, as well as power grid enterprises. For these enterprises, one-off excessive input tax refund is allowed.

The above three VAT reform measures were key decisions made by the government, following a comprehensive analysis of the developmental trends of the global and domestic economies, with the aim of building a modernised economic system, deepening supply-side structural reform and improving the business environment. These measures are a breakthrough in the mission to establish a quality VAT system, as well as observing the fundamental principles of tax neutrality, efficiency, fairness and simplicity in formulating tax policy as advocated in the OECD guidelines. These reform measures demonstrate not only a better alignment of China's VAT system with international standards, but also China's commitment and contribution as a member of the OECD's Global Forum on VAT. The rest of this article analyses the key features of this round of reforms, and the rationale behind them, in more detail.

The more VAT rate tiers exist, the more complicated the VAT system is and, correspondingly, the higher compliance and administration costs are for taxpayers and tax authorities. The wider the gap between the VAT rates, the more likely it is that taxpayers will tend to opt for the lower rates. All of these factors can compromise the efficiency of the VAT system.

As mentioned, on July 1 2017, the four-tier VAT rates were simplified and unified into the 3-tier rate structure of 17%, 11% and 6% and, on May 1 2018, the top VAT rates of were lowered to 16% and 10%, resulting in a three-tier VAT rate structure of 16%, 10% and 6%. Narrowing the gap between VAT rates is a measure taken to enhance the compliance efficiency within the tax system. This aligns with the fundamental principle of efficiency under the OECD's International VAT/GST Guidelines and is an important step towards the realisation of a more scientific and regulated VAT rate structure.

China lifted the annual turnover threshold for small-scale VAT payers to RMB 5,000,000 from the previous thresholds for manufacturing and trading companies. This measure enforces the principle of fairness by eliminating different tax treatments of taxpayers in different industries. The VAT system becomes simpler when more small and medium-sized enterprises (SMEs) are below the threshold and no longer required to compute their VAT payable based on the output tax and input tax credit method. Tax rules become clearer and easier to understand, financial accounting becomes simpler, and the tax filing process becomes more efficient, resulting in a lower cost of compliance for SMEs.

The principle of neutrality is the foundation of constructing of a VAT system and also a key element of a modernised taxation system. Neutrality covers a wide range of areas, but one of its most important objectives is to eliminate the cascading effect of tax so as to avoid the accumulation of tax burdens along production and trading processes, in order to allow the tax system to operate smoothly in a manner where the tax burden can be passed along the supply chain on to the end consumers.

The deepening of the VAT reform in 2018 has expanded the scope of refunds to a wider range of industries

In the past, only certain enterprises and industries in China were allowed to obtain a refund on the input tax recoverable balance. The deepening of the VAT reform in 2018 has expanded the scope of refunds to a wider range of industries, and the scale of VAT refunds exceeded RMB 100 billion. China has been proactive and prudent in exploring new measures to improve the VAT refund mechanism. Guided by the principle of neutrality, China has continuously enhanced the robust implementation of the VAT system, and demonstrated a strong commitment to developing a scientific, modernised and internationally aligned VAT system.

Since the formal rollout of deepening the VAT reform in China on May 1 2018, relevant policies have been carried out smoothly with positive feedback from the society. The reform not only achieved the objective of enhancing the tax system, but also had a spillover effect that resulted in a reduction of the overall tax burden for taxpayers and consumers.

As estimated, the three VAT reform measures mentioned above have reduced the tax burden of the largest companies by RMB 400 billion in one year, and more than a third of the total tax reduction benefited the manufacturing sector. The effective reduction of the tax burden has significantly reduced the pressure on cash capital, encouraged investment in fixed assets and expansion of production facilities, and boosted confidence in future development. This has given momentum to the developing Chinese economy, propelling its transformation and upgrading its manufacturing sector. At the same time, these measures have contributed to the sustainable growth of the global economy.

The downward adjustment of VAT rates not only reduced the VAT payable by corporate suppliers and improved their cash flow, but also, to a certain extent, benefited end consumers directly via the lowering of product prices. On the day when the VAT rates were adjusted, some renowned international enterprises such as Apple, Mercedes-Benz, Jaguar, Land Rover and Lincoln reacted promptly and lowered their retail prices in China. In return, the increase in consumption further stimulated market demand and facilitated the expansion of the market, resulting in a healthy business cycle and a win-win situation among suppliers and consumers.

The simplification and unification of VAT policies for SMEs has enabled them to choose between the general taxation method and the simplified taxation method based on their own business situation, achieving the goal of "one reduction, two simplifications" which refers to the reduction of tax burden, and the corresponding simplification of financial accounting and tax filing process.

The benefits brought by the reform do reduce the tax burden of SMEs, improve the business environment, boost the confidence of SMEs in business development, help create employment and enhance market prosperity.

Going forward, China will further reinforce international tax co-operation while respecting and learning from the OECD VAT system framework and principles. With the aim of fostering sustainable and healthy economic development, China will continue its endeavors to deepen the VAT reform and to be dedicated to the establishment of a modernised VAT system.