Transportation and logistics – challenges of VAT reform
China’s unification plan for indirect taxes will see the dual business tax (BT) and value added tax (VAT) regime gradually replaced by a single VAT system. Many businesses in the transportation and logistics industry are still wrestling with the uncertainties and local variations created by the reform, so far introduced on a pilot basis. Jennifer Weng, Tracy Zhang and Bin Yang of KPMG China provide advice on how these issues may be resolved.
Before the full unification, VAT is levied on sales of tangible goods and repair services in China, and BT applies to sales of immovable assets, transfer of intangible assets and provision of other services in China. Considering the complexity that would arise from the overnight revocation of the widely-applied BT system, the unification is taking a phase-by-phase approach with the first pilot programme rolled out in Shanghai on January 1 2012. Under the pilot programme, the VAT rates for transportation services and ancillary logistics services are 11% and 6% respectively. The term "ancillary logistics services" is a broadly-defined concept, which basically covers almost all non-transportation business such as freight forwarding, shipping agency, warehousing and customs clearance.
More provinces and cities including Beijing, Jiangsu, Anhui, Fujian (including Xiamen), Guangdong (including Shenzhen), Tianjin, Zhejiang (including Ningbo) and Hubei, were included in the pilot programme in 2012 with effective dates that fall from September 1 to December 1 2012.
As anticipated, the VAT reform pilot programme was implemented nationwide in China from August 1 2013 by Circular Caishui  No 37 (Circular 37). Some more service sectors (that is, the film and media sectors) have also been included in the covered industries. Equally, companies carrying transportation and logistics business will be subject to VAT starting from that date, including foreign enterprises, which provide such services to customers in China.
Yes, a welcome reform, but …
The above geographic and scope expansion, after less than two years of the pilot programme in Shanghai and other provinces, may imply that the government has been satisfied with the experiment in these selected locations. No doubt, in due course the unification will simplify tax code – one set of regulations instead of two, and rationalise tax administration –VAT and BT collection are handled by the state tax bureau and the local tax bureau respectively. More importantly, as BT does not carry input credit like VAT, it creates a tax cascading effect that disadvantages business-to-business transactions, creating tax leakage on acquisition of services and discouraging businesses from outsourcing some of their functions. The replacement of BT with VAT should generally eliminate such cascading effect.
The VAT pilot programme also prescribes special VAT treatments for exported services. Until the programme started, special VAT treatments were only available to the exports of tangible moveable goods. Generally, a zero rating is now available to international transportation services provided by domestic companies that have the relevant licences. With a zero rating, the service provider will not be required to charge output VAT and it can apply for a refund of input VAT incurred on its purchases. On the other hand, for international transportation services provided by companies without the relevant licence, or other logistics companies, a VAT exemption will be available. With a VAT exemption, the service provider will not be required to charge output VAT but will not able to obtain any refund or credit on the input VAT incurred on purchases either.
However, in reality, the responses of the companies in the transportation and logistics industry have been rather mixed. Certain taxpayers, including some transportation companies, shipping agents and freight forwarders, are concerned that the new VAT regime may even increase their tax costs. To understand the issues facing these taxpayers, it is necessary to understand how the rules used to work under the old BT regime.
Before the reform
For BT purposes, the applicable tax rates and basis would be dependent on the business category of the taxpayer. Specifically:
For "transportation business", that is, sea, air, road or railway (railway transportation services and courier and express services under "postal services" are not included in the VAT reform at present), the applicable BT rate is 3% on gross revenue. For joint transportation activities, the main contractor is allowed to deduct transportation costs paid to a sub-contractor from gross revenue in calculating the amount subject to BT. A PRC company providing international transportation services (that is, moving cargo or passengers cross-border or outside China) is also exempt from BT
For courier and express service providers, the taxpayer may be assessed as providing either postal services or transportation services. The BT rate is also 3%
For "agency services", which include shipping agency, freight forwarding, customs agency and other logistics services with an agent role, the BT rate is 5% on the actual agency fees received from the consignor. That is, BT should be levied on a net basis with gross receipts less allowable deductions. In practice, it is generally accepted that external costs paid to third-party service providers (either onshore or offshore) can be deducted, such as:
Freight costs paid to carriers (for example, air and sea)
Miscellaneous charges incurred in the transportation (for example, handling charges and harbour fees)
Sub-contracting costs paid to other freight forwarders.
For other services in transportation and logistics industries (such as warehousing services, port services), the BT rate is 5% on a gross basis except for some circumstances under which an effective net basis may be applied.
The effect of these rules on transportation and logistics companies are:
For eligible companies, although an input credit system as in VAT is not available, the net-basis BT treatment has effectively allowed BT to be calculated on value add only. Companies that fall within this category include those providing agency services which are allowed to exclude third-party costs and reimbursed expenses in calculating the amounts subject to BT.
For companies engaging in transportation services and postal services, a more favourable BT rate of 3% as compared with 5% will apply. A transportation company can also deduct subcontracted transportation costs (not including other third-party costs).
In other words, to some extent, the cascading effect that would otherwise exist under a BT regime has already been eliminated under the net-basis BT method. Moreover, the applicable BT rate of either 3% (for transportation services) or 5% (for other services) is more favourable than the corresponding rates of 11% and 6% under the VAT reform. (Of course, if the customer of the transportation or logistics services is generally a VAT payer, the higher rate VAT would be creditable whereas the lower rate BT would form part of its tax costs.)
Transportation industry – winners and losers
Because of the differences between the VAT rules and BT rules, there are winners and losers under the pilot programme. The impact of the programme does not only depend on the type of company a business is but also the type of services (for example, domestic or international) it is involved in.
For domestic companies involved in international transportation businesses, the pilot programme will bring benefits in many cases as they are potentially eligible for zero-rated VAT or exemption from VAT. To start with, they will not have to charge output VAT as compared with 3% BT. Secondly, for those which can enjoy zero rating, a refund of the input VAT will be available which would not be possible under the BT system.
However, for a domestic company involved in domestic transportation businesses, the result can be mixed. If and to the extent that the domestic company can pass on the output VAT to the customers, the VAT pilot programme can be beneficial since the company can obtain credit on input VAT on its purchases which it would be unable to under the BT pilot programme. And if its customers can get full credit on VAT charged by the company, the company may be able to negotiate for a higher fee to share the tax cost savings with the customers. However, here is the rub, some customers, for example, individuals or small businesses or those which have not come under the VAT pilot programme or are still unable to get credit on the VAT charged by the company. In those cases, there might be resistance from the customers to pass on the VAT in full because under the BT system, they would only have to bear 3% BT.
On the other hand, the domestic transportation company may not be to claim credit on input VAT incurred on its purchases in full because the VAT special invoices are generally not available, for example, those for fuel costs charged to individual drivers by gas stations and road tolls collected by the authorities. And a large portion of costs of transportation companies are staff costs, which do not carry input VAT credit. There is also no grandfathering relief for input VAT on fixed assets that were acquired before the VAT pilot programme began. This shortfall can create an unlevel playing field for businesses which are at different phases of investment.
For foreign transportation companies, the benefit of input VAT credit will not be available. They will not be able to enjoy zero rating or VAT exemption even for international transportation services, either. In other words, they will have to charge VAT at 11% even for international transportation services provided to customers in China. For carriers that operate through an agent in China, the agent will be obligated to withhold the VAT. In these circumstances, however, if the relevant tax treaties or international transportation treaties are available, the foreign transportation companies may avail themselves of an exemption from VAT on top of one from corporate income tax.
We understand that the central government and local governments in various cities has received feedback about these concerns via different channels. Some businesses and groups have expressed a wish for lower VAT rates and the alignment of tax calculation basis between domestic transportation companies and foreign transportation companies. Some local governments have agreed to provide financial subsidies to mitigate additional tax burdens during the transition periods. However, no measures that will provide more sustainable solutions for these issues have been issued.
Logistics industry – no more net basis
Many sectors in the logistics industry, principally shipping agents and freight forwarders, fall within the category of auxiliary logistics services and are subject to 6% under the VAT pilot programme as opposed to 5% under the BT system. Assuming that the service providers' customers can claim full credit on the VAT charged by the service providers and the service providers themselves can claim full credit for VAT on their own purchases, the reform should be beneficial to both parties.
Confusion and uncertainty have arisen however because during the transition period, that is, before August 1 2013, while only Shanghai and the other nine cities were covered by the VAT pilot programme, the rules allowed companies, such as logistics companies, that used to account for BT on a net basis to continue to apply a net basis under the VAT pilot programme. In practice, during the transitional period, the net basis would be applied as follows:
The service provider would still charge output VAT on its gross revenue without any deduction and issue VAT invoices based on the gross revenue as well.
The service provider would claim credit on input VAT on costs which had been subject to VAT and were supported by special VAT invoices (including previously BT-deductible items and some BT non-deductible items such as general consulting fees)
The service provider would also claim credit on deemed input VAT on costs that used to be deductible under the BT system but were not supported by VAT invoices, using this formula:
Input VAT = Deductible costs / (1+6%) × 6%
In other words, the concept of deeming input VAT credits is merely a mechanism designed to achieve a result so piloted taxpayers would pay VAT on a basis similar to what they would under the BT system in the past.
The deemed input VAT so claimed by freight forwarding companies and shipping agency companies would include:
domestic expenses paid to external vendors which were still paying BT, such as transportation costs to sub-contractors outside of piloted locations;
overseas expenses paid to foreign entities which could not issue VAT invoices, such as sub-forwarding fees to overseas affiliates and overseas handling charges; and
air and sea freight charges from overseas carriers, many of whom were exempted from PRC indirect taxes under treaty protection.
The rationale for such grandfathering rules at that time might be that, at the point, logistics companies in other regions of China would still be applying a net basis under the BT system, which could create a disadvantage with those covered by the VAT pilot programme. This could explain why since August 1 2013, when the VAT pilot programme started to be applied nationwide, the net basis has no longer been available.
As it can be imagined, freight forwarders and shipping agents have not welcomed these changes with open arms. Before August 1, many found the 1% increase in tax rate bearable due to the net basis on top of the potential availability of input VAT credit on future investments such as equipment. Officials from SAT and the Ministry of Finance have recently confirmed that the net basis would not continue. Some officials also felt that such a method would create a mismatch between output and input, that is, the service recipients are entitled to claim input VAT on gross payments while the service providers only account for output VAT on the net basis, thus breaking the credit chain and leading to tax losses for the government. Therefore, logistics service providers will suffer a heavier tax burden than before if they cannot pass on the VAT in full to their customers.
As the transportation and logistics industries are connected to the whole economy, the way these industries are taxed can have far-reaching knock-on effects. It is understandable that the central and local governments take seriously the feedback of the businesses in these industries about their concerns with the VAT reform, many of which might not have been foreseen by the authorities. We are aware that dialogue is going on at different levels with a view to developing workable solutions to the issues raised by the key industrial players, both domestic and foreign service providers.
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Jennifer Weng specialises in providing PRC tax advisory services to clients in the real estate and logistics industries.
Jennifer assists multinational clients to formulate entry and exit strategies in relation to their PRC investments. She regularly undertakes due diligence work and restructuring projects, and frequently assists foreign multinationals in discussing tax policy matters with the PRC tax authorities.
Jennifer was seconded to the international corporate tax group of the KPMG New York office for a year to assist US companies focusing on various international tax projects.
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Tracy Zhang joined KPMG China's Beijing office in 1996. In 2006, she was seconded to the Qingdao office and was the head of the local tax practice. From April 2007 until July 2008, she worked with both the international corporate tax practice in KPMG New York as well as the financial services practice in KPMG London, respectively.
Tracy is a PRC regulatory and tax specialist on China investment related issues. Since 2004, she has been functioning as one of the leaders of the financial services tax team in KPMG Beijing, looking after domestic and foreign financial services, logistics, and real estate clients. She has also been involved in developing structures for foreign investments into China; tax due diligence reviews in connection with M&A transactions; and advising on cross-border transactions.
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Bin Yang worked with the Guangdong government and a multinational foreign investment company for 14 years before he joined KPMG. When working with the government, he was responsible for regulations consultation and project management regarding foreign investment to China.
Since joining KPMG in 2006, Bin has been mainly responsible for regulatory and company structuring advisory and implementation.
Bin is knowledgeable in business laws and regulations, and has good understanding of enterprise investment practice; he is also familiar with the business environment in China. He has plenty of experience in enterprise set-up, advisory and implementation of corporate restructuring. He has successfully assisted many multinationals as well as medium and small companies from the manufacturing, trading, property and service industries to enter the China market and improve company structures.
Bin also has an in-depth knowledge of R&D incentives in China and he has been actively assisting multinational companies as well as China domestic enterprises is R&D planning, R&D incentive application and R&D audits.