In the first phase of the VAT pilot programme, which commenced in Shanghai on January 1 2012 before being progressively expanded nationwide, VAT has replaced BT for the transportation and "modern services sector". The modern services sector comprises consulting services, R&D and technical services, leasing of tangible movable property, cultural and creative services, IT services, radio, film and television services, and logistics and ancillary services.
The first phase of the VAT pilot programme has made considerable inroads in alleviating the tax burden on businesses in China:
- Manufacturers, wholesalers and retailers are now eligible to claim input VAT credits for the services they purchase;
- Businesses in the services sector are now eligible to claim input VAT credits for the fixed assets, goods and services they use in their business; and
- Exporters are eligible to zero rate or exempt the services they provide across borders.
While the first phase of the VAT pilot programme has been implemented relatively smoothly, international experience will show that the next phase, due to commence in 2014, will be far more challenging. In 2014, it is expected that VAT will replace BT in several critical sectors, including telecommunications, real estate and construction, financial services and insurance, and hospitality services. In this edition of China – Looking Ahead, we will take a look at how these forthcoming reforms are likely to affect these sectors. We will also examine some recent developments and what they portend for the future of indirect taxes in China.
Telecommunications and e-commerce
In recent consultations conducted by KPMG with China's Ministry of Finance (MoF) and the State Administration of Taxation (SAT), we understand that the telecommunications sector, dominated by the three State Owned Enterprises – China Mobile, China Telecom and China Unicom – will be subject to 11% VAT, in lieu of 3% BT, in the very near future. There is speculation that so-called value added telecommunications providers, such as data storage and processing operators, information services, internet access services and call centre operators, may be subject to 6% VAT.
These industries are likely to confront a range of issues including the potential for a range of mixed or composite supplies to contend with, including where handsets are bundled with usage agreements, or when digital content is bundled with telecommunications services. Both Chinese and international telecommunications providers will be closely following the VAT treatment of roaming charges, due to the growth of Chinese consumers travelling abroad and international visitors roaming while in China.
The centralisation by large telecommunications providers of their purchasing functions to obtain cost savings also pose challenges for regulators, with significant input VAT credit balances likely to accrue to those centralised procurement functions, while output VAT will typically be accounted for at the individual branch level.
In the e-commerce sector, recent technological developments have highlighted the need for the modernisation of the VAT system. The ability for ordinary consumers to purchase electronically supplied services from offshore providers through the internet has led to indirect tax revenue leakages around the world, and global reforms being led by the OECD.
In China, the gap between the VAT system and modern commerce is perhaps even more pronounced. Foreign companies cannot, as a general rule, even register for VAT purposes. The use of a VAT withholding system on imported services, rather than a reverse charge, coupled with China's currency controls, has resulted in real leakages of VAT revenue collection on both business-to-business (B2B) and business-to-consumer (B2C) transactions. The VAT reforms provide a strong platform to review these issues thoroughly and modernise the VAT collection system. With an increasingly tech-savvy population, hungry to experience the best the world has to offer, the time is ripe for reforms in this area. Put simply, the system needs to facilitate foreign businesses being able to both discharge their VAT liabilities in China efficiently, and access input credit relief on their inputs.
Real estate and construction
In recent consultations with the MoF, government officials have signalled an intention to apply 11% VAT to both real estate and construction services, in lieu of 5% BT and 3% BT, respectively.
While much of the focus is on the applicable VAT rate, a further question is the breadth of the tax base for real estate transactions. The BT system applies not only to commercial, retail and industrial property, but also to residential real estate transactions at all stages of the supply chain. That is, the sale and lease of both new and second-hand real estate, residential or commercial, by developers and the general public, attract BT.
Any new VAT system which narrows the scope of the tax when compared with the existing BT system would create a revenue gap. Furthermore, with the residential property market in China's biggest cities experiencing significant and sustained growth over the past decade, the temptation for the government to introduce VAT to rein in demand cannot be discounted. Potentially, China may be among the first countries in the world to apply VAT to all forms of real estate transactions, not only at the business level, but also by private individuals. The scale and complexity of doing so for a population of more than 1.3 billion cannot be underestimated.
A further challenge for policymakers is in managing the transition from BT to VAT. Whether to tax construction or real estate transactions under existing contracts, with the potential for effective retrospective pricing or profitability impacts on existing projects, and whether to tax property sales on a gross revenue or margin basis, remains of considerable interest. Additionally, many Chinese consumers have made substantial property gains in recent years and the question of whether the VAT will tax only active development profits and speculative investment, as opposed to merely passive gains, remains to be seen.
The impact of these reforms on existing business models used by developers and real estate funds is likely to be significant as well. For example, where property is developed for the purpose of leasing on a long-term basis, significant input VAT credits are likely to precede output VAT for a long period of time. These timing differences create a real long-term carrying cost. By contrast, pre-sales of properties by developers create the reverse problem – output VAT being generated before input VAT credits, which can create a permanent excess VAT credit balance on a project-by-project basis. The key point here is that the general policy of not allowing businesses to access refunds of excess VAT credits can transform transactions which would be relatively straightforward in other countries, into substantial VAT burdens in China.
Finally, the existing tax system in China already imposes a raft of different taxes on real estate transactions, including corporate income tax, land appreciation tax, stamp duty, deed tax and city level taxes, and raises the question of the need for wholesale reform of property taxes. One doubts whether that will be forthcoming any time soon. The prospect of having a VAT and a land appreciation tax, both of which tax the value added is very real. The question of whether the liability to one form of tax is deductible under another will be watched with considerable interest.
In 2011, the combined real estate and construction sectors raised 51% of all BT revenue, highlighting the fact that this single sector of the economy poses the most significant risks and opportunities in implementation of the VAT reforms. As a recent OECD report highlighted:
Levying VAT on newly constructed immovable property instead of BT may also have an effect on house prices. This type of tax reform would therefore have to be planned and evaluated carefully and should be part of a broader property tax reform. The timing of such a type of reform seems crucial.
Financial services and insurance
It is expected that the financial services and insurance sectors will be among the last industries to move to VAT, possibly in the second half of 2014. Those sectors are subject to 5% BT, though with some transactions subject to BT on a gross revenue basis, some on a net basis and others exempt.
The most critical issue will be the approach to taxing interest income under a VAT given that it is clearly the largest revenue source for Chinese banks. While practically all countries exempt interest from a VAT, China may be among the first to tax it. The reason lies in the fact that interest income, except for inter-bank lending between approved providers, is subject to BT. Given that historically at least, interest margins have been heavily regulated in China, the theory is that the margin incorporates an allowance for indirect taxes. However, with interest margins gradually being deregulated, it is not clear that this implicit assumption will hold true into the future.
It is expected the VAT reforms will result in interest income being subject to VAT. That is, the banks will have an obligation to remit VAT at a rate which is yet to be determined, in relation to their interest income. Both the banks and business borrowers will be eligible to claim input VAT credits for their expenses in relation to these transactions. The tax base for the banks may be the margin they derive, which may be achieved by exempting from VAT and granting a deemed input VAT credit for interbank lending. The systems changes required to achieve this outcome will pose massive challenges to the banking sector.
While this approach may be appropriate in an environment of regulated interest rates, and necessary to protect government revenues, it may not be internationally competitive. If Shanghai is to become a global financial centre, it will be competing with markets in New York, London and Hong Kong, none of which tax interest income under a VAT (or equivalent indirect tax). So the question remains as to whether this approach, which may be necessary to apply domestically, would also apply to cross-border loans, which could hamper the efforts of the Chinese banks competing on a global stage.
This example highlights one of the challenges for the policy makers in implementing the VAT reforms in China – it is such a vast economy, undergoing one of the most substantial changes in modern history. Reforms implemented today can very quickly become redundant, or at least ill-directed tomorrow.
The Chinese insurance sector is a further example of this. At present, the insurance market is, by the standards of fully developed economies, relatively unsophisticated. Insurance penetration of the market in China is 3.8% (being premium income as a percentage of GDP), which remains low compared to the global average, which is more than 7%.
In recent consultations with KPMG, the MoF and the China Insurance Regulatory Commission (CIRC) have indicated an intention to apply VAT to the general insurance sector, based on the VAT models used in countries such as New Zealand and South Africa, and for life insurance to be exempt from VAT, which is consistent with international norms.
If implemented in this way, the introduction of a VAT model for general insurance which taxes the difference between premium income and claims paid, would radically alter the compliance obligations of insurers in China. Both Chinese and foreign insurers will need to implement changes to their systems, claims management processes, contracting and pricing. With most policies of 12 months or more duration, the effective timeframe for implementation is likely to be very short.
One sector which has received comparatively little attention to date in the VAT reform process is hospitality. Taxpayers in this industry pay BT at the rate of 5% in the category of "other services".
The introduction of VAT for hospitality services, in particular, hotels, is likely to have a significant impact. Again, questions of mixed and composite supplies will arise given the proliferation of multiple VAT rates in China. For example, hotel accommodation may be taxed at one rate, while conference or event facilities may be taxed at a different one. Takeaway food and beverages may be subject to VAT at a 17% rate, while the same food and beverages sold in restaurants where services are provided may be subject to VAT at a different rate. When combined, a single conference may attract VAT at different rates for the accommodation component, the event facilities and the food and beverages served to guests. Price shifting and complexity for hotels will undoubtedly arise.
For businesses, a critical question will be the extent to which they can claim input VAT credits for the use of conference and event facilities, and for employee business travel accommodation. The idea of a full VAT credit being available should not be regarded as automatically assured given that domestic air travel costs are already not creditable for VAT purposes.
Finally, reward schemes commonly used in the hospitality sector may be subject to new indirect tax imposts. At present, the BT system does not have a deemed sales rule which applies market values to gifts and similar giveaways. However, the existing VAT rules do apply such market value concepts, potentially resulting in real VAT liabilities for the operators of these reward schemes. Experiences in the EU with reward schemes highlights the potential for challenging VAT issues to arise.
Early warning signs
Theoretically, the introduction of a VAT in place of BT should alleviate the tax burden on business. That is because BT is a tax on business and is reflected in the profit and loss of the business. By contrast, VAT is a tax which is collected by business but is ultimately imposed in an economic sense on the end-consumer. It is a balance sheet item.
Logically therefore, the replacement of BT with a VAT should have facilitated the passing on of the VAT impost to consumers in the form of price changes. However, that outcome has, by and large, not eventuated in China. Several factors have contributed to the introduction of VAT being viewed through a somewhat different lens by businesses there:
- Unlike many other countries, the VAT system in China uses multiple VAT rates – 3% for small scale taxpayers, 6% for the modern services industry, 11% for the transportation sector, 13% for certain food items, and 17% as the general VAT rate applicable to the sale and importation of goods, and leasing of tangible movable property. The use of multiple VAT rates leads to competitive neutrality issues under which economically equivalent services may be taxed at different VAT rates. The consumption of goods and services by businesses likewise leads to different levels of input VAT credits which impact on the overall net VAT burden of businesses.
- In China, VAT registration occurs at the branch level rather than at the legal entity level. Furthermore, the inability to secure refunds of excess input VAT credits (except in relation to certain exports), means that timing and mismatching issues can create real and permanent liabilities.
- The staged rollout of the VAT reforms has, until recently, led to VAT being imposed on services provided in some cities, and BT in others. Correspondingly, it has led to some inputs being subject to VAT and others remaining subject to BT. The overall VAT liability of a business may be impacted by the mix of its inputs, and the location of its suppliers.
One hopes that once VAT applies to all industries and in all cities throughout mainland China, the VAT system will start to reflect more of its economic foundations as a consumption tax collected by, but not economically imposed on, businesses.
An early warning sign came about in August 2013 with the replacement and consolidation of a series of VAT pilot programme rules into a single circular, Caishui  37. In that circular, the previous net basis approach to accounting for VAT was abolished, causing unintended and detrimental consequences to parts of the transport and logistics sector; and the abolition of various concessions for the asset leasing sector, resulting in an increased tax burden, which has caused many to rethink their business models. This has raised the prospect that the light touch regulatory approach to the implementation of the VAT reforms may soon be at an end.
Due to the relatively short timeframes for implementation, many businesses made hasty decisions at the time of the introduction of the VAT pilot programme. Those decisions should now be revisited as the programme matures and a more thorough and risk managed review of compliance is undertaken by the tax authorities.
A ray of light
Just as there may be early warning signs on the horizon, there is an equal measure of hope and opportunity. For example, in 2013 the government introduced VAT consolidation rules which broadly allow input VAT credit balances of certain branches to be offset against output VAT liabilities of other branches. While those rules are limited to consolidation of VAT returns at the branch level only (that is, they do not allow consolidation between parent and subsidiary), it is a step in the right direction. At this stage, the implementation rules which give practical effect to consolidation are limited to airlines, but the framework for their application across all industries is now in place. It is hoped that they will be implemented more broadly in 2014 and beyond.
A further significant development was the release in 2013 of SAT Announcements 47 and 52, which contain the implementation rules for zero rating and exempting exported services respectively. The release of these implementation rules pave the way for many cross-border services benefiting from concessional VAT treatment which was not previously available under the previous BT regime.
One of the relatively unique, and at times challenging, aspects of the indirect tax system in China is the so-called Golden Tax System. This is the regulated invoicing system under which businesses must use hardware approved by the government to issue special and general VAT invoices. The hardware contains IC cards which ensure that every invoice issued through the system transmits data to the tax authorities used to reconcile with the VAT return submitted by the business. Those special VAT invoices, when issued, must then be validated by the recipient business if it is to be used for the purposes of claiming input VAT credits.
The strict controls over invoicing in China are intended as a key measure to reduce fraud. Concepts of carousel or missing trader fraud which have posed threats to the VAT systems used in many other places around the world, especially in the EU, are notably absent in China.
The flipside of the Chinese system is that the rigidity of the Golden Tax System can create challenges for businesses, especially multinational companies. Software to link transactions through the Golden Tax System with a business' own enterprise resource planning (ERP) systems are needed; centralisation of tax and finance functions among the different branches of a business throughout mainland China can be difficult; and electronic invoicing remains in an embryonic state. The extent to which multinational companies seeking to centralise their indirect tax functions either globally, or regionally, are often tempered by the need for specific solutions for China. The Golden Tax System is the oft cited reason for those differences.
The key question which remains is whether proposed future enhancements to the Golden Tax System will respond to the growing modernisation and centralisation of efficient indirect tax functions occurring on a global scale. The increased use of tax engines or tax determination software, centralised compliance solutions and data analytics are all recent trends adopted internationally to manage the sheer volume and complexity of indirect taxes. Each of these solutions is designed to maximise compliance and mitigate the risk of errors, yet their implementation and widespread usage in China remain some distance away. These solutions are not a threat to the Golden Tax System, rather, they apply different techniques and approaches, all striving to achieve enhanced compliance. As future refinements to the Golden Tax System are made, e-invoicing becomes more widespread and software developers refine their solutions for China, greater alignment or a co-existence between these systems and the Golden Tax System must surely be on the horizon. The time is near when different indirect tax technology and compliance solutions for China will no longer be necessary.
If 2013 may be regarded as a year of change as the first phase of the VAT reforms were implemented nationwide, 2014 has the potential to significantly surpass it in terms of the sheer magnitude of the reform process being implemented.
Seconded Tax Partner
Lachlan Wolfers is the leader of KPMG's centre of excellence for indirect taxes in China. Before that, he was the leader of KPMG's indirect taxes and tax controversy practices in Australia. He is a member of the network's global leadership team for indirect taxes, and its regional leader for indirect taxes.
Lachlan is regularly invited to advise the Ministry of Finance and the State Administration of Taxation in relation to the VAT reform programme, as well as other tax reform initiatives such as the introduction of a system of advance rulings.
He holds a masters of taxation with first class honours, as well as combined economics and law degrees, also with honours, all from the University of Sydney.
Lachlan has also co-written the leading textbook on capital gains tax in Australia, as well as writing chapters for textbooks on income tax and GST. He is a regular presenter and media commentator on tax issues, both in China and previously in Australia.
John Wang was previously a tax official in the Chongqing Municipality State Tax Bureau, with more than seven years of tax audit and administration experience.
John joined KPMG China after completing his MBA courses in the UK in 2004.
In his career as a tax consultant at KPMG, John has deployed the knowledge and skills acquired from both his work at the tax authority and his MBA studies in providing advisory services to multinational clients and domestic clients in a wide variety of industries. He has been actively involved in helping companies prepare for the continuing PRC VAT reform.
Tax Senior Manager
Shirley Shen started her career with professional accounting firms in Australia in 2004 and has experience working across various disciplines including tax and accounting. Before joining KPMG China in 2007, she worked in the tax department of another big-four firm for two years. Shirley has strong experience in the energy and natural resources industry. She provides tax health check, tax provision review, tax due diligence, structuring and planning advice to major multinational and domestic clients.
She is actively involved in the VAT reform in China by assisting the Legislative Affairs Office of Budgetary Affairs Commission of the National People's Congress and the Ministry of Finance since 2008.
Shirley is a key member of KPMG's indirect tax centre of excellence and has been involved in many VAT reform projects for multinational companies and state-owned enterprises. She is a noted speaker on VAT issues and has presented numerous seminars for various professional associations, industry groups and clients on the VAT reforms in China.