China’s VAT Reform

Value Added Tax (VAT) is the most prevalent type of consumption tax in the world. The tax is assessed on the sales or purchase price of merchandise or services. Most countries in the world have adopted VAT and apply VAT to both goods and services. In fact, some countries use the name goods and services tax instead of VAT, for example, Singapore and Canada. However, in China, goods tax and services tax can be two different taxes. The tax on goods is VAT. Prior to 2012, except for processing, repair and replacement, services were subject to the Business Tax (BT), which is similar to sales tax. China launched a tax reform in 2012, with a goal to “synchronize” VAT and BT. The process is ongoing. As of today, the two taxes still co-exist, yet an increasing number of services have been transferred to the VAT regime. An explanation of VAT often calls upon a contrast to sales tax. Under both VAT and sales tax systems, the end consumer bears the tax burden, yet the mechanism of levying tax differs. VAT is imposed on each transaction along the chain of supply. The VAT payable by a business is the tax due on its sale of merchandise or service (output VAT) minus the tax it owes on the cost (input VAT). The recovery of the input VAT is called input tax credit. For example, under a VAT system, a retailer is accountable for input tax on its purchase of the goods from the manufacturer, and is obligated to collect output tax from consumers on its sale of the goods. The amount of tax that the retailer ends up remitting is the difference of the output tax and input tax. Sales tax, on the other hand, is a single-stage tax on the retail sale to the end consumer, while prior sales on the supply chain are often exempt from tax as sale for resale (e.g., sale of raw materials to a manufacturer as well as the manufacturer’s sale of the finished product to the retailer). The input tax credit does not exist for sales tax. Business Tax in China is similar to sales tax in that it is not creditable. A service business pays VAT on its purchase of supplies. However, the business cannot claim input tax credit for the VAT paid, because its provision of services is subject to BT instead of VAT. In other words, the VAT that a service business has paid for its purchases of supplies is rolled over to the cost of providing its service, which is then taxed under BT, hence an effective “tax on tax”. Not only are they two different types of taxes, the VAT and BT also have disparaging rates and administrations. The general rate for VAT is 17%, while the general rate for BT is 5%. Each taxing locality in China has two tax bureaus: the State Administration of Tax (SAT) administers VAT, and the local tax authorities administer BT. The VAT revenue largely belongs to the central/federal government, while the local governments retain the business tax revenue. One result of the co-existence of VAT and BT is that a service provider separately accounts for its VAT payable on its purchase of supplies and BT to be collected on its sales of services. China implemented a pilot VAT program first in Shanghai on January 1, 2012, intending to end the co-existence of two tax systems in the area of consumption. Under the pilot VAT program, two categories of services were moved from BT to VAT, with two new VAT rates added: transportation services, taxed at 11%, and some modern services, taxed at 6%. The BT to VAT (B2V) reform effectively extended to other regions in China since its inception in Shanghai: Beijing (September 1, 2012); Jiangsu, Anhui (October 1, 2012); Fujian, Guangdong (November 1, 2012); Tianjin, Zhejiang, Hubei (December 1, 2012). On August 1, 2013, the reform became nationwide. The SAT central office issued a detailed guidance on the VAT on services, including scope, rates, exception, and administration. Taxware accordingly built into its tax automation system codes, rates, and tax rules matching the services now under VAT, which are: transportation services; research, development and technology services; information technology services; cultural creative services; logistic auxiliary services; leasing of tangible movable property; certification and consulting services; broadcasting, cinematic and television services. Except for transportation services (taxed at 11%) and leasing of tangible movable property (taxed at 17%, which is also the standard rate for sales of goods), all the other services are categorized as modern services (taxed at 6%). Export rule was clarified as well. Some distortion from the standard VAT export rule remains. The standard VAT rule on export is to tax it at zero percent (0-rating). A zero-rated supply is still a taxable supply; as a result, input tax credit is available. By contrast, input tax credit is not available for an exempt supply. For services now subject to VAT, only international transportation service and export of research, development and design services are zero-rated, while export of other modern services is exempt. The expansion of B2V reform on August 1, 2013 left people guessing on other major modern services. Near the end of the same year, the State Council meeting announced the inclusion of railroad services and postal services in the VAT regime, both subject to a rate of 11% and effective January 1, 2014. Shortly after the State Council announcement, the SAT central office released a comprehensive guidance, incorporating, expanding, and modifying the August guideline. A much applauded modification regards the international freight forwarding. The tax base for freight forwarders and agents that are registered in China as VAT general taxpayers now excludes freight charges paid to international carriers. The January 2014 expansion of VAT to cover more services is not the end of the reform. Some services still remain in the BT regime at this point, notably financial and insurances services, telecommunications services, and personal services such as haircut and restaurant services. The B2V reform is an ongoing process to streamline and simplify the taxation of goods and services in China. Taxware continues to track the reform and adjust its automated tax system accordingly.