New vat rules to spur cross-border transactions for multinational firms

This year the Chinese government has embarked on one of the most ambitious tax reform programs in recent history. The reforms initially consist of introducing a pilot program in Shanghai in which business tax (BT) is replaced with a value-added tax (VAT) for the transport, asset leasing and modern services sectors. The initial program is the first step, in an overall plan, of replacing BT with VAT across the whole services sector in the Chinese mainland.

These changes are taking place because BT is an inefficient turnover tax that taxes business. That is, in effect it taxes each stage of a supply chain, irrespective of the profit or "value added" by each business in that supply chain. By contrast, VAT is a tax that is collected by business, but in effect is borne only by the end consumer.

More than 150 countries now have a VAT. The VAT (relative to other taxes) is a more stable form of revenue in times of economic turbulence, it is relatively inexpensive to collect, and because it is embedded in the price of goods and services sold to consumers, they more readily accept it.

The adoption of a VAT in China is also more suitable for a modern economy; is more conducive to achieving the government's goals under the 12th Five-Year Plan (2011-15) of growing the services sector; and reflects a desire to adopt world's best practice in China's tax system and administration. Indeed, the tax authorities in Shanghai have done a remarkable job working with businesses to implement the changes in a short time.

The scope of the current pilot program is very broad and captures most parts of the services sector, with the exception of financial and insurance services, real estate, construction, entertainment and post and telecommunications. These remaining services are likely to be brought within the scope of the VAT changes later.

It is expected that the changes will be expanded to Beijing shortly, and other cities and provinces throughout the next year or so. Such has been the success of the Shanghai pilot program that it has created a ripple effect, with another 10 cities and provinces applying to join the pilot program.

The Shanghai pilot program introduces two new VAT rates, 6 percent for modern services and 11 percent for the transport sector, to accompany the existing VAT rates of 13 percent applicable to foodstuffs and some other items, and 17 percent for sales of most goods. By international standards, China's VAT rates still remain relatively low.

By changing the two main forms of indirect tax in China, BT and VAT, into a single system it results in significant benefits for all sectors of the economy. For example, for the first time businesses in China's dominant manufacturing sector can now claim input VAT credits for the services they acquire. Furthermore, businesses in the services sector that now pay VAT can claim input VAT credits for the goods, fixed assets, and services they acquire in their business.

Not surprisingly, praise for the VAT changes come largely from business, whose tax burden has generally fallen as a result of the changes, providing a welcome relief during these turbulent economic times.

Large multinational companies have also welcomed the move away from BT to VAT, given that they are generally more familiar with VAT. China's VAT system operates in a similar way to Europe's VAT system, albeit with uniquely Chinese characteristics such as the "Golden Tax System". This is essentially the invoicing system that links transactions entered into by businesses, with invoices and data that is automatically provided electronically to the tax authorities.

Another major benefit for multinational companies is that the new VAT rules contain more favorable measures for cross border transactions compared with the old BT regime. This potentially benefits multinational corporations seeking to provide services to, or from, their overseas head office. Potentially, services can now be provided to, or from China, with no real VAT leakage. This is a significant improvement on the previous BT system where there was ordinarily a 5 percent tax cost for any export or import of services.

Implementing such a big change inevitably causes some challenges. For example, much of the complexity under the pilot program arises because VAT applies to the services sector in Shanghai, whereas BT still applies elsewhere throughout the country. This can create competitive market distortions. Moreover, in sectors such as transport, logistics and asset leasing, some taxpayers have had their tax burden increase. However, the benefit of conducting a pilot program is that it allows the tax authorities to monitor the impact and make changes to ensure the system becomes more workable.

This highlights a key point about these reforms: once they have spread right across China, the VAT system will become much simpler to operate, particularly for large multinational groups. At present, China's indirect tax system requires VAT and BT to be accounted for at the branch level, meaning that each branch of a company that concludes its own contracts must pay VAT (to the State tax bureau) and/or BT (to the local tax bureau). Ultimately, the VAT reforms will reduce indirect tax compliance costs for businesses by having to only file one VAT return for each operating branch, with only one tax authority. As such, many businesses are seeking a more aggressive reform timeline. In due course, further reductions in compliance costs may be achieved by allowing for the consolidation of VAT returns at the legal entity or even corporate group level.

Another key point is that these changes do not simply represent a tax change; rather, they have impacts right across a business. Personnel from sales, procurement, marketing, legal, IT and finance functions are all affected by the changes. Many large companies have formed project teams to implement the changes, helped by external advice from KPMG.

Our advice to companies is that they need to prepare early. For example, if they enter into contracts now that potentially extend beyond when VAT commences in that location, they need to ensure they can recover VAT. Otherwise, it can affect the bottom line profitability of the business. Likewise, they need to take into account these changes when negotiating with suppliers, to ensure they can get the benefit of cost savings arising from the changes in the form of reduced prices.

We would also strongly recommend that taxpayers consider conducting a post-implementation health check. The sheer size and scale of these changes, the inclusion of new VAT rates for different types of services and the inevitable practical IT issues involved in switching over from BT to VAT mean that there is a higher likelihood of errors being made. Small errors in VAT have a tendency to produce large problems if they are not corrected quickly, because of the repetition of transactions.

Overall, the VAT pilot program represents a giant step forward in the modernization and development of indirect taxes in China, with the reform process set to continue over the next few years.

The authors are partners, KPMG China. The views do not necessarily reflect those of China Daily.

(China Daily 06/15/2012 page9)