China has both business tax (BT) and value-added tax (VAT) applicable to businesses of the service industries which has long been labelled as ‘over-burdensome’ for business operators as it creates a double taxation and unfairness. The matter has been on the agenda of policymakers for many years and things finally started to move forward in October 2011 when the State Council of China publicised a decision to launch the BT-VAT transformation pilot program in Shanghai which marks a landmark step towards a nationwide reform of the VAT system. In Nov 2011, China’s Ministry of Finance (MOF) and the State Administration of Taxation (SAT) jointly issued the Notice for the Introduction of the Pilot Scheme to Convert Business Tax to VAT (Caishui [2011] No.110) (Circular 110) and Notice for Converting from Business Tax to VAT in the Transportation Industry and Certain Modern Service Sectors in Shanghai (Caishui [2011] No.111) (Circular 111) (collectively ’Implementation Measures’) to provide detailed implementation rules for the program. 

 

The pilot program will initially apply to the transportation and modern service industries in Shanghai with the intention of rolling it out nationwide when circumstances warrant it. The VAT reform is expected to eventually extend to all other service sectors as well. On 25 July, 2012, the State Council announced that the VAT reform pilot program will be extended to ten more localities including Tianjin in batches from 1 August, 2012, till the year-end. It is also reported that the pilot program will be further expanded in 2013 to more regions and eventually nationwide for selected industries.
 

On 1 January, 2012, the VAT reform was officially implemented in Shanghai. The pilot program in Shanghai aims to consolidate the overlapping VAT and BT, simplify the tax system and reclassify many services currently liable to BT as, instead, taxable under the VAT regime.

 

The Implementation Measures provide the scope of the pilot program and VAT rates applicable to the transportation industry and certain modern service industries (’Pilot Industries’). These include services for road transportation, water transportation, air transportation, pipeline transportation, as well as services in R & D and technology, IT, culture, auxiliary logistics, certification and consulting and tangible moveable property leasing etc. Enterprises under the pilot program in Shanghai are able to pay VAT instead of BT. It means that output VAT for such enterprises will be calculated on the basis of their service income and applicable VAT rates with the input VAT being credible. The net balance of output and input VAT will be the payable VAT. 

 

Among the taxpayers in China, they are roughly classified into two categories, i.e. the general taxpayer and small-scale taxpayer. The VAT rate for small-scale taxpayers can be as low as 3%; whereas general taxpayer is subject to 17% (or 13% for the import of certain goods). However, for business which have a substantial annual turnover, the general taxpayer status could be beneficial despite the much higher VAT rate because such status offers cost-effective flexibilities to reduce its overall tax burdens. The general taxpayer may deduct the input VAT from output VAT which is not available to small-scale taxpayers. It also helps to enhance a company’s credibility and demonstrate its economic strength since such status allows its clients to issue VAT invoices. 

 

In order to be recognised as a general taxpayer for manufacturing enterprises, it must have an annual taxable turnover of more than CNY 500,000. Other types of enterprises (with at least 50% of income from wholesale or retail of goods) require an annual taxable turnover of more than CNY 800,000.

 

Companies which engage in both Pilot Industries and Non-Pilot Industries still have to pay BT but it has to be accounted for separately from VAT services. When the companies fail to comply in this regard, the tax authority has the power to determine the respective turnover of taxable services. The Implementation Measures also address the scenarios where a company provides VAT applicable services that are subject to different rates and where a company engages in both VAT-able and VAT-exempt services.

 

Services provided to recipients in Shanghai by foreign service providers are subject to VAT rather than BT. Such service recipients who qualify as ‘pilot enterprises’ may claim input VAT credit for the VAT paid. In addition, under the Implementation Measures, such service recipients are required to act as the withholding agent if the foreign service provider does not have an agent within China.

 

The Implementation Measures also make available transitional arrangements for businesses caught in the transformation period, which will serve as guidance for other provinces and cities which are also starting to participate in the BT to VAT reform as of August 2012 following Shanghai’s pilot program. General speaking, businesses who used to be eligible for BT exemption under the existing BT regulations are eligible for VAT exemption until the expiry of BT exemption provided the specified criteria is fulfilled. For those businesses outside Shanghai which provide services to a recipient under the Pilot Program in Shanghai, they have to continue to pay BT and such BT paid will not be deductible by the entity based in Shanghai when computing VAT.

 

To answer the question, it really depends on which sectors of the Pilot Industries the company operates in. It is reported that the majority of general taxpayers have experienced a decrease in tax burden due to the wider range of deductable input VAT according to statistics released by the Shanghai regional government. In the meantime, many small-scale tax payers in Shanghai have also been reportedly benefiting from the reduced 3% VAT rate as opposed to the 5% BT rate previously applicable. However, the transition from BT to VAT has brought about hardship rather than blessings to the logistics sectors due to the increase of tax rate from previous 3% BT to current 11% VAT. In addition, the major input VAT deductible items in the transportation sector are transportation vehicles, fuel and maintenance and repair fees; all of which at this stage would be far from sufficient for input deduction purposes to reduce the overall costs of transportation companies. This is partly because such reform is implemented only in Shanghai rather than across the nation, which restricts the scope of deductible costs for businesses under the Pilot Industries.

 

Although it is widely expected that the pilot reform program may reduce the tax burden of companies in certain service industries by helping them to avoid double taxation, the actual extent of any reduction for certain sectors is less encouraging. 

 

It is imperative that the State authority shall launch a nation-wide VAT reform program applying to more service sectors as soon as possible before the business operators engaged in service industries can genuinely benefit from the indirect tax reform in China. Disparity in tax burdens between different regions and different service sectors certainly causes disruption to business operations instead of easing the burden for them. In addition, the BT-VAT transformation will probably have a substantial impact on the local tax income since VAT legally belongs to the central government of the State rather than local government. It remains to be seen whether the special policy granted to Shanghai in implementing the pilot program allowing the Shanghai government to retain the VAT levied will be able to be offered to other provinces or cities as well when participating in the expanded pilot program later this year.