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FEATURE STORY: Taxing Times: China’s new VAT pilot program will be good for business, once teething problems are overcome
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Recent travels through Tianjin’s business community reveal a deficit of definite information about the new tax regime being applied here. Tianjin is one of a half dozen territories chosen to trial a new VAT system which China hopes will stimulate the services sector and reduce the economy’s dependence on export-orientated manufacturing. 
 
Those who have applied the new system are reassured. “Once word of tax reform came out, most people thought immediately that they’ll be paying more taxes,” explains the manager of a car rental fleet based in Nankai, Xu Jianfang. “But that’s not necessarily true. Actually most businesses will pay less since it’s just a matter of changing how it’s collected,” explains Xu, who only recently signed on for taxes, having left the black economy in a bid for higher-margin clients. He adds that: “instead of me paying business tax in each stage of the production process I’ll pay a VAT at each stage in the process. But I can deduct what I paid my supplier in VAT from what I eventually pay in VAT, so I’m just paying the balance.”
 
Indeed, ultimately the VAT is rolled all the way up the value chain and passed on to the end consumer. In fact, under the new system the government will take less tax from companies (but obviously hopes to stimulate economic growth). Corporate tax takings will fall by CNY 100 billion under the new regime, explained Xiao Jie, head of the State Administration of Tax (SAT) earlier this year. Xiao however expects GDP growth will be spurred 0.5% by the tax reform.
 
Why VAT reform now? It makes sense because the government is dealing with a slowdown in economic growth, largely due to lower demand for Chinese exports in key markets like the EU and USA. A local manufacturer explains the logic: in the 1990s people were only interested in boosting the local manufacturing and exports business. They introduced VAT but it didn’t apply to manufacturing, which only paid the business tax. Businesses termed as services businesses had to pay both VAT and business tax. So they’ve effectively been double-taxed. Now government sees that the growth potential isn’t so much in manufacturing as in services so they’re reforming the system.
 
Transfer Pricing Under Tianjin's New VAT: Why It Matters for Foreign Firms
International businesses in Tianjin would be well advised to take a good look at transfer pricing policies given that cross-border imports of services may no longer be liable to business taxes – but rather new rates of VAT. It’s a matter of discerning if the services fit into the new VAT categories.
 
Transfer pricing refers to the sale of goods and services within organizations, with parts or marketing services from a company division in Europe sold to a manufacturing subsidiary in China – often at inflated prices in order to manipulate the allocation of the total profit among the parts of the company. 
 
Companies with transfer pricing arrangements with Chinese subsidiaries may be affected by the change from the business tax (BT) to the VAT. “This is particularly so since many transfer pricing arrangements cover the BT expenses of the subsidiaries,” explains Frank Ji at McGladrey, an advisory providing tax advice to US firms in China. “Because cross-border service flows covered by the VAT pilot program may no longer generate BT liabilities or irrecoverable VAT liabilities, transfer pricing arrangements may need to be updated to reflect the changes.” 
 
In other words, subsidiaries in China may be able to book ‘input VAT’ paid to related overseas companies and discount this against VAT paid in China. Much will depend on the China-based company being able to categorise the services being provided from overseas so that they fit the Tianjin bureau’s definition of a service to which the new VAT rules apply. On the other hand, corporations here may choose not to continue relations with suppliers who can’t provided the relevant documents to allow the taxpaying firm to deduct ‘input’ VAT against ‘output’ VAT.
 
Clearly transfer pricing remains a sensitive issue for China’s tax collectors. Tax authorities worldwide worry that multinational corporations set transfer prices on cross-border transactions to reduce taxes due on profits in their respective jurisdictions, and many states have clamped down through regulations and investigations of companies.
 
China, according to China-based corporate lawyer Dan Harris (who practises at Harris & Moure), has “been cracking down on transfer pricing and that crackdown just keeps accelerating.” Harris warns companies with operations in China to “look at your prices between your foreign entity and your Chinese entity because if those prices are not reasonable enough to get past the Chinese tax authorities, you will likely be facing serious problems.” Obviously then firms will have to be very careful about what to define as a VAT-deductible service from an overseas subsidiary when submitting their tax filings under Tianjin’s new VAT programme. 
Stimulating Services
China’s rulers are worried that the services sector isn’t growing its share of GDP fast enough. The services sector contributes up to 75% of GDP in some developed nations, and should be at this stage contributing about 55% of China’s annual GDP. But the figure right now is about 44% because government is still favouring investment in manufacturing capacity and infrastructure as a way of delivering economic growth. Adjusting the VAT system to take some of the burden off the services sector is a good way of encouraging its growth.
 
Proof of this goal is the zero-VAT treatment granted to certain services sectors in the new regime, in particular firms involved in research and development (R&D) or in providing services overseas. This will also benefit Chinese firms expanding overseas since their international transport, storage and marketing expenses are all VAT-free. Likewise, under the new system transportation firms will have to pay 11%, while IT and consulting firms will pay 6% - and no business tax will apply. This compares favourably with rates of 17% and 18% paid by most businesses selling products. A 3% VAT rate will be applied to tax paying firms with annual sales revenues of less than CNY 5 million.
 
Others have noted anxiety in the local government about who collects what in the new regime. Most regional governments have submitted two thirds of the VAT take and kept a third: this won’t change under the new regime, even though VAT is administered under the national State Administration of Taxation. “And in any case, Tianjin is administered directly by the central government, so it doesn’t really matter,” notes an interpretation of the new system on the website of the local office of the SAT. 
 
Sharing the Pie
Clearly a major obstacle to implementation of the new regime has been fear amongst local governments that the shift to VAT would reduce the share of local taxes that they can retain. Central government assurances that the reforms will not affect how tax revenues are distributed appear to have provided the necessary catalyst to drive these reforms forward. And in doing so China is also following world practice. The current reforms have been mulled for a decade and over the past few years in particular officials from the Ministry of Finance and the State Administration of Tax have been dispatched globally to study VAT systems. “They’ve clearly seen that indirect taxes like VAT are the way to go,” explains Frank Judge, a Canadian revenue official, retired from service with the Ottawa municipal government, who advised China on tax reform. “An indirect tax is far easier to collect since you’re putting the onus on the various parties along the value chain to factor the tax in along the way and then one party pays it at the end. This leaves less scope for evasion along the way.”
 
VAT is already the top source of tax income for China’s government. It’s worth looking at the breakdown of China’s tax take, as reported by the Ministry of Finance in the first half of 2012. Government over the first six months of the year collected CNY 1.34 trillion in VAT compared to CNY 1.31 in corporate income tax. Business tax yielded CNY 0.78 trillion, whilst consumption and personal income tax yielded CNY 420 and CNY 320 billion respectively. Counting in tariffs and other taxes the country collected CNY 8.97 trillion in taxes in 2011, a healthy increase on CNY 7.32 trillion taken in 2010.
 
While there are some bureaucratic changes involved for financial affairs staff, the new system is good for business. That’s certainly the view of tax experts advising corporations in China. The new system is a “welcome change,” says Alan Wu, head of indirect tax counsel at PriceWaterhouseCoopers in China. The current system is unfair, says Wu, since it “squeezes” companies' profit margins and makes goods more expensive for consumers.  
Businesses, however, have to be prepared for the changeover, says Sarah Chin, who heads up the indirect tax practice at Deloitte China. She advises companies in China to look at how corporations in other jurisdictions have made the switch over to a simplified VAT system, in order to reduce the cost of collecting the tax. 
 
There are clearly many potential hiccups in implementing the new system. Not least is the preparedness of firms along the value chain to sign up and provided VAT documentation to customers. Numerous businesses, most of them retail and entertainment establishments, spoken to for this article were unsure if their suppliers would be willing or ready to supply the required VAT paperwork to allow themselves to then deduct the so-called ‘input’ VAT from their own eventual ‘output’ VAT payments. Indeed many other businesses phoned were not themselves yet signed up to operate the new system. 

By Mark Gao 
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