Value-Added Tax Pilot Program in China—Expansion from Shanghai to other Provinces

January 2013 (No. 1)

Asia Update

On November 16, 2011, the Ministry of Finance (“MoF”) and the State Administration of Taxation (“SAT”) jointly released the Notice on Promulgation of the “Pilot Scheme for Replacing Business Tax with Value-Added Tax” (“Circular 110”) to pave the way of replacing Business Tax (“BT”) with Value Added Tax (“VAT”) for the transportation, technology, creative, logistics, authentication and consulting, and movable property leasing industries. The VAT reform was launched by a pilot program in Shanghai. Circular Cai Shui [2012] No.71 (“Circular 71”) dated July 31, 2012 expanded the VAT pilot program to Beijing, Tianjin, Jiangsu, Zhejiang (including Ningbo), Anhui, Fujian (including Xiamen), Hubei, Guangdong (including Shenzhen) (the “Expanded Locations; Shanghai and the Expanded Locations are referred to jointly as the “Pilot Locations”) between August 1, 2012 and December 31, 2012. In Circular 71, the MoF and the SAT also confirmed that the pilot program rules applicable in each of the Expanded Locations will be the same as in Shanghai.


The pilot program has been implemented in Shanghai since January 1, 2012. To facilitate the expansion of the pilot program in the Expanded Locations, the MoF and the SAT issued several regulations and rules regarding the implementation of the VAT rules, including Circulars Caishui [2011] 131, [2011] 132, [2011] 133 and [2012] 53. This article outlines the main VAT reform rules and its potential impact on a foreign invested company (“FIE”).

Sectors and Rates

Transportation and modern service sectors (“VAT- taxable Services”) are affected by the VAT reform. The VAT-taxable Services and the corresponding VAT rates are listed in the table on page 2.

VAT-Taxable Services

VAT Rates

R&D and technology

R&D services

6%

Technology transfer services

Technology consulting services

Contractual energy management services

Project survey and exploration services

Information technology

Software services

6%

Circuit design and testing services

Information system services

Operation process management services

Culture and creation

Design services

6%

Trademark and copyright transfer services

Intellectual property services

Advertising services

Conference and exhibition services

Logistics and auxiliary services

Aviation services

6%

Port services

Transport terminal services

Salvage assistance services

Cargo transport agent services

Customs brokerage services

Storage services

Load-unloading services

Authentication and consulting

Verification services

6%

Authentication services

Consulting services

Transportation

Land Transportation

11%

Water Transportation

Air Transportation

Pipeline Transportation

Movable Property Leasing

Finance Lease

17%

Operating Lease

 
Under the VAT reform, in addition to domestic entities and individuals in the Pilot Locations that provide VAT-taxable Services, any overseas entities and individuals rendering VAT-taxable Services to persons in the Pilot Locations are also subject to VAT. Where an overseas supplier does not have a business establishment in the Pilot Locations, its withholding agent or service recipient will pay VAT if the withholding agent or service recipient is established or resides in the Pilot Locations. Circular 133 confirms that an applicable VAT rate (6%-17% rather than 3%) will be applied to overseas service providers at the time of calculating the withholding VAT.

Registration as a General VAT Taxpayer or a Small Scale VAT Taxpayer

Entities and individuals providing taxable services with annual turnover less than RMB 5 million (approximately US$780,000) may be treated as “Small Scale VAT Taxpayers.” The VAT rate for these taxpayers is 3%, regardless of the type of services provided by them. However, Small Scale VAT Taxpayers are not entitled to any input VAT credit. Businesses with sales income below the RMB 5 million thresholds may still register as general VAT taxpayers, if they have sound and complete accounting records. In such cases they will have to pay VAT at the applicable rates listed above, but they will be entitled to input VAT credit.

Taxable service providers with annual turnover of RMB 5 million or greater will have to register as general VAT taxpayers and establish internal systems to generate VAT invoices.

Services in Multiple Domestic Locations or Outside of China

Services in Multiple Domestic Locations

Since the VAT reform is presently only implemented within the Pilot Locations rather than all of mainland China, an issue will arise when VAT tax payers provide services to or receive services from individuals or entities which reside or are established outside of the Pilot Locations, as to which kind of tax (BT or VAT) should be paid by the tax payer. The below table sets out when VAT will apply and when BT will apply.

Service Provider (Location)

Service Receiver (Location)

VAT or BT

Pilot Location

Non-Pilot Location

VAT

Non-Pilot Location

Pilot Location

BT

Non-Pilot Location

Non-Pilot Location

BT

Pilot Location

Pilot Location

VAT

 
Whether the entities are included in the Pilot Locations depends on the location of the specific entity. For example, as a parent company and its branches are different tax payers, even where the parent company is in the Pilot Locations, if any branches are established in the non-Pilot Locations they will not be transformed from BT payers to VAT payers.

Services Outside of China

Circular 111 provides that overseas individuals or entities providing VAT-taxable Services to individuals or entities within China shall be deemed as providing services in China and be subject to VAT. The below table sets out under what circumstances the VAT will apply.

Service Provider
(Location)

Service Receiver
(Location)

Where Service
Takes Place

VAT or BT

Outside of China

Within China

In China

VAT (withhold by agent or service receiver)

Outside of China

Within China

Outside of China

N/A

In China

Outside of China

Outside of China

Subject to zero VAT rate or exemption (as discussed below)

 
Application of Zero VAT Rate and Exemption

Circular 131 clarifies the scope of services subject to zero rated VAT and exemption. The export of services that are subject to zero rated VAT and exemption are both exempt from output VAT. The significant difference between zero rated VAT and exemption is that, under zero rated VAT, the input VAT attributable to the export of services can be credited from VAT payable for domestic services or refunded, while, under the exemption system, the input VAT attributable to export of services cannot be credited.

Export of services subject to zero rated VAT

Zero rated VAT is applicable to the export of the following services:

  • Qualified international transportation
  • R&D and design services provided to overseas entities
  • Design services provided to overseas entities (except for design services in relation to immovable property located in China)

For the three above mentioned services, the SAT has released Announcement 13 to specify the refund mechanisms, which should be referred to for the detailed procedures regarding applying for an exemption, credit, or refund status with the tax authorities.

Export of services subject to VAT exemption

  • VAT exemption is applicable to the export of the following services:
  • Unlicensed international transportation
  • Leasing tangible movable property with the object of the lease being used outside of China
  • Engineering as well as exploration services with the related project or mineral resources located outside of China
  • Technology transfer, technology consulting, energy management services (except where the object of the energy management contract is located in China) provided to overseas entities
  • Software services, circuit design and testing services, business process management services provided to overseas entities
  • Convention and exhibition services located outside of China
  • Trademark and copyright transfer services, intellectual property services provided to overseas entities
  • Advertising services where the related advertisement is released outside of China
  • Warehousing services where the location of the warehouse is outside of China
  • Logistics and ancillary services provided to overseas entities (except warehousing services)
  • Certification, verification and consulting services provided to overseas entities (except for services in relation to goods or immovable property located in China)

Effects of the VAT Reform

The tax authorities implemented the VAT reform to eliminate the repeated BT tax levy due to BT’s nature as a turnover tax and to simplify administration for businesses. The VAT reform is intended to reduce the cost to companies, since the VAT is borne by the end customers, meaning that companies may add the payable VAT to the final price paid by their end-consumers. However, in reality, depending on the industries some taxpayers may not be able to benefit from the VAT reform. This is illustrated in the two examples below:

Effect on the transportation sector

After the implementation of VAT reform, there has been a significant change in the tax rate for transportation services, from BT at rate of 3% to VAT at rate of 11%. Under the BT regime, the transportation services paid BT on a ‘net’ basis. That is, BT was not levied on the gross revenue from transportation activities, but was instead imposed on the net revenue from such activities. In effect, businesses in transportation services were entitled to deduct certain expenses from their gross revenue in calculating their BT liability. By comparison, under the VAT reform, if the expense is subject to VAT, then potentially an input VAT credit can be claimed. However, in practice, transportation services may not generate significant input VAT credits until such time as they replace their existing vehicles or fixed assets. Therefore, by replacing BT at a rate of 3% with VAT at a rate of 11% may actually increase the tax liability imposed on transportation services.

To remedy this potential problem, Circular Hucaishui [2012] No.5 was enacted to clarify that taxpayers whose VAT liabilities have increased compared with its prior BT liabilities are entitled to apply for financial subsidies.

Effect on multinational companies

The VAT reform has provided some benefits to multinational companies. First, for those multinational companies engaging in providing export and import services, under the BT regime, a 5% BT applied to most services which were either exported from or imported into China, while under the VAT regime, the exports of services may be zero rated or exempt from VAT, and the imports of services, which are subject to VAT withholding, may claim input VAT credit. Secondly, for those multinational companies engaging in providing services or sales of goods, they are entitled to claim input VAT credits for the purchase of goods, fixed assets and services used in their business, which were not allowed under the BT regime.

Circular Hucaishui [2012] No. 5 confirms that the Shanghai government will provide subsidies to those pilot taxpayers, whose tax burden are significantly increased due to the transformation from BT to VAT. In this regard, it is recommended that pilot taxpayers assess any increase to its tax burden and, if appropriate, apply for any subsidies for which it qualifies.

Taxpayers in the Pilot Locations should also actively communicate with customers and suppliers and re-evaluate their business models, including but not limited to pricing, invoice issuance, previous arrangements for the purpose of avoiding repeated BT tax levy etc., to effectively reduce their VAT liabilities and optimize the cost savings benefits resulting from VAT reform.

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