12 May, 2016
On 1 May 2016, China will complete its VAT pilot program and end the bifurcated value-added tax (VAT) and business tax (BT) system that has been in place since 1994. A comprehensive and uniform VAT system will apply to all industries, and business tax (BT) will be swept into the dustbin of history.
The Ministry of Finance (MOF) and the State Administration of Taxation (SAT) jointly issued Notice 361 on 23 March 2016 to extend the VAT pilot program to the four industries still under the BT regime: financial services, real estate services, construction services and consumer services. Notice 36 also introduces significant changes to the current VAT pilot program rules. On 31 March 2016, the SAT released seven bulletins, numbered consecutively from SAT Bulletin [2016] No. 13 to SAT Bulletin [2016] No. 19, to address the detailed implementation of Notice 36 starting on 1 May 2016.
In this alert, we first comment on the general changes introduced by Notice 36 and the seven bulletins (collectively “New VAT Rules”) and then discuss certain industry-specific changes. We also provide some general recommendations for taxpayers.
1. General Analysis
1.1 Expansion of VAT Pilot Program
The New VAT Rules will transition all remaining BT taxpayers into VAT taxpayers. The applicable VAT rates for the four new industries covered by the VAT regime are as follows:
- 6 percent for financial services;
- 11 percent for real estate services, as well as the leasing or sale of immovable property and the transfer of land use rights;
- 11 percent for construction services;
- 6 percent for consumer services.
- The applicable VAT rate for small-scale VAT taxpayers in these industries will be 3 percent, in common with small-scale VAT taxpayers generally, with an exception that small-scale VAT taxpayers will be taxed at 5 percent on revenues from leasing or sale of immovable property.
In general, the New VAT Rules will permit the use of input VAT credits in these four industries, but with certain exceptions that we will discuss later in this alert.
1.2 Broad Definition of Intangible Assets
The existing BT and VAT rules provide that the transfer of certain types of intangible assets is subject BT or VAT. The New VAT Rules similarly provide that the sale or licensing of the following intangible assets is subject to VAT:
- patented and unpatented technology;
- trademarks;
- copyrights;
- goodwill;
- land use rights;
- other use rights to natural resources, such as mining exploration rights, mining rights and water rights.
But Notice 36 goes a step further by providing a new catch-all category of “other intangible assets” (其他权益性无形资产). This category covers all types of intangible assets capable of bringing economic benefits. The examples provided in Notice 36 include, among other things, operation rights to infrastructure, franchise rights, distribution rights, memberships, quotas, name rights and agency.
This expanded definition of intangible assets resolves the difficulty under current rules of allocating business transfer value for turnover tax purposes. Currently, when a business is sold at a premium above the net asset value of the business, the technical turnover tax treatment of this premium value is unclear, and it is often treated under the general category of “goodwill”. Under the New VAT Rules, the broader concept of “other intangibles” will be able to cover all or part of this premium value.
1.3 Exemption and Zero-rating for Exported Services
The New VAT Rules continue the existing exemption or zero-rating for domestic suppliers of exported services and domestic sellers or licensors of intangibles to overseas parties, and include the new services and intangibles that are now subject to VAT within the scope of exemption or zero-rating.2
Notice 36, however, adds an additional criterion for enjoying VAT exemption or zero-rating, i.e., that the relevant service or intangible must be “completely consumed outside China”. “Completely consumed outside China” is defined to mean: (i) the actual service recipient is outside China or the intangible is completely used outside China; and (ii) the service or intangible is not connected with goods or immovable property located in China.
This new criterion may disqualify certain exported services or transactions that would enjoy VAT exemption or zero-rating under the current VAT pilot program rules. For example, sales and marketing services provided by a Chinese enterprise to a foreign affiliate are currently exempt from VAT based on local interpretation. It is possible based on Notice 36 that the tax authorities will assert these sales and marketing services are connected with goods located in China and therefore not qualified for the VAT exemption.
As a transitional rule, Notice 36 grandfathers service contracts signed before 30 April 2016 and allows the VAT exemption or zero-rating to continue in accordance with the current rules until the contracts expire.
1.4 Adjustment to Sale Price that Lacks Reasonable Commercial Purpose
Notice 36 follows the existing VAT rules in authorizing the tax authorities to adjust a taxpayer’s taxable revenue if the taxpayer provides services or transfers real estate or intangibles at an obviously high or low price without a reasonable commercial purpose.
For the first time in the turnover tax context, Notice 36 defines “lack of reasonable commercial purpose” to mean using artificial arrangements to reduce, avoid or defer VAT payments or to increase VAT refunds, with the main purpose of obtaining these tax benefits.
As the present VAT rules do not define “lack of reasonable commercial purpose”, tax authorities have tended to interpret this term broadly to cover many situations where services are provided substantially below the market price for commercial reasons. This new definition may give taxpayers more room to undertake legitimate transactions at an obviously high or low price with good commercial reasons.
1.5 Mixed Sale of Services and Goods
Where one transaction involves both the sale of goods and the provision of services, Notice 36 provides that the entire transaction should be subject to VAT as either a sale of goods or a provision of services depending on the taxpayer’s main business. If the taxpayer’s main business is the manufacture, wholesale or retail of goods, all of its revenue from mixed sale transactions is subject to VAT at 17% as a sale of goods. The revenue of other taxpayers from mixed sale transactions is subject to VAT as the provision of services at the applicable rate under the New VAT Rules.
This new rule takes away the ability of taxpayers under the current rules to separate revenue from mixed sale transactions into sale of goods and provision of services and pay VAT at the different rates applicable to each revenue category.
1.6 Transfer of Going Concern
Notice 36 keeps the existing transfer of going concern (TOGC) rules under the BT and VAT regimes. This rule provides that a business transfer falls outside the scope of VAT where the transfer includes all of the assets and associated creditor rights, debts and workforce of an enterprise or of a line of business within an enterprise.
The failure of the existing TOGC rules to address the transfer of intangible assets has created technical and practical uncertainty about whether TOGC treatment covers the transfer of intangibles or only the transfer of other assets, such as inventory, fixed assets and real property. Unfortunately, the TOGC rule in the New VAT Rules fails to clarify this uncertainty.
1.7 Adjustment to Credited Input VAT
Where a taxpayer has credited input VAT arising from the acquisition of fixed assets, real estate or intangible assets, but subsequently uses the asset for one of the purposes listed below, Notice 36 requires that a part of the input VAT credited in the previous period must be deducted from the total creditable input VAT for the current period:
- in connection with generating revenue that is taxed using the simplified calculation method;
- in connection with generating revenue that is VAT-exempt;
- for collective welfare or personal consumption; or
- the asset incurs an abnormal loss.
The amount of the adjustment to current period creditable input VAT is equal to the net value (after depreciation or amortization) of the fixed asset, real estate or intangible multiplied by its applicable tax rate.
2. Industry Analysis 2.1 Existing Industries
(a) Modern Services
Notice 36 adjusts the current sub-categories with the broad category of modern services. Among other things, Notice 36:
- introduces a “business support services” category and a catch-all modern services category;
- expands leasing services to cover financial leasing;
- excludes transfer of technology, trademarks, copyrights and goodwill from modern services and re-categorizes them as transfers of intangibles; and
- expressly categorizes market research services as consulting services.
“Business support services” includes (i) enterprise management services, (ii) human resource services, (iii) agency services and (iv) security protection services.
In general, the VAT treatment of modern services provided by domestic suppliers remains unchanged. With respect to the export of modern services, the VAT treatment may change in practice depending on the tax authority’s interpretation of the requirement that the service be completely consumed outside China (see Section 1.3 above).
(b) Transportation, Express and Freight Forwarding Services
Transportation services
Overall, the tax treatment of transportation services remains unchanged except that non-vessel operating common carrier (NVOCC) service is expressly categorized as a transportation service subject to VAT at 11 percent. According to Notice 36, NVOCC services provided by a domestic entity or individual to a foreign person are exempt from VAT. With respect to international transportation services provided via an NVOCC, Notice 36 applies a look-through principle, i.e., the actual domestic transportation company is eligible for VAT zero-rating while the domestic NVOCC is VAT exempt.
Although NVOCC service is now recognized under domestic law as a transportation service for VAT purposes, it is unclear whether NVOCC service will enjoy treaty benefits as an international transportation service under applicable tax treaties.
Express delivery services
Like the current VAT rules, Notice 36 divides express services into transportation services subject to VAT at 11 percent and pick-up and delivery services subject to VAT at 6 percent.
International transportation services provided by a domestic transportation enterprise are zero-rated for VAT purposes. But pick-up and delivery services are VAT exempt only where provided for exported goods.
Freight forwarding services
Although re-categorized from logistics support services to business support services, domestic freight forwarding services receive the same VAT treatment under Notice 36 as under the existing rules, i.e., they are subject to VAT at a 6 percent rate. International freight forwarding services (direct or indirect) remained exempted from VAT on a transitional basis.
Notably, Notice 36 provides that the taxable revenue for freight forwarding services (international or domestic) is the total revenue and any additional charges received less government fees collected from and paid on behalf of the principal.
This means the netting method for international freight forwarding services under the current rules is no longer available under Notice 36.
2.2 New Industries
(a) Real Estate Services
Applicable tax rates and taxable revenue
Normally, a general VAT taxpayer is liable to VAT on gross sales revenue3 from the transfer or lease of real property at an 11 percent rate with input VAT credits available.4 As an exception, a general VAT taxpayer can elect the simplified taxation method, i.e., elect to be taxed at 5 percent of taxable revenue without input VAT credits, for the transfer or lease of real property that the taxpayer acquired before 30 April 2016. A small-scale taxpayer is automatically taxed using the simplified taxation method.
Provisional filing and prepayment
Regardless of the taxation method, all taxpayers (excluding individuals) must provisionally file and prepay VAT where the real property is located if the property is not located in the same county (city) as the taxpayer. The applicable VAT prepayment rates are:
- 5 percent on the gross sales revenue from transfer of self-built real properties;
- 5 percent on the net sales revenue from transfer of real properties other than self-built real properties;
- 5 percent on the gross rent from lease of real properties acquired before 30 April 2016; and
- 3 percent on the gross rent from lease of real properties acquired after 1 May 2016.
- After the VAT prepayment, a general VAT taxpayer must file with its own in-charge tax authority.
This prepayment procedure will increase the administrative burden on real property sellers and landlords and increase the likelihood of overpayment. Although a taxpayer can claim a VAT refund if the prepaid tax exceeds the VAT payable,5 claiming a tax refund is always a painful exercise for taxpayers. Moreover, the tax authorities may disagree over which of them is responsible for issuing the refund.
Input VAT credits from real property
Under the New VAT Rules, a general VAT taxpayer can credit the input VAT from real property acquired after 1 May 2016 or where construction of the real property started after that date. The credits should be taken in two instalments: 60 percent creditable in the current period when the taxpayer obtains the VAT special invoice; and the remaining 40 percent creditable in the thirteenth month after the taxpayer obtains the VAT special invoice.
However, a general VAT taxpayer can credit the input VAT from the following real property without being subject to the above instalment limitation:
- real property self-developed by a real property development enterprise;
- real property obtained via financial leasing; and
- temporary construction or buildings built on a construction site. Transfer of a residential property by an individual
- Under Notice 36, the VAT treatment on a transfer of a residential property by an individual differs depending on how long the residential property was held: for less than two years, 5 percent VAT on the gross sales
- price; for two years or more, VAT exempt. However, in Beijing, Shanghai, Guangzhou and Shenzhen, an individual is liable for VAT on the net sales revenue from the transfer of a non-ordinary residential property held for two years or more.
(b) Construction Services
Applicable tax rates and taxable revenue
Construction services provided by a general VAT taxpayer are normally subject to VAT at 11 percent on the gross sales revenue, while those provided by a small-scale VAT taxpayer are subject to VAT at 3 percent on the gross sales revenue less any amounts paid to a sub-contractor.
Notably, a contractor with general VAT taxpayer status can choose to apply the simplified taxation method, i.e., to be taxed at 3 percent on the gross sales revenue less any amounts paid to a sub-contractor, if:
- the contractor provides the construction services for a project but does not provide the construction materials or only purchases (and provides) auxiliary materials;
- the contractor provides the construction services for a project and the owner independently purchases all or part of the equipment, materials and power; or
- the contractor provides services for “old construction projects”.6
Provisional filing and prepayment
A taxpayer that provides construction services in a county or a city other than where the taxpayer is registered must provisionally file and prepay VAT where the construction services are provided. The applicable VAT prepayment rates are:
- 2 percent on the gross sales revenue if the taxpayer applies the general taxation method; or
- 3 percent on the gross sales revenue less any amounts paid to a sub-contractor if the taxpayer applies the simplified taxation method.
(c) Financial Services
Tax rates and taxable services
VAT applies at a 6 percent rate to financial services provided by a general VAT taxpayer and at a 3 percent rate to financial services provided by a small-scale VAT taxpayer. Financial services are further divided into the following four sub-categories:
- Lending services – includes interest income from the provision of capital, such as loan interest, interest on bonds held to maturity, sale-and-lease-back financing arrangements and fixed or guaranteed minimum returns on monetary investment;
- Chargeable financial services – These services include service fees from the provision of services related to the flow of funds and other financial operations, such as currency exchange services, credit card services, financial guarantee services and clearing, and settlement and payment services;
- Insurance services – These services include commercial insurance services, including personal insurance and property insurance; and
- Transfer of financial products – includes foreign currency, securities, non-goods futures and other financial products (such as all forms of financial derivatives and all forms of asset management products, such as funds, trusts and financial instruments).
Notably, financial leasing is excluded from financial services. Instead, it is grouped under leasing services, which are subject to VAT at 17 percent for tangible assets and 11 percent for real property.
Items not subject to VAT and VAT-exempt items
Insurance compensation and bank deposit interest are not within the scope of VAT. In addition, the following items are exempt from VAT as a continuation of the present BT exemption:
Specific types of interest income, such as interest on:
– national and local government bonds;
– loans from the People’s Bank of China to financial institutions;
– foreign exchange loans provided by the State Administration of Foreign Exchange via financial institutions in the course of foreign exchange operations; and
– intra-bank and interbank borrowing and lending;
Insurance premium income from personal insurance with a period of more than one year; and
Income from:
– trading of securities by a qualified foreign institutional investor;
– trading of A shares by Hong Kong investors via the Hong Kong Shanghai Stock Connect program;
– trading of China funds by Hong Kong investors via the mutual recognition of funds program;
– trading of shares and bonds by fund managers of securities investment funds; and
– transfer of financial products by individuals.
Input VAT on lending services
Input VAT on lending services and on financing advisory fees, handling fees and consultancy fees directly related to a loan paid by the borrower to the lender cannot be credited against the taxpayer’s output VAT.
The non-creditable input VAT will increase the borrower’s financing costs. Therefore, taxpayers will be incentivized to choose financing methods other than loans (e.g., finance leasing) or to use independent financial advisors to arrange loans.
Netting method for transfer of financial products
Similar to the current BT position, the VAT taxable revenue on the transfer of financial products is the gain, i.e., the sale price less the purchase price. Losses can be carried forward to taxable periods in the same year but cannot be carried forward to the next calendar year. The taxpayer
can choose either the weighted average method or the moving weighted average method to calculate the purchase price. Once selected, the method cannot be changed for 36 months.
Further, Notice 36 provides that special VAT invoices cannot be issued for the transfer of financial products. This taxation approach based on gains rather than revenue is more realistic and practical for trading in financial products, although the prohibition of carrying forward losses from one year to the next will continue to result in loss of tax relief.
Cross-border financial services
VAT exemption is extended to insurance services for exported goods (including export goods insurance and export credit insurance) and chargeable financial services provided to foreign entities if the chargeable financial services do not involve flow of funds to or from Chinese entities and are not related to goods, intangible assets or immoveable property
in China. However, Notice 36 does not generally allow VAT exemption or zero-rating for cross-border lending services or financial product transfers.
(d) Consumer Services
Tax rates and taxable services
From 1 May 2016, consumer services provided by a general VAT taxpayer are subject to VAT at a 6 percent rate, and consumer services provided by a small-scale VAT taxpayer are subject to VAT at a 3 percent rate.
Consumer services are divided into the following six sub-categories: • cultural and sports services;
- educational and medical services;
- tourism and entertainment services;
- catering and accommodation services; • daily services for residents; and
- other consumer services.
Taxable revenue
Generally, taxable revenue from the provision of consumer services is the gross sales revenue received. As an exception for the tourism services, a taxpayer can choose to calculate its taxable revenue by deducting travel fees paid to third parties from the gross sales revenue received from the service recipients. Under this method, the taxpayer is not allowed to issue special VAT invoices to the service recipient for the deducted amount.
Non-creditable consumer services
Notice 36 provides that input VAT on catering services, daily residential services and entertainment services cannot be credited against the taxpayer’s output VAT.
3. Actions to Consider
In response to the transition of all industries under the VAT regime, we recommend that companies engaged in the new sectors subject to VAT, whether as a service provider or service recipient or as a seller or buyer, consider the following actions:
- analyse the impact of the New VAT Rules on its business activities and choose appropriate pricing strategies to reflect the tax burden on both transactional parties;
- review contracts signed while BT was the applicable tax, analyse whether the service provider or seller has the right to collect VAT from the service recipient or buyer, and consider renegotiating the contracts where necessary; and
- ensure compliance with VAT administration rules, such as general VAT taxpayer registration, invoice management and VAT declaration.
1 Notice of the Ministry of Finance and the State Administration of Taxation on Fully Expanding the Value-added Tax Pilot Program, Cai Shui [2016] No. 36, dated 23 March 2016, effective from 1 May 2016.
2 Under both the VAT exemption regime and the VAT zero-rating regime, no output VAT is levied on service fees. However, a credit or refund of input VAT incurred in the provision of the relevant services is only available under the VAT zero-rating regime.
3 “Gross sales revenue” as used in this alert means total sales revenue plus any additional charges.
4 As an exception, for a real property development enterprise that is taxed using the general taxation method, its taxable revenue equals the gross sales revenue less the purchase price of the land use rights paid to the government.
5 The language of Notice 36 suggests that the tax authority is more likely to allow the taxpayer to stop future VAT prepayments or payments for a period than it is to grant a tax refund in the current period.
6 “Old construction projects” refers to construction projects with a commencement date on or before 30 April 2016 as indicated in the Construction Permit for Construction Engineering or the construction project contract (the latter if there is no Construction Permit for Construction Engineering).
For further information, please contact:
Jon Eichelberger, Partner, Baker & McKenzie
jon.eichelberger@bakermckenzie.com
