The Chinese government is evaluating an updated draft version of the value-added tax law (VAT law), which will consolidate previous tax regulations into one mayor piece of legislation. VAT is China’s largest source of tax revenue, which is why the progress on its legislation is a big focus for local authorities.
Last December, the National People’s Congress (NPC) released the draft version of the VAT law. If approved, the document will implement important changes and adjustments to current tax standards and regulations.
The draft was open for public consultation until January 28, and it is expected to be approved by the NPC in the course of 2023.
Since their creation, the Chinese VAT rules have existed as regulations issued by the State Council rather than as a law passed by the NPC. However, in recent years China has sought to put existing taxes on a statutory basis, and the enactment of a VAT law has long been a core objective of this initiative.
The last major change to the VAT regime came in 2012–16 when business tax (BT) was merged into VAT. BT applied to service provision, financing arrangements, real estate and IP transactions, and the merger left various oddities in the VAT system which the new VAT law is seeking to clarify.
Another important aspect of the draft VAT law is the alignment of Chinese rules with the OECD International VAT/GST Guidelines, without increasing the tax burden.
The draft seeks to strengthen the provisions on granting refunds of excess input VAT credits, a relatively recent innovation in the Chinese VAT space.
In China, VAT taxpayers are categorized into two types: general taxpayers and small-scale taxpayers. Small-scale taxpayers are subject to a lower VAT levy rate of 3%, as opposed to general taxpayers, who are subject to a progressive VAT rate of 0 to 13%, depending on the types of goods and services they provide (a 5% VAT rate is levied on the sale of immovable property and real estate rental services).
Although small-scale taxpayers are subject to lower VAT levy rates and several VAT incentives, they cannot credit input VAT from output VAT, and they are not entitled to VAT refunds for export products, unlike general taxpayers.
How businesses are categorized depends on their annual taxable sales amount; from 2018 onward, the threshold for small-scale taxpayers has been up to RMB 5 million (approx. US$742,214) in sales. But VAT taxpayers whose annual taxable sales are below the threshold, as well as those with newly established companies, can voluntarily apply for general taxpayer recognition provided they can set up legitimate and accurate bookkeeping.
One of the key changes in the draft law is the set VAT rates. In 2019, the headline VAT rate was lowered to 13 from 16%, along with the other rates (from 10 to 9% for certain goods and services). The initial rate in the interim VAT regulations was 17%, however the draft VAT law has confirmed it at 13%, indicating that this will be the set rate and will not be raised again.
The existing VAT rules provide for a ‘simplified’ VAT levy for smaller businesses of 3%, and a 5% rate applying to the sale and rental of real estate (a legacy of the old BT regime). The draft states that the 3% rate will be retained but it remains to be seen whether the 5% rate will also be ‘folded’ into it.
Different from most other countries, China does not exempt loan interest from VAT. Previously, BT applied to interest, and this was carried into the VAT regime. However, up to now, no input credit was provided for loan interest. This changes in the draft, and the new credit will provide much welcome relief to businesses. At the same time, simplifications are brought to the granting of VAT input credit for food, beverage, and entertainment services provided that the consumption is business related.
The existing VAT rules set out a multitude of instances in which a supply is deemed for VAT purposes; these are narrowed significantly in the draft. The axe is taken to the deeming charge on consignment sales, inter-province transfers between branches of the same company, capital injections, distribution-in-kind to shareholders and free-of-charge provision of services. That said, the draft still applies the deeming rule to free-of-charge supplies of financial products.
The draft VAT law clarifies the definition of several tax terms, such as “taxable transactions” and “domestic taxable transactions”.
“Domestic taxable transactions” include scenarios such as where the place of departure or location of the goods for sale is within China; the sale of services and intangible assets consumed within China, or the sellers are domestic entities or individuals; where real estate is sold or leased, or the right to use natural resources is transferred within China; and for the sale of financial products issued domestically, or the sellers are domestic entities and individuals.
According to the draft VAT law, if the seller is overseas and the buyer is in China, but the service is consumed overseas, then it will not be considered a “domestic taxable transaction”; if both the seller and the buyer are overseas, but the service is consumed in China, then it will be considered a “domestic taxable transaction”.
Chinese lawmakers are following the “destination principle” for determining where supplies of internationally traded services should be subject to VAT, taxing supplies in the jurisdiction in which they are consumed. However, this may also imply that VAT will be triggered when the service provider and the service recipient are outside of China, but the service is consumed in China.
The draft VAT law has significantly reduced the scope of deemed sales that are still subject to VAT. These transactions include the use of self-produced or entrusted processed goods by entities or sole proprietors for collective welfare or personal consumption; the gifting of goods by entities and sole proprietors; the gifting of intangible assets, real estate or financial commodities by entities and individuals; and other circumstances prescribed by the financial and tax authorities of the State Council.
The draft omits services provided free of charge in the scope of deemed sales. This change would be a benefit to large corporations with subsidiaries that regularly provide free services to one another. Tax authorities still have the right to verify the price of the services for income tax purposes, even if it is not regarded as a sale for VAT purposes.
The application of mixed sales rules (which apply the VAT rate of the main supply) have been widened in the Draft. Going forward, where the supplies are subject to VAT at two rates, the mixed sales rule can be applied; up to now, there needed to be both goods and services in the mix.
Certain activities do not constitute “taxable transactions”, according to the draft, and are therefore not subject to VAT. These are the provision of services by an employee in order to obtain wages and salaries from an employer; the collection of administrative fees and government funds; the collection of compensation for being expropriated or requisitioned in accordance with the law; and obtaining income from deposit interest.
The main change in the draft VAT law is that the above items are now consolidated under non-taxable activity, which confirms their status as tax-exempt items.
If passed into law, the new legislation will not change drastically China’s VAT system and will not have a significant impact on businesses. The changes represent an effort to improve China’s tax system and reduce the tax burden on key industries, such as manufacturing, construction, and transportation.
Nevertheless, a few differences will benefit businesses, such as the addition of new items into the scope of tax deductibles and more creditable items and narrowed scope of deemed sales.
Enterprises operating in China should evaluate the potential impact of the draft VAT law before it comes into effect, to prepare for any possible changes, address a higher tax liability and take advantage of the benefits.
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