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Grace Lin
Cuatrecasas, Shanghai
grace.lin@cuatrecasas.com

 

On 27 November 2019, the Ministry of Finance (MoF) and the State Administration of Taxation (SAT) jointly released the draft Value-added Tax (VAT) Law (the Draft) for public comment.

As VAT is China’s largest tax, progress of legislation relating to it attracts significant attention. The release of the Draft represents not only another major step towards implementing the principle of statutory taxation under China’s Legislation Law, but also consolidates achievements of VAT reform carried out over several years.

Background

On 13 December 1993, the State Council released the Interim Regulation on VAT (the Interim Regulation). Starting from 1 January 1994, the Interim Regulation established that entities and individuals are subject to VAT for selling goods, providing processing, repair and maintenance services, and importing goods into Chinese territory, excluding Taiwan and the special administrative regions of Hong Kong and Macao. With authorisation established in the Interim Regulation, on 25 December 1993, the MoF released the Implementing Rules on the Interim Regulation (the Implementing Rules).

After nearly 20 years since implementing VAT, on 1 January 2012, China launched a VAT reform which gradually replaced business tax with VAT. The business tax regime was applicable to service provision (except for processing, repair and maintenance services), real estate sales, and the transfer of intangible assets. This reform reached its high point on 23 March 2016, with the release of the tax circular Caishui [2016] No 36 (Circular 36), which expanded the scope of VAT to the final four sectors of construction, real estate, finance and consumer services. From 1 May 2016, all taxpayers previously subject to business tax became subject to VAT. To formalise this process, on 30 October 2017, the State Council passed a resolution to abolish business tax and revised the Interim Regulation.

In 2015, the Legislation Law was amended to require all existing taxes stipulated in the administrative regulations to come into law by 2020. The Interim Regulation (and MoF and SAT’s supplementing regulations) no longer met the legislative tax requirement. Consequently, releasing the VAT Law was imperative. Furthermore, the achievements of the VAT reform carried out over the last four years must now be legislated into law.

In this context, the Draft was released for public comment.

The proposed major changes

Rather than merely combining the content of the Interim Regulation and Circular 36, the Draft proposes several major changes, which are summarised below.

Definition of VAT scope

Under article 1 of the Draft, VAT taxable activities carried out in China (taxable activities) and the import of goods are subject to VAT.

Although there are no substantial changes, the article has been made more concise by replacing the original wording of ‘sale of goods, provision of processing, repair and maintenance labour services, sale of services, intangible assets and real estate’ by the term ‘taxable activities’.

It also makes it clear that the VAT scope is divided into two categories: taxable activities and the import of goods, which are addressed separately throughout the Draft.

Under article 8, the sale of financial products is mentioned separately as one type of taxable activity. The nature of this transaction (eg, its complexity, high frequency and large scale) has caused much debate, such as on how to calculate the tax base, make the input VAT deduction and issue VAT invoices. Applying VAT to these transactions will result in sizeable tax administration costs, which may outweigh its benefit. For this reason, following international practice and applying a tax exemption to the sale of financial products is widely considered a good option. Whether the final version of the VAT Law will adopt this measure however, remains unclear.

Specifying the nature of VAT price

Under articles 4 and 15, the tax base for calculating VAT does not include VAT itself. Therefore, for the first time, VAT is defined in law as a tax excluded from the price. Nevertheless, as article 15 already covers this matter, article 4 may be considered redundant and can be removed.

Definition of a VAT taxpayer

Article 5 defines VAT taxpayers as: (i) entities and individuals conducting taxable activities in China and whose quarterly revenue reaches the VAT taxable threshold of RMB 300,000; and (ii) importers of goods. Entities and individuals which do not reach the taxable threshold can choose to pay VAT voluntarily.

This change is significant, as it sets a threshold to becoming a VAT taxpayer. The threshold only applies to taxable activities, not to the import of goods. It also no longer distinguishes the status of VAT general and small-scale taxpayers, as was previously defined in the Interim Regulation, its Implementing Rules, and Circular 36.

This new definition has attracted criticism from the general public, for several reasons:

• it seems at odds with article 1 (on VAT scope), which includes all taxable activities carried out by entities and individuals, regardless of revenue. If the Draft is meant to reduce the tax burden of small revenue taxpayers, this can be achieved by granting an exemption policy instead of excluding them from being taxpayers, which is not coherent from a legislative perspective;

• ‘Taxpayer’ is a key term in any tax legislation, so it must be defined clearly by law, not by choice. Therefore, entities or individuals should not be given the right to choose whether they wish to become a taxpayer; and

• revenue is not a stable factor, it fluctuates over time. With this definition, an entity may be a VAT taxpayer in one quarter but not in another. This will cause difficulties in tax administration.

For these reasons, we hope the taxable threshold will be removed in the final version of the VAT Law, replacing it with a tax exemption granted to taxpayers with similar revenue.

Definition of domestic taxable activities

As mentioned in article 1, only taxable activities carried out in China and the import of goods are subject to VAT. To clarify, article 9 defines domestic taxable activities and article 10 defines the import of goods for the:

• sale of goods, where the shipment starts or the location of goods is in Chinese territory (ie, domestic sales and export);

• provision of services and the sale of intangible assets (except for the right to use natural resources), the seller is a domestic entity or individual, or the services or intangible assets are consumed in Chinese territory;

• sale of real estate and the transfer of the right to use natural resources, the real estate and the natural resources are located in Chinese territory;

• sale of financial products, the seller is a domestic entity or individual, or the financial products are issued in Chinese territory; or

• import of goods, the shipment starts overseas, and the destination is in Chinese territory.

The above interpretation relates to the provision of services and the sale of intangible assets, except for the right to use natural resources. It differs significantly from the established current regulations, under which either the seller or the buyer is in China.

The service provision of overseas entities or individuals are therefore only subject to VAT when services are consumed in Chinese territory. Accurately defining ‘consumption of services in Chinese territory’ in the new implementing rules is crucial, as it has been difficult to interpret this in the past.

A new provision has also been added for the sale of financial products. However, as explained above, because of the difficulties this type of transaction could cause tax authorities, whether it should be subject to VAT remains debateable.

Definition of deemed taxable activities

Under article 11 of the Draft, even without a consideration, a transaction will still be considered a VAT taxable activity when:

1. entities and individual businesses use self-produced or contracted processed goods for collective welfare or individual consumption;

2. entities and individual businesses donate goods (except for public welfare undertakings);

3. entities and individuals donate intangible assets, real estate, or financial products (except for public welfare undertakings); and

4. other situations as specified by the MoF and SAT.

The Draft makes significant changes to the definition of deemed taxable activities, removing many situations considered VAT taxable activities under the Implementing Rules, including:

1. entrusting other entities and individuals to sell goods on commission;

2. selling the entrusted goods on commission;

3. when a taxpayer has two branches, conducts unified accounting and delivers goods for sale from one branch to another, except when the two branches are in the same county (county-level cities);

4. using self-produced or contracted processed goods for non-VAT taxable projects;

5. using self-produced, contracted processed or purchased goods for investment; and

6. distributing self-produced, contracted processed or purchased goods to shareholders.

The removal of the situations described in situations (iii), (iv) and (v) has raised some doubts, as it would result in breaking the VAT value chain, ie, to keep the VAT value chain complete for a transaction, input VAT from the deduction side always matches output VAT from the sale side. Without output VAT from the sale side, input VAT must be transferred out as cost, meaning input VAT is non-deducible.

However, under article 22 on non-deductible VAT, the input VAT relating to the above three situations are not included. Therefore, without considering these situations VAT taxable activities, no output VAT would arise to match input VAT, meaning that the VAT value chain would be broken. The final version of the VAT Law may therefore consider reinserting these three situations as deemed taxable activities.

Another significant change to article 22 is that it no longer includes a free service provision as a deemed taxable activity.

List of non-taxable activities

Article 12 includes a non-exhaustive list of non-taxable activities, and it empowers the MoF and SAT to regulate this matter further in future.

However, as this is a basic element in tax legislation, whether the MoF and SAT should be able to regulate the VAT scope is widely questioned, as it should be clearly provided under law or at least be delegated to the State Council for the purpose of flexibility in legislation, and not subject to departmental regulation.

Under current regulations, the VAT scope does not include: (i) the transfer of whole or partial assets together with the related creditor’s rights, liabilities and labour in the process of asset restructuring; and (ii) financial subsidies that are not related to the revenue or quantity of the sale of goods, services, intangible assets and real estate. Therefore, if the VAT Law is meant to provide a list of non-taxable activities, these transactions should also be included.

Three-tier tax rates

Article 13 confirms the three-tier tax rate structure being implemented:

1. 13 per cent on the sale of goods (except for the goods specified otherwise), the provision of processing, repair and maintenance services, and the leasing of tangible assets;

2. nine per cent on the provision of transport, postal, basic telecommunication, and construction services, the leasing and sale of real estate, the transfer of land use rights, and the sale and import of specified goods listed in article 13 (eg, agricultural products, water, gas, books, and feedstuffs); and

3. six per cent on the provision of services and the sale of intangible assets and financial products other than the above.

With the three-tier tax rates being enacted into law, in the short-term, China will not establish a two-tier tax rate regime.

VAT declaration period

To reduce the frequency of tax declarations, and to make it more convenient for taxpayers, article 35 deletes the declaration period of one, three and five days, and adds a half-year period.

Transition period

To clear up the current policies gradually, article 45 provides a five-year transition period. The right to regulate this is delegated to the State Council.

Final thoughts

The Draft introduces many changes to the current VAT regime. However, some articles on key tax elements have not been well designed or drafted. We hope the final version of the VAT Law will answer the concerns raised by the general public.

According to the official legislative schedule, several tax laws, including the VAT Law, must complete their legislative process in 2020. Therefore, the VAT Law will probably be released by the middle of the year.

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