On 17 November 2011, the Ministry of Finance ("MOF") and the State Administration of Taxation ("SAT") introduced a pilot programme in Shanghai to replace Business Tax with Value-added Tax ("VAT") commencing 1 January 2012. The pilot programme marks a major step forward for China in aligning its indirect tax system to the VAT systems of other countries. Although its application is limited to selected industries in Shanghai only, the pilot programme will have a far-reaching impact and is likely to serve as a roadmap on how the reform of indirect taxes will be ultimately implemented nationwide. On 29 December 2011, it was reported that the Beijing Municipal Government had filed an official application with MOF and SAT for launching the same pilot programme.
VAT and Business Tax are the two most important, but different, indirect taxes in China. Under the current Chinese rules VAT is levied at the statutory rate of 17% or reduced rates, on the sale of goods, provision of repairs, processing and replacement services, and importation of goods. A regular VAT taxpayer can deduct VAT paid on a purchase from its own VAT liability. As a result, VAT avoids the cascade effect of other indirect taxes by taxing only the value added at each stage of production.
Business Tax, on the other hand, is levied at 3% or 5% generally on assignment of intangible assets, transfer of immovable properties, and provision of services that are not subject to VAT. Business Tax differs from VAT in that it cannot be credited and will add up through the supply chain. This results in serious issues, such as double taxation and price distortions. China therefore is endeavouring to reform its indirect tax system to apply VAT across goods and service sectors.
Under the pilot programme, the transportation services industry and "modern services industry" (together "selected industries") in Shanghai, which are currently subject to Business Tax, will be subject to VAT as of 1 January 2012. The transportation service industry, including road transportation services, water transportation services, air transportation services and pipeline transportation services, will be subject to 11% VAT. Most of the selected modern services, including R&D and technology services, IT services, cultural and innovation services, logistics and auxiliary services, attestation and consulting services, will be subject to 6% VAT; the rate of VAT on tangible movable property leasing services will be 17%.
The pilot programme will mainly affect businesses in Shanghai, but may also affect businesses elsewhere, including foreign parties. The key elements in that respect are the following:
- Businesses registered in Shanghai and engaged in the selected industries ("pilot VAT taxpayers") will be the most affected as they will become eligible to register as regular VAT taxpayers and have to pay VAT, instead of Business Tax, on sales as of 1 January 2012. As a result, they will be able to claim input VAT credit charged on purchases of goods and services against their own VAT liability.
- Foreign parties that provide services that fall within the selected industries in Shanghai will be subject to VAT as well, rather than Business Tax.
- VAT taxpayers (both in Shanghai and elsewhere in China) that purchase services from pilot VAT taxpayers after 1 January 2012 will be able to claim input VAT credit on these purchases.
- The pilot programme provides that, in principle, export of services will be either zero-rated (i.e. VAT refunded) or VAT exempted.
- Generally zero-rated are the supply of international transport services, design services (excluding design services in respect of immovable properties located in China) and R&D services to overseas parties;
- VAT exempt are the export of other services and the supply of some services actually performed outside China, such as exploration services, exhibition services and warehousing services, as well as providing leasing services relating to tangible movable properties which will be used outside China (unless in each case MOF and SAT provide that a zero rate is applicable).
- In addition, the relevant circulars provide detailed rules regarding the choice of simplified VAT reporting, transition and retention of Business Tax preferences, etc.
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