Tax & Accounting Blog

China’s VAT Journey Continues

Blog, Indirect Tax, ONESOURCE May 4, 2016

“To pay tax is a glorious duty of the people and the patriotic concept of paying tax according to law should be established among the people …”

The act of paying tax to the state, in China, has been regarded as a sort of worker´s holy sacrament dating back to the days of Mao. This communion brought the worker and the government together for a glorious display of patriotism and reverence for all that is stoic and frugal.

May 1st has officially concluded China’s largest tax reform to date. All industries have transitioned from Business Tax (corporate income tax) to value added tax (VAT). As reported by the Xinhua News Agency, this step is expected to reduce the fiscal burden on businesses by more than half a trillion Yuan in 2016 or nearly 77 billion dollars.

A tax reform model (pilot scheme) was first tested through the introduction of VAT in Shanghai back in 2012. Changes were introduced in several spheres – transport, logistics and information technology, and then expanded to other industries. Over the past four years, the Chinese government has reduced the tax burden on businesses by 640 billion Yuan, Xinhua writes. Now VAT has been extended to construction, real estate, financial services and consumer services.

These industries first became subject to a tax on industry and commerce back in 1958. The Industry and Commerce Tax was an expansion of the Soviet style turnover tax. Tax applied to all industries and commodities was applied once to the final finished product. Among the contributors were listed organizations and individual entrepreneurs, who provide employment services in the country, as well as those who own intellectual property rights and sell real estate. The Ministry of Finance stated that employment services refer to activities related to transport, construction, insurance and postal services, physical culture and sports, entertainment events, and so on. Due to the further nationalization of all sectors of the economy the industry and commerce tax has almost disappeared.

Today it has returned in the form of VAT. The government hopes to ease Chinese economic crisis with the transition of all industries to VAT and that it will have the same positive impact on the economy as it has in the Shanghai experiment. Chinese authorities also hope that the so called “supply side reform” in the industrial sectors, where the supply of goods significantly exceeds demand will lead to lower prices and lower rates of inflation. However it can also lead to business closures and job losses.

According to the government plan, a change in the tax regime would lead to tax savings of up to 500 billion Yuan in 2016, but the abolition of the Business Tax would make local governments increasingly dependent on the central government due to the disproportionate dispensing of VAT revenues. Previously, Business tax had been exclusively regional and the tax revenue had provided the main source of fiscal income to the local governments. On April 7, 2016, the government publication “China Daily” reported that the regional share in the distribution of VAT could potentially rise from 25% to 50% to cover the losses from the abolition of Business Tax. However, it might not be sufficient to cover all of the local government losses. It may be premature to say what the consequences of the government move will look, but the central government has been gradually taking sole control of the main tax revenue sources since 1994 (Resources Tax, Income Tax and now VAT). The growing revenue deficit in the regions reinforces and exacerbates their dependency on government loans and subsidies.

The central government is betting that the replacement of the Business Tax with VAT will reduce the tax burden on leading industries such as, construction, real estate, and financial services. Based on the new regulations that have been released, a higher VAT rate will be paid on the purchase of materials and equipment, which will reduce the tax base for the output VAT. Additionally, Chinese real estate developers will be offered the inclusion of the rights to land use in the tax base as a form of subsidy. In the past, costs associated with the lease or purchase of land for construction, were a significant financial burden for any project and, in the end, non-recoverable. The successful introduction of reforms that will reduce the tax burden for the construction industry should be able to compensate for slowing economic growth.

Official Government sources report that the reform of the tax system is a crucial step in the restructuring of the economy. Based on enacted legislation, the tax burden will be primarily lifted from China’s largest corporations, while redirecting the flow of tax revenue into the hands of the central government. Only time will show if the lightened tax burden will stimulate corporations to re-invest in the economy and improve measurable economic growth.