In 2012 the Chinese government embarked upon an ambitious staged reform program as part of its 12th Five Year Plan, designed to replace Business Tax (BT) with a Value Added Tax (VAT) throughout the services sector of the economy. These reforms were designed to overcome the problem of tax cascading arising whenever business-to-business transactions took place under the BT system. The reforms were intended to overcome mismatches occurring whenever BT taxpayers purchased goods for which they were unable to claim input VAT credits, and similarly overcome the problem of VAT taxpayers being unable to claim credits for the BT incurred on the services they purchased.
To date, the VAT pilot program has extended from the modern services and transportation industry in Shanghai (in 2012), to a national basis (in 2013), and then further expanded to cover television, radio and film broadcasting services (in 2013), and postal and telecommunications services (in 2014).
The main sectors yet to transition to VAT represent the most financially significant for the government, the most challenging from a technical perspective, and the most economically interdependent: these are the real estate and construction industry; the financial services and insurance industry; and ‘lifestyle services’, which comprises food and beverage, hospitality, entertainment and a general catch-all of all “other services”.
One of the most challenging aspects of introducing a VAT is managing the transition; being only partway through the implementation process means there are still many BT taxpayers and therefore the VAT system is yet to fully perform its proper economic function as a consumption tax collected by business but passed on to the end-consumer. In addition, policy changes are regularly being made to remedy unintended consequences or gaps arising from the rules initially released.
Here we look at some of the specific issues affecting the financial and insurance services sector, and the real estate and construction sector.
The financial services and insurance industry is expected to transition to VAT from 2015, and the current thinking is that the VAT rate will be either 6 percent or 11 percent. The Chinese VAT system is expected to be amongst the first in the world to apply full VAT concepts to transactions in this sector.
The rationale for imposing VAT derives partly from the fact that BT currently applies to most financial services and insurance transactions (at a rate of 5 percent), so a loss of revenue would arise if the more traditional approach of exemption were to apply. The proposed imposition of VAT on bank lending activities is being watched with considerable attention internationally, and it will be interesting to see if other countries follow this lead. From a pricing perspective, one question will be whether the banks will absorb all or part of the VAT into their current interest rate pricing models, or whether they will simply pass it on. Clarity on this may take some time to emerge given that the introduction of VAT broadly coincides with the progressive relaxation of the regulated interest rate pricing mechanisms in China. One important consequence for business borrowers is that if the banks choose to absorb some or all of the VAT impost, then potentially those borrowers will benefit from a net reduction in their interest expenses after input VAT credits have been factored in.
For the insurance sector, recent proposals by the Ministry of Finance (MOF) suggest that VAT will apply at the rate of 6 percent to premiums for most forms of general insurance, while life insurance is expected to be exempt. From a claims perspective, it now seems less likely that the authorities will adopt models applicable in countries such as Australia, New Zealand, South Africa and Singapore under which input VAT credits (or their equivalent) can arise from the cash settlement of certain general insurance claims. Instead, recent proposals by the MOF suggest a move towards the adoption of a hybrid system where insurers’ claims-related costs are ineligible for input VAT credits, but non-claims related costs would be eligible. Drawing that distinction in practice will be a challenge for both insurers and the tax authorities.
The real estate and construction sector is also expected to transition to VAT during 2015, with a rate of 11 percent. There has been some media speculation that the rate could be as high as 17 percent, but that would seem to be unlikely given the potentially adverse impacts it could have on the property market in China. Indeed, one of the challenges in introducing a VAT for the property market is whether it will have an inflationary effect, or whether it will potentially detrimentally impact on demand during a time when the market is already showing signs of coming off a high, at least in many of the larger cities.
The scope of VAT in the real estate and construction sector is expected to be amongst the broadest in the world. A key reason for this is that BT currently applies to virtually all real estate transactions at the rate of 5 percent - whether those transactions involve residential or commercial real estate, sales of new or second-hand real estate, and whether by developers or private individuals.
When it comes to sales by private individuals, it is expected that a form of simplified VAT methodology will apply. That is, private individuals will be unable to claim input VAT credits for their purchase, but equally they will pay a reduced rate of VAT (expected to be 3 percent) on a subsequent sale.
A number of policy questions are raised by this approach, including:
The experience with VAT/GST systems in other countries suggests that these are not easy problems to resolve, and inevitably definitional problems will arise in practice.
Turning now to real estate funds, irrespective of whether they are holding residential property or commercial property, a key feature is that many development projects take place in China through the purchase and subsequent sale of an equity interest in a development entity. In some cases, the equity interest may be held through a chain of entities, some of which are located offshore. The question which this raises from a VAT perspective is whether there will be ‘look through’ rules which will effectively tax the underlying change of ownership or control of the real estate being developed. If so, how will that tax be calculated, disclosed and enforced?
A further issue is that in many cases, the equity in a development entity may be sold at a time when the development entity has a substantial input VAT credit balance arising from the works already completed. Absent any change of ownership or control rules which vitiate that credit balance, this is an asset of value which should be taken into account by the parties in calculating the price. These issues rarely arise in other countries because refunds of excess VAT credits are routinely given.
The Chinese VAT system is already exhibiting some distinctive characteristics which depart from pure theories of a VAT. For example, the existence of multiple VAT rates means that the nature of what is purchased may influence the ultimate tax liability of the business making the purchase – in other words, some purchases can be more valuable than others in generating credits. Additionally, the mindset of many businesses sits part-way between BT concepts (which recognize the tax as a P&L item) and modern principles of VAT (where the tax is intended to be passed on in the supply chain). The other major distortion is that businesses are generally ineligible to claim refunds of excess input VAT credits (except for certain exporters). As a consequence, issues that in other countries would give rise to minor timing concerns only can cause timing differences lasting decades long. The primary example where this is expected to arise is for real estate funds who lease the final product – substantial input VAT is incurred during development but the output VAT is generated over an extended period of time.
The real question is whether, in due course, the Chinese VAT system will exhibit more ‘typical’ characteristics of a VAT system. Looking ahead, the answer would seem to be yes. Over the course of the next few years, a number of changes could take place which should help determine that a more modern VAT system emerges.
Those changes may include:
The implementation of VAT in China in substitution for BT appears to be a step in the right direction. Policymakers’ focus to date has been on managing the transition as smoothly as possible, which has led to multiple VAT rates being applied, and a staged implementation process. However, over the next few years the policy-makers could shift their focus to the longer-term and address aspects of the Chinese VAT system requiring modernization or further development. The challenges of doing so are considerable, but potentially China could be left with the world’s leading VAT system given its unprecedented broad base.