China has two major kinds of turnover taxes—Value Added Tax (“VAT”) and Business Tax (“BT”)—which apply in different scopes of transactions. Generally speaking, importation and sales of tangible and movable goods, services of processing, repairing or maintenance are subject to VAT. The advantage of VAT is that, under the Output-Input Credit System, input VAT can be credited or deducted. But the disadvantage is that the procedure of operation is complex and requires a high standard of accounting system of the business. Also, taxable labor services (most of labor services except for services of processing, repairing, and maintenance), transfer of intangible assets, and immovable property are subject to BT. The calculation and payment of BT are much simpler than VAT, but BT is likely to lead to double taxation as BT cannot be deducted by the customer. Considering the situation above, BT will be gradually replaced by VAT in order to reduce the tax burden of Chinese businesses in the future. A pilot tax reform program stipulates that the BT payer in Shanghai engaging in some industries shall pay VAT instead of BT as of January 1, 2012. We will introduce this tax reform to you and analyze the relevant impacts on the tax burden and the copying strategies.

I. Scope of tax reform

In 2011, PRC tax and finance authorities issued a series of circulars to start this BT-VAT reform. In accordance with Caishui [2011] No.110 (“Circular 110”) and No.111 (“Circular 111”), as of January 1, 2012, some of the taxable services, which are provided by a taxpayer registered in Shanghai or provided by foreign entities to their customers registered in Shanghai, shall be subject to VAT instead of BT. The pilot taxpayer whose office is located in Shanghai shall pay VAT at the Shanghai local tax bureau. And the BT paid by the Shanghai pilot taxpayer at other areas in China can be treated as input tax to be credited against the output tax. However, non-pilot taxpayers engaging in businesses in Shanghai still need to pay BT in accordance with the current valid BT rules.

II. General VAT Payer and Small-Scale VAT Payer

PRC tax authority has divided Chinese VAT payers into general VAT payers and small-scale VAT payers. There are some requirements for being a general VAT payer. For instance, annual turnover shall be more than RMB 5 million, and the VAT payer shall have proper accounting records. If a VAT payer fails to meet these requirements, it shall be a small-scale VAT payer. In accordance with VAT regulations, the general VAT payer shall apply to General Taxation Method and the small-scale VAT payer shall apply to Simple Taxation Method for calculation of tax. The general VAT payer is granted a right to issue the VAT invoice (VAT Fapiao) to the customer and also can credit input VAT invoice issued by the general VAT payer provider against its output tax upon General Taxation Method. However, the small-scale VAT payer neither has a right to credit input tax against output tax by using the input VAT invoice nor is eligible to issue the VAT invoice.

General Taxation Method is as follows:

Tax Amount Payable = (Tax-exclusive Sales × Tax Rate) – Input Tax Amount

And Simple Taxation Method is as follows:

Tax Amount Payable = Tax-exclusive Sales × Levying Rate

Based on these formulas, we see that VAT rates (including Tax Rate and Levying Rate) and the tax burden have a direct relationship, and Input Tax Amount and the tax burden have an inverse relationship (applicable only to the General Taxation Method).

In accordance with Circular 111 and relevant regulations, different taxable services and VAT payers shall apply to various VAT rates instead of BT as of January 1, 2012 (please see chart below). VAT rates of 17%, 13%, 11%, and 6% known as “Tax Rates” apply to the general VAT payer and the foreign provider, VAT rates of 3% known as “Levying Rate” apply to the small-scale VAT payer, and VATs rate of 0% apply to the taxpayer who exports goods or services to a foreign entity. BT rates are 5%–20% (only for entertainment industry), 5%, and 3%. 

How can we assess the impact of the reform program? Is the tax burden reduced or increased after it? We need to compare the current tax burden of a business as a VAT payer with that of the business as a BT payer before the reform.

1. The business becomes a general VAT payer from a BT payer

1. If the provider of the business is also a general VAT payer, the change of the tax burden of the business depends on Tax Rates and the amount of input VAT from the provider. The general VAT payer provider can issue a VAT invoice to the business. So if the business becomes a general VAT payer, it can credit the input tax against the output tax by using the VAT invoice issued by the provider. Based upon Output-Input Credit System, input VAT is not taxable and cannot be considered as the real cost of the business. In the past, as a BT payer, the business could not credit the input tax, so this would reduce the tax burden. However, VAT Tax Rates are higher than BT rates. This might increase the tax burden. To sum up, Tax Rates and the total amount of input, VAT will jointly influence the tax burden of the business and we need to analyze the impact case by case.
2. If the provider of the business is a small-scale VAT payer or BT payer, the tax burden of the business will be increased. The provider as a small-scale VAT payer or BT payer cannot issue the VAT invoice, so under this circumstance, the business cannot obtain any VAT invoice to credit input VAT against its output tax. This does not change the tax burden. However, Tax Rates are higher than BT rates, so the tax burden of the business shall be increased.
3. If the provider of the business is a foreign entity, this business should withhold and pay the VAT for the foreign provider who has no agent in China, and the change of the tax burden of the business depends on Tax Rates and the amount of input VAT. The business should be subject to Tax Rates which are higher than BT rates, so this might increase tax burden. But, in accordance with related regulations, tax bureaus will issue the General Tax Payment Voucher upon the payment of VAT, and the business can credit input tax which is equivalent to the tax payment on the General Tax Payment Voucher against its output tax. In other words, the General Tax Payment Voucher has a similar function of the VAT invoice, so this would reduce tax burden. Therefore, the change of the tax burden will be influenced by Tax Rates and the total amount of input VAT.

2. The business becomes a small-scale VAT payer from a BT payer

No matter if the provider of the business is a Chinese taxpayer (including the general VAT payer, small-scale VAT payer, and BT payer) or a foreign provider, the tax burden would be decreased or remain the same. Neither a small-scale VAT payer (current status) nor BT payer (status in the past) can credit the input VAT against its output, so there is no change on the tax burden. However, if the business becomes a small-scale VAT payer, it shall pay VAT by a constant Levying Rate of 3% which is less than or equal to BT rates, so the tax burden of the business is reduced or remains the same.

3. Exportation of trade in services

Circular 110 stipulates a general rule that exportation of services apply to zero-rate or VAT exemption. Specifically, Caishui [2011] No.131 (“Circular 131”) provides that exportation of international transportation services, research and development services, and design services shall apply zero-rate. Also, for exportation of most other taxable services listed in Circular 131, VAT exemption applies. Please note that zero-rate is different from exemption. Exemption just means that there is no VAT paid in exportation, but zero-rate means all VAT paid before the exportation shall be refunded, which means that the price of the goods or services do not contain any VAT when they are exported. Prior to the reform, the exportation of most taxable services was subject to BT. Therefore, the tax burden of the business who engages in exportation of services shall be reduced.

4. BT incentives

Regarding BT incentives, there is also a transitional arrangement in Circular 110 that BT incentives can still apply but would be subject to changes in the future. As this BT-VAT tax reform is a tax reduction program, the business that enjoyed BT incentives in the past does not need to be concerned.

IV. Coping Strategies

Given these significant changes, we suggest that related business should adjust its structure to enjoy the benefits of the tax reform. A business has to assess and calculate a balanced point based on its characteristic of industries, position in transactions (provider or customer), applicable rate, and the amount of input VAT so that it can make an informed decision whether the business will become a general VAT payer or small-scale VAT payer.

For example, if a transportation business can obtain enough input VAT which can neutralize or exceed the increased tax burden caused by the rise of tax rate from 3% to 11%, it shall become a general VAT payer. As a general VAT payer provider, the business might have some advantages over small-scale VAT payer providers. For example, the customer can use a VAT invoice issued by a general VAT payer provider to credit its input against output for tax reduction purpose.

Until now, the BT-VAT pilot reform program only applies in Shanghai and is limited to several industries, but we believe that it will expand to other areas in China and all industries in the near future. We suggest that you consult with your tax consultants or lawyers regarding this tax reform and update your tax planning strategies.

The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.