On 30 June 2017, China’s Ministry of Finance (MOF) and State Administration of Taxation (SAT) jointly issued the ‘Notice of Issues on VAT on Asset Management Products’ (Circular Caishui  56, hereinafter “Circular 56”), which further clarifies the Value Added Tax (VAT) rules for asset management products, including the range of asset management products which are affected, methods for collection, filing and calculation of VAT. Circular 56 also postpones the commencement date to 1 January 2018. Together with the adoption of a more simplified VAT method, the difficulties in implementing the VAT policies for asset management products has been reduced. However, considering that asset managers still need to carry out a tax assessment of their assets, revise contracts, potentially restructure business flows, communicate with stakeholders and especially test and implement related systems changes, the timeframe for implementation by 1 January 2018 is still relatively short. In this China Tax Alert, we discuss the key implications of Circular 56 and the preparation that needs to be carried out before 1 January 2018.
On 30 June 2017, China’s Ministry of Finance (MOF) and State Administration of Taxation (SAT) jointly issued the ‘Notice of Issues on VAT on Asset Management Products’ (Circular Caishui  56, hereinafter “Circular 56”), which further clarifies the Value Added Tax (VAT) rules for asset management products, including the range of asset management products which are affected, methods for collection, filing and calculation of VAT.
By way of context, in December 2016, the MOF and SAT issued the ‘Notice on Clarification of VAT Policies for Finance, Real Estate Development, Education Support Services’ etc. (Circular Caishui  140, hereinafter “Circular 140”). Article 4 of Circular 140 said that the asset manager for asset management products (hereinafter “asset manager”) shall be the VAT taxpayer. In January 2017, the MOF and SAT issued ‘Supplementary Notice on Issues concerning VAT Policies for Asset Management Products’ (Circular Caishui  2, hereinafter “Circular 2”), which postponed the commencement date of Article 4 of Circular 140 to 1 July 2017. Circular 56 further postpones the commencement date to 1 January 2018.
After the issuance of Circular 140, especially after the issuance of Circular 2, a number of taxpayers started to prepare for the VAT reforms for asset management products. However, given that Circular 56 provides an additional 6 months’ time for preparation, together with the adoption of a more simplified VAT method, the difficulties of implementing the VAT policies for asset management products has been reduced. However, considering that taxpayers still need to carry out a tax assessment of their assets, revise contracts, potentially restructure business flows, communicate to stakeholders and especially test and implement related systems changes, the time for implementation by 1 January 2018 is still relatively short.
In this China Tax Alert, we will discuss the key implications of Circular 56 and the preparations that taxpayers need to consider in the coming half year.
Main content of new policy and KPMG observation and analysis
Below we analyze the main content of Circular 56 article by article, and share our observations.
Simplified VAT method
According to Circular 56, the simplified VAT method will temporarily be applied to the operation of asset management products (hereinafter “operation of asset management products”), with a VAT rate of 3%. The simplified VAT method means that output VAT at 3% will be payable on revenue, but no input VAT credits will be claimable for expenses.
There is no doubt that the simplified VAT method will reduce taxpayers’ compliance costs, as well as the difficulty of tax collection and administration from the perspective of the tax authorities. A number of issues related to claiming input VAT credits under the general VAT method now have disappeared after the release of Circular 56, e.g., whether the asset manager could issue invoices to itself on the asset management fees it charges, and whether the input VAT could be credited between different products. The rate of 3% will be also favorable to most taxpayers as the tax burden will usually be reduced compared with the rate of 6% under the general VAT method.
Importantly, Circular 56 points out that the simplified VAT method is “temporarily” applied to the operations of asset management products. Currently the VAT rules for the reforms are still in a pilot phase, and therefore the rules may change as the government moves towards the adoption of formal VAT legislation.
Further clarification on the definition of asset management products and who is an asset manager
Following the announcement of Circular 140, there was uncertainty amongst taxpayers as to the scope of the “asset management products” and “asset managers” which fell within the rules. However, Circular 56 seeks to clarify this by way of specific definitions as follows:
— Asset management products, includes bank financial products, trust funds (including collective funds trusts, single fund trusts), property trusts, public securities investment funds, specific client asset management plans, collective asset management plans, targeted asset management plans, private equity funds, debt investment plans, equity investment plans, debt-equity combination investment schemes, asset-backed plans, portfolio insurance asset management products, pension management products.
— Asset managers include banks, trust companies, public fund management companies and their subsidiaries, securities companies and their subsidiaries, futures companies and their subsidiaries, private equity fund managers, insurance asset management companies, professional insurance asset management agencies, pension insurance companies.
For those which are not specifically listed in Circular 56, the MOF and SAT also state that the definition of other asset managers and asset management products will be determined by the MOF and SAT.
For asset management products which are not clearly within scope, it is suggested that they communicate with their in-charge tax authorities and make a judgment in line with the relevant regulations.
Differentiating asset management products from other business activities
Circular 56 draws a distinction between “asset management products operation” and “other business” activities. In order to facilitate the distinction, the scope of what is subject to the 3% simplified method is asset managers in relation to “asset management products operation”. Management services provided for fiduciary assets under commission or trust, as well as asset managers’ other VAT taxable activities which are not related to the operation of asset management products, are stated as “other business” in Circular 56.
As to asset management products operation, the simplified VAT method will be temporarily adopted with the tax rate of 3%. However, asset managers still need to determine the VAT treatment on the gains from investment, based on the rules related to whether the gain is principal protected and whether the investment was held to maturity, as provided by Circular 140. They also need to take into account other tax policies such as VAT exemptions.
As to other business, asset managers must pay VAT based on the related valid VAT reform policies. Circular 56 specifies that management services provided for fiduciary assets under commission or trust should be recognized as other business, and service fees such as management fees, sales fees and custody fees paid to asset managers should be subject to the VAT rate of 6% and they will be eligible for related input VAT credits, provided that the asset manager is registered as a general VAT taxpayer.
Circular 56 also indicates that asset managers should separately compute the revenue and VAT for their operations of asset management products from other business activities. Where taxpayers do not compute the tax separately, the simplified VAT method is not applicable to the operation of the asset management products. For asset managers, this requirement is consistent with the content of other current supervisory regulations – to distinguish the asset management products from other business activities, maintain separate accounting ledgers, and carry out separate accounting.
Clarify how to account for sales amount and VAT payable for operating of asset management products
According to Circular 56, the asset manager may account for the sales amount and VAT payable on a product-by-product basis or on a consolidated basis in relation to the operations of asset management products.
Although asset managers are empowered to choose either of the above two accounting methods when accounting for the sales amount and VAT payable, a difficulty for asset managers in practice is that how to evaluate the feasibility of applying each method.
It is suggested that asset managers shall focus on the implications of the two alternative accounting methods depending on whether they are carrying on lending activities or trading of financial products (given these are the two most common activities associated with asset management products):
- Lending activities
According to Circular 36, the sales amount from lending activities includes interest and other income of an interest nature. It is relatively easy to account for the VAT payable from lending activities as the output VAT is imposed on the gross revenue (i.e. there is no deduction item). Therefore, applying different methods will not trigger differences in the recognition of the sales amount and VAT payable from asset management products. As such, irrespective whether applying a product-by-product approach or a consolidated approach should not produce a different outcome.
- Trading of financial products
Circular 36 applies VAT to the net gains derived from financial products, which is calculated by deducting the purchase price from the selling price. Circular 36 allows businesses to carry forward their trading losses to the next filing period within the same accounting year, but not to the next year. Therefore, as gains derived from trading of financial products are calculated on a net basis, and trading losses cannot be carried forward to the next calendar year, the consolidated method is expected to have a different impact from a product-by-product method for asset management products.
Under the product-by-product accounting method, the trading losses of certain products can only be carried forward to offset gains derived by the same product in future periods. Therefore, potentially some of the products managed by one asset manager may have trading losses at year end or at product clearance stage, which cannot be carried forward. Under the consolidated accounting method, the trading losses of a certain product could be used to offset gains of other products managed by the same asset manager. From a tax cost perspective, this method could realize tax savings in an overall sense. However, it should be noted that, if an asset manager adopts this method, the tax costs will be shared among all products. Asset managers must consider whether this is in line with the regulatory requirements on the management of products, as well as the feedback of investors of different products. Specifically, whether this effectively involves co-mingling of asset management products.
In addition, asset managers will also need to carefully review the allocation of the tax costs among different products if net gains derived from different products are calculated on a consolidated basis.
From an implementation perspective, given regulatory requirements require that each product shall be accounted for separately, if an asset manager chooses to account for VAT on a product-by-product basis, it will be fully consistent with the regulatory requirements. Moreover, it will be relatively easier for the asset manager to leverage its own VAT reform experiences when applying VAT to its products. However, if an asset manager chooses to account for VAT on a consolidated basis, it needs to consider how it will comply with regulatory requirements. As a result, asset managers may need to establish a set of tax accounting books or similar records to calculate and record VAT for each product as well as VAT accounting treatments across products (if any) in case of any potential review conducted by the tax authorities afterwards, and also, these records could be used for internal management purposes.
It should be noted that, Circular 56 does not provide detailed implementation instructions on how to account for the sales amount and VAT payable on a product-by-product basis or on a consolidated basis. There are still some implementation issues which need to be further clarified. Such as, whether an asset manager is empowered to account for VAT on a consolidated basis for some products, while accounting for VAT on a product-by-product basis for other products? Similarly, if an asset manager adopts one accounting method, whether it could change to another accounting method later? In addition, as the two accounting methods may have different impacts on asset management products, we are also expecting feedback and guidance from other industry regulatory authorities.
VAT filing on a consolidated basis
Circular 56 stipulates that the asset manager should perform VAT filing for the operations of asset management products and other businesses on a consolidated basis. This means an asset manager acting in respect of each asset management product will not be registered as a VAT taxpayer and neither will it be required to perform VAT filing separately. An asset manager will instead file VAT returns for the operation of asset management products and other businesses on a consolidated basis under its own tax registration number.
Circular 56 does not provide detailed instructions on how to complete VAT returns. For example, how to fill in the sales amount and VAT payable in relation to the operations of asset management products. Taxpayers should follow the existing filing instructions to file the VAT returns for the operations of asset management products unless a further implementation rule is released.
Moreover, Circular 56 maintains the same treatment when defining the obligations of asset managers, that is, the asset manager shall be the VAT taxpayer in its own right. This, however, is different from the understanding of many industry participants, where there is a tendency to interpret the rules as only requiring an asset manager to withhold VAT on behalf of the investors for the VAT taxable income generated from the asset management products. Although the gap in understanding will not impact the fact that VAT will be paid for asset management products, there is a concern that it could impact which party should bear the VAT burden, and therefore price negotiations and obligations as between asset managers and investors.
Implementation date and offset treatment of VAT paid
After the release of Circular 2, the MOF and the SAT conducted several rounds of discussions with asset managers, industry associations and regulatory authorities. As noted, Circular 56 further postpones the implementation date to 1 January 2018, which provides more time for taxpayers to prepare.
It should be noted that the implementation of Circular 56 on a certain product does not depend on the establishment date of that product. Instead an asset manager will need to check whether the operation of a certain product will extend to 1 January 2018. In other words, asset managers should pay VAT for products which are established before 1 January 2018 and are still in operation on or after 1 January 2018.
Circular 56 also provides that for taxable activities which occur before 1 January 2018 and where VAT has not been paid for such activities, then there is no need to pay VAT for those taxable activities. Where taxable activities occur before 1 January 2018 and VAT has already been paid, the amount of VAT paid could be used to offset the amount of VAT payable of the asset manager in the subsequent filing months.
Uncertain issues to be clarified
Circular 56 clarifies that the simplified VAT method shall be applied to asset management products, the scope and range of products and asset managers as well as other issues. However, Circular 56 leaves a number of issues unresolved or uncertain following the release of Circular 140, including:
- How to determine whether income is derived from principal protected or non-principal protected products? Since this is the criterion to determine whether it is subject to VAT as a loan service (i.e. only principal protected products are a loan service), uncertainty in the terms used in an agreement could possibly lead to different VAT treatments. For example, for asset management products where the agreement contains redemption clauses, or guarantee terms, whether the income derived from these products would be described as having “the principal… fully recovered upon maturity upon contract terms” as stated in Circular 140, and therefore could be further treated as income derived from principal protected products and subject to VAT?
- How to differentiate whether assets are “held to maturity” from “trading of financial products”? This distinction matters because the income will not fall within the scope of financial products trading if it is held to maturity. Instead, such income would be subject to VAT as a loan service if it is principal protected, or not subject to VAT if it is considered as non-principal protected. In this context the uncertainty arises where certain funds, trusts and other asset management products do not have a specific maturity date, or the holding period may last for several decades. Whether the fund redemption conducted by the fund issuer during the holding period should be treated as a “trading of financial products”? Another example is where the product contract provides for product termination clauses without a fixed maturity date, e.g., mandatory redemption will be triggered once the termination clause is satisfied.
- The detailed scope and range of asset management products. For example, whether private investment funds includes both private equity investment funds and private security investment funds? According to the Provisional Measures on Supervision and Administration of Private Investment Funds (Circular Zhengjianhuiling No.105), private equity investment funds are also categorized as private investment funds. Given partnership private equity investment funds are required to pay VAT at a rate of 6%, this may result in a tax burden discrepancy compared to other private investment funds. In addition, whether domestic investment income gained by offshore asset management products should also apply the simplified VAT collection method?
- Treatment of special assets. For example, whether the income derived from investing in structured deposits should be treated as deposit interest or investment income? Whether the income derived from the exchange and transfer of income rights and stock transfers traded at the National Equities Exchange and Quotations (NEEQ) should be treated as the trading of financial products? How to calculate the taxable income of convertible bonds, bonds with attached warrants, exchangeable bonds?
- Whether the asset manager is a financial institution or not. For example, whether an asset management product is managed by a financial institution could enjoy the benefit of the inter-bank VAT exemption (for instance, the asset manager could apply for VAT exemption in relation to the interest income derived from financial bonds) since its asset manager is defined as a financial institution from a VAT perspective? If an asset manager invests in other asset management products issued by financial institutions, and this investment is deemed as principal protected investment, is the income derived from such investment eligible for VAT exemption?
- Treatment of offshore investments. For example, whether income derived from investment in offshore assets is subject to VAT? Could the simplified VAT collection method apply in this situation?