Chinese Premier Li Keqiang released a government work report as part of the ‘two sessions meeting’ on 5 March 2019 in which it announces that the current 16% and 10% VAT rates applicable to the supply of certain goods and services would be reduced to 13% and 9% respectively. This change will certainly bring welcome relief to businesses and consumers, and represents a significant step by the government to enhance economic activity in certain sectors, and reduce the overall tax burden impact.
The Chinese government has a long history of using its VAT system as a key tool in managing the economy, and this announcement is no exception. With this announcement, the government will have reduced the headline VAT rate by nearly 25% over the past 12 months – initially from 17% to 16% (with effect from 1 May 2018) and now from 16% to 13%. Once completed, China’s headline VAT rate will be significantly below the OECD average rate of 19%.
It is important to recognise that this significant rate reduction likely represents the first step only in a broader process of reforms of the Chinese VAT system. In particular, it is expected during 2019 and 2020 that the government will seek to reduce the number of VAT rates from three rates (being 6%, 9% and 13% as a result of this announcement), down to two rates. The government is also expected to upgrade the status of the VAT rules to formal legislation and implementation rules. The question which remains is whether (and to what extent) the government uses the VAT legislative process as an opportunity for further reforms, including in better aligning China’s VAT system with OECD principles.
In addition to the rate reduction, there will also be preferential treatments available, such as an increase to the credits to manufacturers and lifestyle related service providers, to ensure the tax burden of all the taxpayers is reduced. Details are expected to be issued by the policy makers shortly.
While at first glance this VAT rate reduction announcement may not seem challenging from a tax implementation perspective, as this Alert highlights, there are many issues for businesses to consider.
Date of effect
Premier Li’s announcement does not mention a specific commencement date for the new rates to take effect, though he does reference it happening during 2019. Further detail in the form of a Circular should be expected shortly. Based on a similar experience in 2018, taxpayers may expect the rate reduction to take effect quickly, likely within the next few months. Consequently, taxpayers will need to take action to get ready for the new rates, both from a business and systems perspective.
The government’s work report refers to the proposed new 13% rate applying to manufacturing, and it also refers to the 10% rate applying to transportation and construction activities. However, it does not mention whether these rate reductions will apply to all types of goods and services which are currently subject to the 16% and 10% rates.
If history is a guide here, it may reasonably be expected that the rate reductions will apply more broadly to all sectors currently paying VAT at these rates, as happened when a similar announcement was made back in March 2018 (when the 17% and 11% VAT rates were reduced to 16% and 10% respectively). This would seem to be necessary to achieve the government’s objective of reducing (rather than expanding) the number of VAT rates in existence. Furthermore, it is difficult to see how such rate reductions could be ring-fenced to particular stages of economic activity, recognising also that if the objective is to stimulate economic activity amongst consumers, then any rate reduction needs to flow through to the retail sector. For these reasons, we anticipate that the rate reductions will apply more broadly.
On the assumption this is confirmed in a later announcement, then we would expect
|Applies to:||Current rate||New rate to take effect during 2019|
|Sales of goods, importation of goods, leasing of tangible movable property,Repair and processing services||16%||13%|
|Transportation services, sales and leases of immovable property, basic telecommunications services, construction services, postal services, agricultural products and water and gas supplies||10%||9%|
|Financial services, modern services (including Research and Development and technical services, information technology services, cultural and creative services, logistics services, logistics and ancillary services, certification and consulting services), and lifestyle services (including cultural and sports services, education and healthcare, travel and entertainment, food and beverage, accommodation and citizens daily services)||6%||6%|
The government’s work report indicated there would be no change to the 6% VAT rate. However, it did refer to a desire to ensure a reduced tax burden impact. No specific details are provided at this stage. Whilst speculative, even industries paying output VAT at 6% should benefit in the form of price reductions for many of their inputs which will bear VAT at 13% and 9% - for example, in the rent they pay, in the equipment they use in their business, and other general overhead costs.
While businesses and consumers will no doubt be pleased with the reduction to VAT rates, especially the reduction in the main 16% VAT rate to 13%, it is important to recognize that this is likely a first step in a longer-term process by which the government will reduce the number of VAT rates in operation from three rates, and in upgrading the status of the VAT rules to legislative form. While the 6% VAT rate was unchanged as a result of this announcement, it is perhaps too early to speculate whether the two rates will end up being 13% and 9%. Key to the success in implementing these rate changes for business is not only to focus on the impact on their outputs, but also to ensure the tax burden reduction flows through in the form of lower prices for their inputs. This will often require negotiation with suppliers.
It is important to recognize that a reduction in these two VAT rates of 16% and 10% to 13% and 9% respectively can still give rise to significant implications for businesses. Specifically, businesses need to consider the following issues, many of which will likely require further clarification pending the implementation rules and also from the tax officials. While the date of effect of the new rates is yet to be announced, even then, the precise impact will need to be carefully worked through:
|Time of supply||
Even when the date of effect of the new rates is announced. It will need to be determined whether it applies by reference to:
(a) When the supply was made;
(b) When the supplier was required to account for the output VAT; or
(c) When the special VAT invoice was issued.
This will need to be clarified. When similar changes have taken place in China, the general principle has been to apply the approach in paragraph (b).
|Advance payments||Issues will arise as to whether advance payments received before the date of effect for the purchase of goods or services which take place on or after date of effect are subject to the new VAT rates or the current VAT rates. The travel industry is a primary example where customers may pre-book and pre-pay flight tickets well before travel occurring after the date of effect.|
|Deemed sales||Where a supplier buys goods before the date of effect (and claims an input VAT credit at 16%), an issue arises as to the applicable VAT rate under the deemed sales rules if those goods are given away on or after the date of effect.|
|Goods returns||Goods sold before the date of effect but returned on or after the date of effect will need to be issued with a red-letter invoice to cancel the supplier’s output VAT and recipient’s input VAT at 16%, not 13%. But when goods are returned and replaced, issues will arise in practice as to whether or not that is a new supply subject to 13% VAT taking place on or after the date of effect. Similarly, suppliers may anticipate some impact on demand as customers hold off purchasing major items until the date of effect to benefit from the lower VAT rates.|
Contracts which provide for VAT to be added to the price can readily adjusted to reflect the new VAT rates simply by adding say VAT at 13% (or 9%) instead of 16% (or 10%).
However, contracts in which the price is inclusive of VAT may give rise to commercial uncertainties as to whether the reduction in rates needs to be passed on to the service recipient or not. This will often be a matter for negotiation between the parties.
Given the potential for VAT rates to change again in the future, especially as a result of a move to a two rate structure, it does highlight how VAT-inclusive pricing can be problematic.
|Pricing||Businesses with advertised or displayed pricing will likely need to consider changing their displays so as to pass on the tax savings to customers – otherwise it may detrimentally impact on their market competitiveness.|
|Annual price lists||It is common in certain industries for suppliers to agree or advertise prices on an annual basis at the commencement of each year, say by way of a standard rate card. Where this occurs, questions will arise as to whether those annual price lists should be revisited in light of the reduction in VAT rates.|
|Trading stock||Businesses may be in the position of having purchased trading stock on hand at 16% VAT, but then sell that stock on or after the date of effect with a lower 13% VAT rate.|
|Rebates and discounts||It is common that volume rebates and discounts are applied to the price of the next sale transaction or invoice amount, rather than the current sale (which would then necessitate the issuance of a ‘red letter’ invoice). If a rebate or discount is earned before the date of effect but then applied to a sale on or after the date of effect, the value of the ‘credit’ is effectively reduced.|
|Rounded pricing||It is common in certain industries for the prices of various products to be rounded to particular amounts, such as RMB1, or for pricing to be targeted at specific amounts such as RMB888. In these instances, a reduction in the VAT rate may not necessarily result in a price reduction and therefore increases the seller’s margin. This will be a commercial decision to be made on a case-by-case basis.|
|Purchase of immovable property||Circular Caishui  36 provides that purchases of immovable property and construction costs for immovable properties are potentially eligible for a staged 60% input VAT credit in year 1 and a 40% input VAT credit in year 2. When the date of effect straddles this 2 year period, there is an issue as to whether the input VAT credit is calculated for year 2 at the 9% rate or at the original 10% rate. The latter would seem more appropriate.|
|Change in use of capital assets||Circular Caishui  36 also provides for adjustments to input VAT credits based on the change in use of capital assets – for example, where the use changes from a creditable to a non-creditable purpose (or vice versa). The question is whether those changes should be calculated at the new VAT rates or the originally applied VAT rates. Again, the latter would seem more appropriate.|
|Refund rates for exports of goods||While exports of goods are zero rated, there are different VAT refund rates applicable to the inputs, depending upon the HS code of the goods being exported. The current VAT refund rates are 0%, 6%, 10%, 13% and 16%. These refund rates will presumably need to be adjusted in light of the announcement.|
|Systems changes||Businesses will need to ensure they have additional tax codes in their systems to recognize both output tax and input tax at 13% and 9%.|
For assistance with these issues, please contact a member of our VAT team or your usual KPMG adviser.