KPMG’s response to China’s tax reform initiatives
KPMG’s response to China’s tax reform initiatives
KPMG welcomes today’s announcement by China's Premier Li Keqiang to the National People’s Congress to replace the existing Business Tax (BT) system with a modern Value Added Tax (VAT) system, with effect from 1 May 2016.
Lachlan Wolfers, KPMG China’s Head of Indirect Taxes, says: “This is a significant and positive development as China will have one of the most progressive VAT systems in the world.”
While Premier Li’s announcement precedes the release of detailed implementation rules (which are expected shortly), the main industries affected by the changeover, and the expected VAT rates are:
- Real estate and construction services – 11% VAT to replace the current 5% BT and 3% BT respectively;
- Financial services and insurance – 6% VAT to replace the current 5% BT; and
- Food and beverage (F&B), hospitality, healthcare and other lifestyle services – 6% VAT to replace the current 5% BT.
The change will result in a unified VAT system in China for the first time for both goods and services.
Given the potential economic impact of these measures, Premier Li emphasised in his announcement that the VAT reforms will not increase the tax burden impact on industry, which has been a major concern for the real estate industry given its significantly higher VAT rate. According to a December 2015 report by China International Capital Corp Ltd (which is China’s first joint venture investment bank), the overall tax savings for business from the VAT reforms are expected to reach RMB 900 billion (approximately 0.4% of GDP) by the time all industries have transitioned to VAT.
China’s VAT system to be watched by the rest of the world
The announcement by the Chinese government contains a unique feature – China will be among the first countries in the world to apply VAT broadly to the financial services sector. That means that interest on loans made to businesses and consumers alike will now be subject to VAT. “To the best of our knowledge, there are only one or two relatively small economies in the world which have even tried this,” says Wolfers.
The implications of this change will be widespread – for example, every time a bank charges interest on a loan to a customer, or there is a gain made from trading in financial products such as stocks, bonds or foreign exchange transactions, or an insurance premium is levied on a customer, VAT will apply.
“The European Union has spent years studying whether VAT could be applied to financial services, and have not been able to implement it. However, in applying VAT to financial services in China, it shows that it is possible. It would not be a surprise to see other countries following suit if the Chinese do it successfully.”
Why is the change occurring?
The transition from a BT system to a VAT system is part of a broader transition in China from a manufacturing based economy to a service based economy. The BT system was regarded as being inefficient and antiquated because BT was quite literally a tax on business. By contrast, the adoption of a modern VAT system should better promote the development of the services sector because it is a tax collected by business, but ultimately only imposed on the end consumer.
“Business tax was a cascading tax in the sense that the tax applied to each stage of the supply chain. It was a real cost of doing business either in China, or with Chinese service providers. However, the changeover to VAT means that, over time, indirect taxes will no longer be a cost of doing business. Through a system of giving credits to businesses for their purchases to offset the tax they pay on their sales, ultimately the net effect is that the tax is only really levied on the final price charged to the end consumer,” says Khoon Ming Ho, Partner, Head of Tax, KPMG China.
“While there will inevitably be some short term challenges to businesses in getting ready for the transition to VAT, over time the adoption of a more modern system will benefit the economy as a whole,” he adds.
Wolfers explains: “One issue which is not often acknowledged is that the adoption of a unified VAT system in China should (over the long-term) improve overall tax collections for the government, with tax evasion through the undisclosed transactions likely to decrease. Under the old system, there was no real incentive for businesses in the services sector to get VAT invoices when purchasing goods, and likewise no real incentive for businesses selling goods to get invoices when they bought services. “Now the whole chain is strengthened since every business which is paying VAT will want official invoices for their purchases so they can claim credits. Tax evasion through undisclosed transactions is likely to take a real hit with these changes.”
Key impact on multinational businesses
Many multinational companies doing business in China will likely applaud the changes, given that the adoption of a broad-based VAT system is in line with indirect tax systems in approximately 160 countries around the world. The main VAT rates in China – 6%, 11% and 17% - all compare favourably with the average rate among OECD countries of 19.1%. [Source: OECD’s Consumption Tax Trends 2014]
There are three key impacts for multinationals doing business in China:
- Businesses in the traditional manufacturing, wholesaling and retailing sectors can now claim VAT credits for the services they purchase. In many cases, this means an immediate 5% reduction in the cost of those services, so this is a really positive change.
- Businesses in the services sector will be eligible to claim VAT credits for the goods and other fixed assets they purchase. So this means that the effective cost of say investing in a new IT system, or the purchase of other major fixed assets, may fall by up to 17% as a result of these changes.
- Businesses in China providing services to overseas may no longer be required to pay VAT. This compares favourably with the current BT system where a 5% tax cost was typically incurred. Similarly, the real cost of a Chinese business purchasing services from overseas should also fall by up to 5% since they will be eligible for a VAT credit for the first time.
Businesses affected by these changes have only a short time to prepare for the changes. The implementation of VAT often requires modifications to IT systems, changes to pricing, to legal contracts, to business processes, and supply chains. In short, this is more than just a tax change – this is a substantial business change.
Key impact on consumers and business
The most significant issue for consumers is the impact the new 11% VAT rate will have on real estate transactions. “Everyone is wondering whether it will result in real estate prices increasing, or whether it will result in reduced profits and returns for developers and investors because of the higher tax rate, says Wolfers.
“While we are still awaiting the detail, Premier Li’s announcement specifically referred to the need for the government to manage the tax burden impact on business, with Premier Li confirming that input VAT credits would be available for “newly added” real estate assets by businesses” says Wolfers.
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