By Chet Scheltema, Manager, Dezan Shira & Associates
China initiated Value-Added Tax (VAT) reform with a pilot program in Shanghai in 2012, expanded it nationwide to selected industries in 2013, and continues to extend the reform into previously untouched sectors. The railway transportation and postal sectors were recently included, and the real estate and financial sectors are expected in the coming year.
China’s VAT system is complicated and contains pitfalls to the unwary. Failing to effectively navigate the system can result in the assumption of substantial tax liabilities that would consume what may already be thin profit margins. One is well advised to obtain the services of tax professionals well-versed in China’s VAT intricacies. Two pitfalls to the unwary that have recently come to the fore are the difficulty in qualifying for general VAT taxpayer status because an enterprise’s office premises do not satisfy certain tax bureau’s unwritten or “soft” standards and because the quota of VAT invoices granted to a taxpayer may be inadequate to meet the taxpayer’s commercial needs.
Introduction to the Chinese VAT System
Chinese Value-Added Tax is imposed on nearly every business transaction not specifically exempted or excluded, and the tax ranges from 3 percent to 17 percent. However, it is possible to reduce this potentially substantial tax burden through a simple process whereby “input VAT” is used to offset “output VAT.” For instance, if a trading company or manufacturing company purchases goods (and shoulders the burden of a 17 percent VAT), it could qualify to use such paid-out VAT (“input VAT”) as a type of credit to offset its VAT liability when it sells goods. Obtaining the qualification to use “input VAT” to offset “output VAT” is the key to lightening the potentially heavy burden of the VAT. Those companies that obtain this status are called “general taxpayers” or “general VAT taxpayers.”
General VAT Taxpayer Status
A Chinese foreign invested enterprise could become a general VAT taxpayer at two points in its history. One moment is when the taxpayer’s annuals sales revenue (12 months of cumulative sales) reaches a certain threshold, in which case it is obligated to become a general VAT taxpayer.
- RMB 5 million (US$ 800,000) for a services company
- RMB 0.8 million (US$ 130,000) for a trading company
- RMB 0.5 million (US$ 80,000) for a manufacturing company
The other time that a foreign invested enterprise could qualify for general VAT taxpayer status is at the time of its initial establishment without reference to any sales revenue threshold.
Because a newly established enterprise does not have a financial record of revenue generation, it is more difficult for tax authorities to assess the suitability of the enterprise for general VAT taxpayer status. An enterprises could conceivably obtain and abuse such status by selling the tax invoices issued in its name at discounted rates, which invoices could then be used by others to evade the payment of taxes in full and for deduction purposes.
Because of such taxpayer abuse of benefits associated with being a general VAT taxpayer, tax authorities have begun to identify indicators of potential fraud and to use unwritten or “soft factors” in assessing the suitability of an enterprise for general VAT tax payer status. These factors include such things as the amount of the enterprises official “registered capital” and the apparent legitimacy of the company’s business based upon the persuasiveness of the presentation made to the tax officer reviewing the application. They also include factors related to the apparent size and strength of its operations. For instance, if there is a sizeable office or assembly space populated with numerous employees, then the tax inspector will be more likely to believe the business is a legitimate enterprise. In contrast, if the enterprise’s office space is small and inexpensive and appears unoccupied, then the tax assessor may develop concerns about the legitimacy of the operation and may reject the application for general VAT taxpayer status.
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Whether a low cost, minimalist office space provided by a serve-office landlord will satisfy tax bureau officers’ unwritten, “soft” requirements is obviously hard to predict and such uncertainty has become a matter of concern to applicants for general VAT taxpayer status. Some Chinese tax bureaus have recently taken a hardline and refused to grant general VAT taxpayer status when the office space provided is located within one of these pooled office spaces. And once general VAT taxpayer status has been rejected, it can become very difficult to overcome the initial objection of the tax bureau and persuade officials to reverse their decision. In such an instance, the enterprise would only become a general VAT taxpayer status if and when its annual sales volume reaches the thresholds identified above. Meanwhile, the enterprise would be subject to VAT rates of between 3 percent and 17 percent with no ability to offset “output VAT” with “input VAT.”
In order to increase the odds of tax bureau inspectors approving an enterprises application for general VAT taxpayer status, the following suggestions are offered:
- Understand the unwritten or “soft” requirements of the relevant tax bureau and prepare to attempt to satisfy them;
- Inquire of local tax experts to understand these unwritten standards and how best to negotiate with the relevant tax bureau;
- When selecting an office or rental space, investigate the record of successes and failures of similarly situated renters in achieving general VAT taxpayer status;
- Prepare a work space that has every appearance of legitimacy, including by having as much equipment as possible and populated by as many busy employees as possible;
- Reconsider merely renting the cheapest office space available to satisfy the corporate registration requirements, lest the enterprise risk failure in its application for general VAT taxpayer status.
VAT Monthly Quota
In order for an enterprise to avail itself of the benefits of general taxpayer status, i.e., use “input VAT” to offset “output VAT” and thereby reduce its overall tax burden, the enterprise and its business partners and vendors need to be able to issue each other invoices or “fapiaos,” which would include “input VAT” invoices, otherwise known as “special VAT invoices.” These would ideally be issued in an amount equal to the full taxable value of any transaction between the transaction partners, otherwise “input VAT” tax credit may be lost and also tax deduction credits lost.
Unfortunately, a newly established enterprise may initially only be given a very limited monthly invoice quota, and increasing the invoice quota is often difficult and involves making special application to the tax bureau, justifying the increase by providing supporting contracts or vendor-issued pro-forma invoices, and pre-paying the associated tax. Where transactions are large, such a tax pre-payment can be sizeable and highly undesirable.
By way of example, if a trading company purchases US$1,000,000 of equipment from its partner (and pays 17 percent VAT), then it would need to receive from its partner “special VAT invoices” or “input VAT” invoices equivalent in amount to US$170,000 in order to fully avail itself of “input VAT” credit to offset “output VAT” paid elsewhere. If its partner or vendor is unable to issue these “special VAT invoices” (“input VAT” invoices) for the full amount of US$170,000, then “input VAT” credit would be lost and the overall tax burden of the enterprise would increase. If the taxpayer issuing the invoices has an insufficient quota, then it would need to apply to the tax bureau for a temporary quota increase, but a positive decision of the tax bureau would not be guaranteed and the Value-Added Tax would in any case have to be pre-paid to receive the additional, temporary invoices. Some companies simply may not be able to afford to do this.
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In Beijing, the monthly quota of VAT invoices of a new, small, foreign invested enterprise would typically be twenty-five pieces of “special VAT invoices” and twenty-five pieces of general VAT invoices (cannot be used as “input VAT” credit) at RMB10,000 per invoice. As described above, if the company has higher sales volume during any given month than could be managed within the existing quota, then the enterprise may apply for a temporary increase of the monthly VAT invoice quota. After several such temporary increase approvals, a permanent increase may be approved.
Practically speaking, it is difficult to receive approval for a permanent VAT increase of the invoice quota to the higher level of RMB100,000 per invoice from RMB10,000 per invoice if the annual income of the company has not yet reached RMB60 million. And recently the approval rate for quota increases has slowed in Beijing because the State Tax Bureau and Local Tax Bureau are separately managed (in contrast to Shanghai) and the VAT conversion program has resulted in a shifting of much work away from the Local Tax Bureau to the State Tax Bureau without any concomitant increase in State Tax Bureau resources.
In order to increase the odds of obtaining a temporary, and then a permanent, monthly quota increase, the following suggestions are offered:
- Understand and anticipate business partner capabilities, or lack thereof, to issue tax invoices and their expectations of receiving tax invoices and in what amounts and at what time;
- Keep in mind that tax invoice management issues may drive commercial transaction structuring and payment terms as much as legal or business factors;
- Seek tax advice early and anticipate the requests of the tax bureau for supporting documentation and transaction terms documentation to justify a quota increase;
- Prepare transactional documentation that can be easily understood and interpreted by tax bureau officials and that will result in a favorable assessment;
- Anticipate the need to pre-pay taxes to obtain a temporary quota increase and budget accordingly, as these payments may be substantial;
- Consult regularly with local tax experts early about the particular practices of the relevant tax bureau.
Since China’s Value-Added Tax system is complicated and contains pitfalls certain to ensnare the unwary, make VAT planning a central aspect of any China business model development and any transaction execution. Failing to effectively navigate the system can result in the assumption of substantial, unwanted tax liabilities. One is well advised to obtain the services of expert tax professionals early on that are well-versed in China’s VAT intricacies, such as the tax professionals of Dezan Shira & Associates.
Asia Briefing Ltd. is a subsidiary of Dezan Shira & Associates. Dezan Shira is a specialist foreign direct investment practice, providing corporate establishment, business advisory, tax advisory and compliance, accounting, payroll, due diligence and financial review services to multinationals investing in China, Hong Kong, India, Vietnam, Singapore and the rest of ASEAN. For further information, please email email@example.com or visit www.dezshira.com.
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