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Value-added tax transformation in action
In our previous China Tax/Business News Flash 2008 Issue 13, Issue 17 and Issue 19, we reported that China has amended the Provisional Regulations for Value-added Tax ("VAT"), Business Tax and Consumption Tax and their respective Detailed Implementation Rules. The most important change in the VAT regime is the transformation from the "production-based" VAT system into the "consumption-based" VAT system effective 1 January 2009. Effectively, input VAT incurred on fixed assets is eligible for credit against output VAT starting from 1 January 2009.
To prepare for the implementation of this important VAT Transformation, the Ministry of Finance ("MOF"), the State Administration of Taxation ("SAT") and the General Administration of Customs ("GAC") issued a series of circulars in late December 2008 setting out the details:
- Caishui [2008] No. 170 ("Circular 170") issued jointly by the MOF and SAT which mainly clarifies the details for the implementation of the "consumption-based" VAT system;
- Caishui [2008] No.176 ("Circular 176") issued jointly by the MOF and SAT which formally cancels the VAT refund policy on purchase of domestically-made equipment by foreign investment enterprises ("FIEs") and provide some grandfathering treatment for the affected FIEs; and
- Notice [2008] No.43 ("Notice 43") issued jointly by the SAT, MOF and GAC; and Notice [2008] No.103 ("Notice 103") issued by the GAC which formally cancel the VAT exemption treatment for the importation of equipment for encouraged projects and provide some grandfathering treatment for the affected projects.
In this Issue, we will focus on the key points brought about by these new policy circulars and discuss the implications to taxpayers in general.
Circular 170
Scope of fixed assets ("FA") eligible for input VAT credit 
Circular 170 clarifies that input VAT incurred by general VAT taxpayers for the acquisition of FA (including donation and investment) and self-manufactured FA (including expansion and installation) are both creditable against output VAT. The amount of creditable input VAT refers to those incurred by the taxpayers on or after 1 January 2009 and recorded on VAT invoices issued on or after 1 January 2009.
Transitional treatment for locations adopting trial run of "consumption-based" VAT system
For locations where the "Trial Run of consumption-based" VAT system has been adopted prior to 2009, the amount of input VAT on FA which has not been refunded as at 31 December 2008 may be treated as creditable input VAT in January 2009.
VAT treatment on self-used FA
Under the former VAT regime, sales of self-used FAs by a VAT taxpayer were generally exempt from VAT if certain conditions were met. If not, for instance, where the sales proceeds were greater than the original cost of the FA, then the sales should be subject to VAT at the rate of half of 4%.
Circular 170 changes the VAT treatments on the sales of such self-used FA as summarised in the following table:
| Type of taxpayers |
Date of Acquisition of the FA |
Date of Disposal of FA |
VAT Treatments |
| All |
On or after 1 January 2009 |
On or after 1 January 2009 |
- For General-VAT taxpayers: Output VAT = sales proceeds x 17%
- For Small-scale VAT taxpayers: VAT payable = Sales proceeds x 3%
|
| Not eligible for "Trial Run" before 31 December 2008 |
On or before 31 December 2008 |
On or after 1 January 2009 |
For all VAT taxpayers: VAT payable = Sales proceeds / (1 + 4%) x 2% |
| Eligible for "Trial Run" before 31 December 2008 |
Before the adoption of the trial run |
On or after 1 January 2009 |
For all VAT taxpayers: VAT payable = Sales proceeds / (1 + 4%) x 2% |
| Eligible for "Trial Run" on or before 31 December 2008 |
After the adoption of the trial run |
On or after 1 January 2009 |
- For General-VAT taxpayers: Output VAT = Sales proceeds x 17%
- For Small-scale VAT taxpayers: VAT payable = Sales proceeds x 3%
| In addition, if the self-used FA is subject to the deemed sales provision under the VAT regulations, the net book value of the FA should be used as the sales proceeds.
Calculation of non-creditable Input VAT on FA
Circular 170 requires a claw-back of input VAT credit for FA whose input VAT credit has been claimed but subsequently fall into the category of non-creditable input VAT as stipulated, e.g. the FA are subsequently used solely for non-VATable activities.
Circular 176
The MOF and SAT jointly issued Circular 176 to formally cancel the VAT refund policy on purchase of domestically-made equipment by FIEs effective 1 January 2009. Fortunately, it grants a 6-month grandfathering period for FIEs affected by such policy change. The affected FIE is allowed to continue to apply for the VAT refund before 30 June 2009 if it satisfies all the following conditions:
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- The FIE has obtained the "Project Confirmation Letter" on or before 9 November 2008 (the day before the Amended VAT Regulations were released by the State Council) and lodged a record with the in-charge tax bureau on or before 31 December 2008;
- The FIE actually purchases the domestically-made equipment, obtains the VAT invoice, and applies for the VAT refund with the in-charge tax bureau on or before 30 June 2009;
- The equipment has been included in the of the FIE.
In addition, Circular 176 prohibits the FIEs to claim credit on the input VAT already refunded.
Further, there was also a circular Guoshuifa [2008] No.121 issued by the SAT in late December 2008 on refund application procedures which appears to require FIEs approved before 1 July 2006 to fulfil extra record filing procedures before 28 February 2009 in order to apply for such VAT refund.
Notice 43 and Notice 103
The MOF, SAT and GAC jointly issued Notice 43 and the GAC issued Notice 103 to formally cancel the VAT exemption treatment for the importation of equipment by taxpayers having the following encouraged projects starting from 1 January 2009.
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- Encouraged domestic and foreign invested projects
- Projects funded by foreign governments and international financial organizations
- Enterprises engaged in processing trade with the foreign businesses providing equipment for no consideration
- Foreign invested projects in Central and Western China supported and prescribed by the Central Government
- Technological innovation projects carried out by FIEs and foreign invested R&D centres using their own capital
- Software production enterprises and integrated circuits production enterprises
- Urban mass transit projects
- Other projects eligible for the VAT exemption treatment
A 6-month grandfathering period is also granted to some of the projects under certain conditions. For example, projects under items a, b, d and g which have obtained the "Project Confirmation Letters" on or before 9 November 2008 are still eligible for the VAT exemption provided the equipment is imported and declared on or before 30 June 2009. The 6-month grandfathering period is also granted to projects under item c where the processing enterprise has filed for record the processing trade customs duty handbook for the equipment on or before 31 December 2008. This should be welcome by businesses with processing arrangements.
Another welcome clarification is that the customs duty exemption treatment still remains, even though the VAT exemption treatment for the importation of equipment is cancelled.
PwC observations
Implications
- There are no surprises in Circular 170 which provides detailed guidance for the implementation of the VAT Transformation. The principles such as the scope of FA eligible for input VAT credit and VAT treatment on the sales of used FA generally follow those in an old tax circular Caishui [2008] No.108 ("Circular 108") which is applicable to taxpayers who adopted the "Trial Run of consumption-based VAT system" in the Sichuan earth-quake-affected area.
- Circular 176 and Notice 43 are just confirming the cancellation of the preferential VAT treatments that was announced in the earlier press report of the MOF and SAT. However, apparently the policy makers did listen to the concern of taxpayers and have now granted a 6-month grandfathering period to taxpayers who have been approved to claim VAT refund for purchase of domestically-made equipment or VAT exemption on the importation of equipment but have not bought or imported the equipment as at the end of 2008. Taxpayers should carefully plan their FA acquisition schedule to make sure that all the conditions for entitlement of the grandfathering relief are met. On the other hand, we are concerned whether the 6-month grandfathering period is long enough for the affected taxpayers particularly in the current economic environment where they are strapped for cash and may not be able to raise funds to make the capital investment in such a short period.
- Another piece of good news is the continuance of customs duty exemption for the importation of equipment by taxpayers with encouraged projects. At the time the VAT reform was revealed by the MOF and SAT back in November 2008, it was a concern to those affected taxpayers as it was unclear whether the customs duty exemption would also be removed simultaneously with the cancellation of import VAT exemption.
Suggestions
Businesses may consider proper strategies to alleviate the adverse cash flow impact arising from the cancellation of the preferential VAT exemption on imported equipment. Actions worth considering may include:
- Alternative ways of acquiring FA
- Consider the use of a leasing arrangement for imported equipment. Leasing arrangement can stretch the payment of the import VAT over the term of the lease and thereby lessening the cash flow impact. However, there are a number of issues which also need to be considered, such as impact of additional financing costs, China tax implications to the lessor on the lease payments, etc.
- Consider setting up new manufacturing facilities in bonded zones. The merit of this arrangement is that there would not be any VAT and customs duty on equipment imported into the zones. However, this has to be reviewed in the context of overall investment strategy because bonded zones are mostly located in the coastal cities and have their own geographical limitation in terms of access to labour, suppliers and potential customers and sales / distribution channels.
- Proper schedule of acquisition plan
For businesses that are in pre-operating phases, the acquisition of FA will need to face additional cash flow pressure, as import VAT is now topping up the cash outlay. A proper schedule for acquisition of FA should be considered to match the timing of construction, commissioning and production, sales etc. This is particularly important for companies which are heavily capitalized with FA.
- Improve administration of VAT filing
Since input VAT credit can now be claimed on FA, businesses should ensure that VAT invoices for procurement of FA be properly obtained and retained for VAT filing purposes.
We are expecting that more fine-tuning tax policies will be issued in the near future to address the implementation details of the new Provisional VAT Regulations. We will closely monitor the development of the detailed implementation rules and share with you our insight as soon as the information is available.
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