Impact of China's VAT Reform on Foreign-Invested Enterprises
On November 10, 2008, the State Council of China approved the amendments to the Provisional Regulations of the PRC on Value Added Tax ("Amended VAT Regulations"). The key change is a shift from a production-based VAT regime to a consumption-based VAT regime. Under the current regime, the recovery of input VAT incurred on the purchase of fixed assets is disallowed. The Amended VAT Regulations will allow general VAT payers to recover input VAT incurred on the purchase of certain fixed assets.
The new VAT treatment of fixed assets applies to equipment newly purchased on or after January 1, 2009. Equipment for this purpose includes machines, machinery, means of transportation, and other equipment and tools related to production and operation. However, input VAT recovery is disallowed for the purchase of cars, motorcycles, and yachts that are subject to consumption tax and could be used for private purposes. The input VAT recovery also does not apply to immovable properties such as buildings and structures.
Cancellation of VAT Exemption on Import and VAT Refund on Domestic Purchase
Currently, VAT exemption on the importing of equipment and VAT refunds on the purchase of domestically produced equipment are available to qualified enterprises, especially to certain foreign-invested enterprises. Foreign investments in China are classified as "encouraged," "permitted," "restricted," and "prohibited" under the foreign investment catalogue. If a foreign-invested enterprise is classified as "encouraged," the enterprise is eligible for VAT exemption on imported equipment for its own use up to its approved amount of total investment, unless the imported item is on a list of nonexempted items. If an "encouraged" foreign-invested enterprise purchases equipment produced domestically within China, the enterprise can claim a VAT refund for the input VAT incurred on the purchase of such equipment. This preferential VAT policy will be abolished on January 1, 2009.
Because of the different classifications and business nature of foreign investments in China, the VAT reform may have different impacts on various foreign-invested enterprises.
General VAT Payers That Currently Do Not Enjoy VAT Preferential Treatment. Foreign-invested enterprises in "permitted" and "restricted" categories currently do not enjoy VAT exemption on the importing of equipment or VAT refunds on the purchase of domestically produced equipment. Under the current regime, those enterprises cannot recover input VAT incurred on equipment purchases; such input VAT will be capitalized in the asset cost for depreciation for corporate income tax purposes. If those enterprises are general VAT payers, the Amended VAT Regulations will allow them to credit input VAT on qualified equipment purchases (both imported and domestic). The regular VAT rate is 17 percent. The benefit as a result of the VAT reform for those enterprises is an approximate 12.75 percent reduction in the cost of equipment purchase (i.e., a 17 percent VAT recovery net of corporate income tax benefits at 25 percent).
Business Tax Payers That Are Not Eligible for VAT Exemption. VAT in China applies to the importing of goods into China, the transfer of goods within China, and the provision of processing and repair services in China. Business tax is imposed on the provision of services (other than processing and repair services) and the transfer of immovable properties and intangibles. If an enterprise is a business tax payer and not a VAT payer, it is charged for input VAT on the purchase of goods; it cannot recover input VAT because it is liable for business tax (not VAT) on its revenue derived from the provision of services or the transfer of immovable property and intangibles. The VAT reform does not directly affect those enterprises. Input VAT recovery will continue to be disallowed for them. Enterprises covered include banks, insurance companies, telecommunication companies, and many other service companies, real estate developers, and construction companies.
General VAT Payers in the "Encouraged" Category of Foreign Investment. Under the current regime, these foreign-invested enterprises are entitled to VAT exemption on imports of equipment and VAT refunds for domestic purchases of equipment subject to certain limitations. On and after January 1, 2009, such VAT exemptions and refunds will no longer be available. This means that these enterprises need to pay VAT on the importing of equipment and then recover the input VAT at the time they sell their own products. Similarly, the input VAT incurring on the purchase of domestic equipment will no longer be refundable, only creditable. Newly established manufacturers will only be able to recover the input VAT after they start production. Furthermore, if manufacturers do not have sufficient domestic sales (i.e., they export all or most products), it may take a long time to offset the excess input VAT. As such, the VAT reform may adversely affect the cash flow of enterprises in this category.
Business Tax Payers in the "Encouraged" Category of Foreign Investment. Some R&D companies may derive income primarily from service fees or royalties that are subject to business tax rather than VAT. Some of those foreign-invested enterprises are classified in the "encouraged" category of foreign investment and currently enjoy VAT exemption on the importing of equipment and VAT refunds on the purchase of domestic equipment. On and after January 1, 2009, such VAT exemptions and refunds will be no longer available. These companies cannot recover input VAT because they are not VAT payers. The VAT reform will increase the cost of fixed-asset investments for these foreign-invested enterprises. As the Chinese government encourages R&D activities, it is not clear whether relief will be given to these enterprises.
There are two types of VAT payers in China. General VAT payers pay VAT at the regular rate (generally 17 percent) and can recover input VAT. Small-scale VAT payers are typically commercial enterprises with annual sales of less than RMB1.8 million and other enterprises with annual sales of less than RMB1 million. Small-scale VAT payers pay VAT on sales at reduced rates and cannot recover input VAT. Currently, the VAT collection rates for the small-scale commercial enterprises and other enterprises are four percent and six percent respectively. Under the Amended VAT Regulations, the VAT rate for all small-scale VAT payers will be reduced to three percent.
Mineral products have been subject to a reduced VAT rate of 13 percent. On and after January 1, 2009, the VAT rate of mineral products will be shifted back to the standard rate of 17 percent.
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