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China's Transition to a VAT System

By Stanley Kolodziejczak and Nancy Regan
October 23, 2012

Over the past 12 months, China has begun to transition from a business tax (“BT”) system to a Value Added Tax (“VAT”) system using Business to Value Added (“B2V”) pilot programs. These B2V pilot programs have been introduced in Beijing and Shanghai for certain industries, including legal consulting services. If the VAT applies, then the 5% BT does not apply. Seven other provinces and municipalities are scheduled to join the B2V pilot program by the end of 2012.

While the Shanghai pilot program is not yet mandatory, it is expected that participation in the other B2V pilot programs will be mandatory for targeted industries. The Beijing VAT pilot program became effective on Sept. 1, 2012. Legal consulting revenue generated by all Beijing Registered Offices (“BRO”) of foreign law firms should now be subject to VAT instead of BT.

The VAT rate may differ depending upon the VAT position of a China-registered taxpayer (e.g., China RO). If the China-registered taxpayer is a small-scale VAT payer, a VAT rate of 3% will apply and no input credit is allowed. A small-scale VAT payer has annual services revenue of less than 5MM RMB subject to VAT. If the China-registered taxpayer is a general VAT payer (generally, a firm with annual services revenue greater than 5MM RMB), a VAT rate of 6% is applicable to the legal services revenue the taxpayer generates, and input credits are allowed. In the case of a foreign (non-China) law firm ' which is a different taxpayer from its BRO ' the VAT rate for legal consulting services is 6%.

U.S. law firms will be subject to VAT, rather than BT, on revenue from China ' either from third-party Chinese clients or from the firm's China RO ' if the Chinese clients/RO is located in a VAT pilot program location. If the Chinese client is not located in a VAT pilot program location, BT will continue to apply.

To determine the proper amount that is subject to VAT, a law firm must establish the total charge collected from the client ' including out-of-pocket reimbursements, late interest charges, etc. ' but excluding VAT. In other words, except for VAT collected from the client, all other charges paid by the client that are associated with the provision of legal services should be subject to VAT.

VAT is incurred upon the earlier of when: 1) bills are issued, and 2) official VAT invoices (fapiao) are issued. If the ultimate fee collected is less than what was reported ' i.e., if a client short pays and the law firm ends up writing off a portion of the invoice, or a lower fee is later negotiated ' it is possible for the law firm to true up by reducing the reported sales amount for a subsequent period if proper documents are available to support this. Subject to different fact patterns (including whether official VAT invoices have been issued, whether the issued original official VAT invoices can be returned, etc.), the approach for applying for a reduction of the taxable sales amount would differ.

In addition to VAT (i.e., 3% for a small-scale VAT payer or 6% for a general VAT payer), there are also additional local surcharges and fees, which must be paid monthly. The amount of these local surcharges depends on the location of the taxpayer. In Beijing, for example, the local surcharges include: Urban Construction and Maintenance Tax at 7%; Educational Surcharge at 3% and the Local Educational Surcharge at 2%. The taxation basis for these
surcharges is the total VAT, BT and/or consumption tax payable in a given month. Therefore, for a typical U.S. law firm's RO located in Beijing, assuming all revenue generated from its legal consulting services is subject to VAT, the total local surcharges should be 12% of VAT payable in a given month.

Input VAT

A general VAT payer will be able to claim a credit for Input VAT paid by the law firm. For example, amounts owed by a firm's BRO to its vendors, the purchase of any tangible goods (e.g., furniture, stationery, coffee/soda, etc.) from all vendors (including Chinese and overseas suppliers) should be subject to VAT. Even if an RO imports goods from overseas, import VAT will apply, and be collected by Customs upon declaration. In addition, the purchase of transportation services (e.g., car service) and services falling within the scope of modern service industries (including consulting services, R&D, cultural services, etc.) provided by vendors in a VAT pilot zone or overseas (to a firm in the pilot zone) will also be subject to VAT. If the BRO is a small-scale VAT payer, no input VAT credit can be claimed.

Whether a purchase will be creditable depends upon:

  • the nature of the purchase ( e.g., rental paid for office space would not be subject to VAT, and therefore not applicable to the credit mechanism);
  • the Chinese vendor's qualification, i.e., whether the vendor itself is a general VAT payer or not;
  • whether the Chinese vendor is able to issue Special VAT invoices or engage the tax bureau to issue Special VAT invoices on its behalf to the firm's BRO;
  • if the purchase is imported, it depends whether the import should be subject to VAT in China.

Conclusion

Since China's VAT pilot programs are still fairly new, it is to be expected that the kinks are still being worked out of the system. We anticipate that changes will occur as the system grows and improvements are made. In order to comply, it is essential to understand the unique nature of the Chinese tax system and to monitor and adapt to its changes.


Stanley Kolodziejczak, a member of this newsletter's Board of Editors, is co-chair of the Law Firm Services group of PwC LLP and has more than 25 years of business, tax and accounting experience. His current experience is working with law firms that are facing the challenges of growth in a changing global market. He can be reached at 646-471-3160 and at [email protected]. Nancy Regan is a director in the Law Firm Services group of PwC LLP with more than 15 years of experience as a tax attorney in and around global law firms. She can be reached at 973-236-5771 and at [email protected].

Over the past 12 months, China has begun to transition from a business tax (“BT”) system to a Value Added Tax (“VAT”) system using Business to Value Added (“B2V”) pilot programs. These B2V pilot programs have been introduced in Beijing and Shanghai for certain industries, including legal consulting services. If the VAT applies, then the 5% BT does not apply. Seven other provinces and municipalities are scheduled to join the B2V pilot program by the end of 2012.

While the Shanghai pilot program is not yet mandatory, it is expected that participation in the other B2V pilot programs will be mandatory for targeted industries. The Beijing VAT pilot program became effective on Sept. 1, 2012. Legal consulting revenue generated by all Beijing Registered Offices (“BRO”) of foreign law firms should now be subject to VAT instead of BT.

The VAT rate may differ depending upon the VAT position of a China-registered taxpayer (e.g., China RO). If the China-registered taxpayer is a small-scale VAT payer, a VAT rate of 3% will apply and no input credit is allowed. A small-scale VAT payer has annual services revenue of less than 5MM RMB subject to VAT. If the China-registered taxpayer is a general VAT payer (generally, a firm with annual services revenue greater than 5MM RMB), a VAT rate of 6% is applicable to the legal services revenue the taxpayer generates, and input credits are allowed. In the case of a foreign (non-China) law firm ' which is a different taxpayer from its BRO ' the VAT rate for legal consulting services is 6%.

U.S. law firms will be subject to VAT, rather than BT, on revenue from China ' either from third-party Chinese clients or from the firm's China RO ' if the Chinese clients/RO is located in a VAT pilot program location. If the Chinese client is not located in a VAT pilot program location, BT will continue to apply.

To determine the proper amount that is subject to VAT, a law firm must establish the total charge collected from the client ' including out-of-pocket reimbursements, late interest charges, etc. ' but excluding VAT. In other words, except for VAT collected from the client, all other charges paid by the client that are associated with the provision of legal services should be subject to VAT.

VAT is incurred upon the earlier of when: 1) bills are issued, and 2) official VAT invoices (fapiao) are issued. If the ultimate fee collected is less than what was reported ' i.e., if a client short pays and the law firm ends up writing off a portion of the invoice, or a lower fee is later negotiated ' it is possible for the law firm to true up by reducing the reported sales amount for a subsequent period if proper documents are available to support this. Subject to different fact patterns (including whether official VAT invoices have been issued, whether the issued original official VAT invoices can be returned, etc.), the approach for applying for a reduction of the taxable sales amount would differ.

In addition to VAT (i.e., 3% for a small-scale VAT payer or 6% for a general VAT payer), there are also additional local surcharges and fees, which must be paid monthly. The amount of these local surcharges depends on the location of the taxpayer. In Beijing, for example, the local surcharges include: Urban Construction and Maintenance Tax at 7%; Educational Surcharge at 3% and the Local Educational Surcharge at 2%. The taxation basis for these
surcharges is the total VAT, BT and/or consumption tax payable in a given month. Therefore, for a typical U.S. law firm's RO located in Beijing, assuming all revenue generated from its legal consulting services is subject to VAT, the total local surcharges should be 12% of VAT payable in a given month.

Input VAT

A general VAT payer will be able to claim a credit for Input VAT paid by the law firm. For example, amounts owed by a firm's BRO to its vendors, the purchase of any tangible goods (e.g., furniture, stationery, coffee/soda, etc.) from all vendors (including Chinese and overseas suppliers) should be subject to VAT. Even if an RO imports goods from overseas, import VAT will apply, and be collected by Customs upon declaration. In addition, the purchase of transportation services (e.g., car service) and services falling within the scope of modern service industries (including consulting services, R&D, cultural services, etc.) provided by vendors in a VAT pilot zone or overseas (to a firm in the pilot zone) will also be subject to VAT. If the BRO is a small-scale VAT payer, no input VAT credit can be claimed.

Whether a purchase will be creditable depends upon:

  • the nature of the purchase ( e.g., rental paid for office space would not be subject to VAT, and therefore not applicable to the credit mechanism);
  • the Chinese vendor's qualification, i.e., whether the vendor itself is a general VAT payer or not;
  • whether the Chinese vendor is able to issue Special VAT invoices or engage the tax bureau to issue Special VAT invoices on its behalf to the firm's BRO;
  • if the purchase is imported, it depends whether the import should be subject to VAT in China.

Conclusion

Since China's VAT pilot programs are still fairly new, it is to be expected that the kinks are still being worked out of the system. We anticipate that changes will occur as the system grows and improvements are made. In order to comply, it is essential to understand the unique nature of the Chinese tax system and to monitor and adapt to its changes.


Stanley Kolodziejczak, a member of this newsletter's Board of Editors, is co-chair of the Law Firm Services group of PwC LLP and has more than 25 years of business, tax and accounting experience. His current experience is working with law firms that are facing the challenges of growth in a changing global market. He can be reached at 646-471-3160 and at [email protected]. Nancy Regan is a director in the Law Firm Services group of PwC LLP with more than 15 years of experience as a tax attorney in and around global law firms. She can be reached at 973-236-5771 and at [email protected].

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