An overview of the Value-Added Tax system in China

As one of the major indirect taxes in China, the value-added tax is closely related to the daily operations of companies. When companies purchased goods or services from their vendors, the total amount they paid included the price plus value-added tax. After a 44-year history, the second draft of value-added tax law amendment was released for public opinion in September 2023. Based on previous experience, the final version of the law may be issued in 2024 or 2025. In the following three chapters, we will provide you a glimpse of the history of value-added tax in China, current value-added tax policies in China, and some common issues related to value-added tax.

Chapter One: History of Value-added Tax in China

• Pilot phase (1979-1993)
  In July 1979, value-added tax was first piloted in Xiangfan, Hubei Province, and gradually piloted nationwide. Under the background of reform and opening up, China entered a new period of socialist modernization construction, and the role of taxation became important. In 1984, the State Council issued “Guo Fa [1984] No. 125” with six draft tax regulations, including the Regulations of the People’s Republic of China on Value-added Tax (Draft). The scope of value-added tax covered 12 categories of goods, such as machinery and equipment, vehicles and bicycles, steel and billets, etc. This marked that value-added tax had officially become a tax in China.
• Gradual establishment phase (1994-2003)
  In 1994, China reformed its tax structure and officially implemented tax sharing. It divided the revenues, expenditures, responsibilities and powers between the central and local governments. In the same year, the Regulations of the People’s Republic of China on Value-added Tax (“Decree No.134”) issued by the State Council came into effect on 1 January 1994. The Decree No.134 was more comprehensive than Guo Fa [1984] No.125 and expanded the scope of taxation. It raised the concept of small scale taxpayers and issued special invoices to improve the input tax credit system. However, the input tax on purchased fixed assets could not be deducted at that time because of the fixed assets investment inflation.
• Transformational reform phase (2004-2011)
  In 2004, the Ministry of Finance and the State Administration of Taxation submitted the value-added tax transformation reform plan, which changed the value-added tax base from production-based to consumption-based. The main difference between the two bases was whether or not the companies would be allowed to deduct the input tax on fixed assets. In 2008, because of the global financial crisis, the State Council issued the Regulations of the People’s Republic of China on Value-added Tax (Revised in 2008) (“Decree No.538”) in accordance with the plan to overcome the adverse impact of the global financial crisis.
• Business tax to value-added tax replacement phase (2012-2018)
  On 1 January 2012, Shanghai became the first city to launch a pilot project to replace business tax with value-added tax for transport and some modern service industries. This pilot project was extended to the whole country on 1 August 2013. The main purpose of the project is to reduce double taxation, which helps companies to reduce their tax burden. Finally, on 1 May 2016, the Ministry of Finance and the State Administration of Taxation issued Circular Cai Shui [2016] No.36 (“Circular No.36”) containing the Measures for the Implementing Rules for the Replacement of Business Tax with Value-added Tax. According to the Circular, all transactions of services, intangible assets and real estate will be included in the scope of value-added tax, and business tax will no longer be required. In 2017, the Regulations of the People’s Republic of China on Value-added Tax (Revised in 2017) consolidated the regulations in Circular No.36 and repealed Decree No.538.
• Legislation of value-added tax law phase (2019-now)
  In 2019, the Ministry of Finance, the State Administration of Taxation and the General Administration of Customs jointly issued the Announcement [2019] No.39(“Circular No.39”) to promote a substantial reduction of value-added tax, which changed the tax rate from 16%, 10% and 6% to 13%, 9% and 6%. The system of refund of input value-added tax retained for credit was first established in Circular No.39.
  
  On 27 November 2019, the Ministry of Finance and the State Administration of Taxation issued an exposure draft of the value-added tax law for the collection of public opinions. In this draft, it added the regulations of deemed sales and non-taxable items, as well as some tax exemption regulations. The draft law was submitted to the State Council in 2020 and passed at the end of 2022. After the draft law was passed by the 13^th National People’s Congress, it was opened for public opinion for 30 days. The second draft of the amendment to the value-added tax law was released in September 2023.

Chapter Two: Current Value-added Tax Policies in China

Currently, the value-added tax law is still in the legislation process, the Regulations of the People’s Republic of China on Value-added Tax (Revised in 2017) is the main regulation on value-added tax on goods, and Circular No.36 is the main regulation on value-added tax on services.

I. Objects of value-added tax

After the replacement phase, transactions subject to value-added tax include sales of goods, services, intangible assets, real estate and imported goods within the Chinese territory.

II. Tax rates of value-added tax

The normal value-added tax rates for each category are summarized in the following table.

III. Taxpayers of value-added tax

Value-added taxpayers can be classified into General Value-added Taxpayers (“general taxpayers”) and Small Scale Value-added Taxpayers (“small taxpayers”). Different with general taxpayers, small taxpayers enjoy a simplified tax rate of 3% or 5%. With a lower tax rate, no input value-added tax is deductible for small taxpayers. In the second draft amendment, only the 3% rate applies to small taxpayer and the 5% rate is not mentioned.

The criteria for small taxpayers are clearly stated in the second amendment. Taxpayers whose annual taxable income is less than RMB 5,000,000 will be classified as small taxpayers, unless they have reliable accounting records.

IV. Invoice of value-added tax

The invoice of value-added tax can be divided into a special value-added tax invoice (“special invoice”) and a general value-added tax invoice (“general invoice”). A special invoice is required for taxpayers who need to credit input value-added tax to offset against output value-added tax. General taxpayers can issue a special invoice by themselves, while small taxpayers shall apply to the competent tax authorities.

V. Refund of value-added tax retained for credit

When taxpayers have more input value-added tax than output value-added tax, the excess input value-added tax will be carried forward to the next tax period. Starting with Circular No.39 on 1 April 2019, general taxpayers who have retained input value-added tax can apply for a refund if they meet the criteria of the tax authorities. This policy provides taxpayers with more flexibility in their cash flow.

VI. Value-added tax exemption

Sales of certain goods and services specified in the tax regulations may be exempt from value-added tax. According to the Regulations of the People’s Republic of China on Value-added Tax (Revised in 2017) and Circular No.36, the scope of tax exemption includes seven goods and forty services. In the second draft amendment, this scope is summarized into nine categories:

• Agricultural products and related services for plants and livestock.
• Prophylactic drugs and devices; medical services provided by medical institutions.
• Sales of antique books; sales of products that are used by the sellers themselves.
• Imported instruments and equipment directly used for scientific research, scientific experiments and teaching.
• Imported materials and equipment provided by foreign government or international institution for gratis aid.
• Products for the disabled; services provided by the disabled.
• Nursing services provided by nurseries, kindergartens, elderly service institutions, and disabled welfare institutions; matchmaking services; funeral services.
• Education services provided by schools; services provided by students under the work-study programs.
• Admission fees for cultural services provided by memorial halls, museums, cultural centers, cultural relics protection administrations, art galleries, exhibition halls, academies of painting and calligraphy, and libraries; admission fees for cultural and religious activities.

VII. Value-added tax refund for export sales

The tax rate for exported goods and services is zero. Certain exports of goods and services may be eligible for a value-added tax refund from the tax authorities. Enterprises shall register with the competent tax authorities and apply for the refund when the export transactions have actually happened.

The criteria of exported goods are the goods physically left the territory of China with a declaration and the export sale has been recorded in the accounting book, while the criteria of exported services are the services provided to foreign entities for complete consumption outside the territory of China within the scope includes research and development services, energy performance contracting services, design services, production and distribution services for radio, film and television programs, software services, circuit design and testing services, information system services, business process management services, offshore services outsourcing business, and technology transfer.

Different types of companies have different calculation methods. For manufacturing companies, the calculation method is “exemption, credit and refund”, which means that the export value-added tax is exempted, the input value-added tax can be credited against the tax payable and the excess part of the input value-added tax can be refunded. Meanwhile, for trading companies, the calculation method is “exemption and refund”, which calculates the refundable value-added tax with the purchase amount and refund rate.

VIII. Super deduction

Currently, there are three super deduction policies which are valid until 31 December 2027. The relevant industries and the super deduction rate are summarized in the following table.

In the second draft amendment, dedicated preferential policies will be implemented to support the development of small taxpayers, micro-enterprises and key industries, and to promote entrepreneurship and employment in the future.

Chapter Three: Common issues related to Value-added Tax

Situation One: A foreign company purchases a machine for its Chinese factory

A German company has a factory in China for assembling the components into final products. Because of the high transport costs from Germany to China, the German company signed a contract with a Chinese company to purchase the necessary equipment for the assembly and asked the Chinese company to transport the equipment to its factory in China.

According to the criteria mentioned in chapter two, the tax rate for exported goods is zero if the goods have physically left the territory of China with a declaration. In this situation, the equipment does not physically leave the territory of China, so the Chinese company cannot declare the equipment to customs and enjoy a zero tax rate.

Situation Two: Chinese company provides non-exempt services to foreign company

A German company wants to know the Chinese tax regulations regarding Research and Development Super Deduction (“R&D Super Deduction”) and High and New Technology Enterprise (“HNTE”). The German company finds a Chinese consulting firm to help it understand the criteria of R&D Super Deduction and HNTE. The consulting fee charged by the Chinese consulting firm includes the price plus the value-added tax.

According to the criteria for exported services, consulting services do not fall within the scope of exported services that can enjoy a zero tax rate. Therefore, this service is subject to value-added tax at the rate of 6%.

Situation Three: Foreign company providing services to Chinese company is subject to value-added tax

A German company providing intercompany services to its Chinese subsidiary is subject to value-added tax. For example, a German company helps its Chinese subsidiary to maintain the data system and provide online support for the system. The Chinese subsidiary pays the German company a monthly fee for the services.

According to Circular No.36, either the seller or the buyer of the service is located in China, the income from the services is subject to value-added tax. In this situation, the Chinese subsidiary shall act as a withholding agent to withhold 6% tax on behalf of the German company.

Our Recommendations

As value-added tax is the most important tax related to the company’s daily operations, we recommend companies to continuously focus on the legislative status of the value-added tax law, understand the changes and plan in advance. To analyze the future trend of the value-added tax law, companies may not only focus on the background of the current market, but also focus on the history of the value-added tax regulations. To help companies understand the new law correctly, we will continue to monitor the status of the amendment of value-added tax law and will provide relevant updates in due course.