Latest draft VAT law published in China―Impact for Financial Services

On 27 December 2022, the latest draft of the value-added tax (VAT) law was submitted to China's Standing Committee of the National People's Congress for first review and then published on 30 December 2022 for a 30-day public consultation. This new draft is long awaited for, after an earlier draft that was circulated for public consultation almost three years ago. This new draft is an important movement to the first VAT Law in China given what we have now are provisional rules.

Similar to the earlier draft, the new draft basically imports most of the current VAT rules aiming to provide a stable policy environment. However, the new draft still introduces certain changes that may impact businesses, notably the modifications to the creditable input VAT.

This article provides a high-level outline of the changes brought by the new draft, and the potential impacts on financial institutions with operations in China.

Categories of domestic VAT-able transactions

The earlier draft classified domestic VAT-able transactions into five sales categories: goods, services, intangible assets, real estate, and financial products (e.g., stocks, bonds, etc.). The new draft only maintains the first four categories, which indicates that the category of "financial products" could be included into the categories of either "services" or "intangible assets" subject to the nature of the underlying transactions.

Place of supply rules

General services

According to the new draft, in terms of the supply of services, if the services are consumed in China or the seller is Chinese enterprise or individual, such services are considered provided in China and, hence, subject to China VAT. The major change of this rule compared with the current VAT regulation is to replace "whether the service recipient is located in China" with "whether the services are consumed in China". This change seems to follow the "use and consumption" principle adopted in Organisation for Economic Co-operation and Development/VAT Directives, whilst it is yet to be defined how to determine whether the services are consumed in China or not.

In terms of the cross-border supply of services, where VAT is due, the Chinese buyer shall act as the withholding agent to withhold VAT and pay to the local tax bureau on behalf of the foreign service provider.

Financial products

The new draft defines that, if the financial products are issued in China or the seller is a Chinese enterprise or an individual, the sale of the said financial products shall be viewed as a taxable supply and subject to China VAT. However, the new draft does not provide further definitions in terms of the scope of the financial products, the "seller" of the financial products, and "issued in China", which is subject to further clarifications in the subsequent rules and regulations.

Input VAT from loan interest

One of the most significant changes that could be brought by the new draft is to allow the credit of input VAT arising from loan interest. The credit of such input VAT has been disallowed since the financial sector was brought into the scope of VAT in 2016, and the earlier draft did not make any changes in this respect. The change in the new draft should be very welcomed by businesses, given it has always been a controversial point, and due to the financial impact.

However, as a subsequence, allowing the input VAT credit on interest will bring a series of issues. For example, under the current China VAT rules, interbank lending activities are VAT exempted. Accordingly, the associated input VAT is not recoverable, and the banks need to segregate such irrecoverable VAT costs by using certain methods. If the input VAT on interest becomes creditable in the future, whether it is still necessary to continue with the current VAT exemption treatment on such interbank lending may need to be discussed. Moreover, financial institutions may encounter a huge increase in compliance costs from the requirements on VAT special invoices which are required by the customers to claim input VAT credit. This VAT invoice requirement, together with the e-invoicing pilot in China may require the financial institutions to look into the system solutions to automate the VAT invoice issuance.

Input VAT from fixed assets, intangible assets, and real estate

The earlier draft, which is consistent with the current rules, would disallow the credit of input VAT arising from the acquisition of fixed assets, intangible assets, and real estate, but only if such assets were exclusively used for non-VAT-able purposes (e.g., private consumption) or VAT-able projects that are not subject to the general taxing method (e.g., VAT-exempt projects). Relying on the above rules, a taxpayer may claim credit for the whole amount of the input VAT arising from the acquisition of a fixed asset, if the asset was used simultaneously for a non-VAT-able project and a VAT-able project (subject to the general taxing method), without apportioning the input VAT between the two projects.

However, the new draft seems to tighten up the rules by removing the above "exclusive usage" condition. This being the case, the taxpayer in the above scenario would need to develop a reasonable method to apportion the input VAT from the fixed asset between the two projects, and only the input VAT attributable to the VAT-able project would be creditable.

This potential change could bring significant change to the cost base of the relevant taxpayers, including financial institutions that invest heavily in capital assets used for both VAT-able and VAT exempted (e.g., interbank lending) supplies.

Transitional arrangement

According to the earlier draft, any VAT rules that were issued before the promulgation of the new VAT law and that still are necessary would remain in effect for up to five years after the law comes into force, subject to stipulations by the State Council.

The section relating to the above transitional arrangement is no longer in the new draft. As such, it is uncertain whether a similar transitional arrangement would be provided under the new VAT law.

Next steps

After the expiration of the consultation period, the comments provided by the public will be reviewed and discussed by the legislators. Based on prior experience with tax legislation, many have anticipated that the second and third reviews of the law would be carried out in the near future so that the law can be passed in 2023. Businesses are advised to closely monitor the legislative development, assess the impact of the potential changes to the current VAT rules, and formulate any action plans accordingly where necessary.