11 April 2016

VAT Reform – Summary and key issues for lawyers to be aware of

On 24 March 2016, the Ministry of Finance and State Administration of Taxation jointly issued Caishui 2016 Circular No. 36 (Circular 36), which includes a series of regulations governing the ultimate plan of Converting Business Tax into  Value Added Tax (VAT Reform). Circular 36 marks the overall replacement of Business Tax (BT) in China with VAT as the sole indirect tax effectively from May1st, 2016.  The completion of VAT Reform represents the start of a new tax regime which will affect all domestic and international businesses operating in China.

Circular 36 is a series of systematic regulations summarizing and upgrading the previous VAT Reform regulations and revisiting the important concepts and insights of implementation.  Further, Circular 36 includes detailed guidelines for the relevant industries.  From May 1, 2016, VAT Reform will extend to cover four more industries, including construction, real estate, financial services and consumer services. The statutory rate of VAT for construction and real estate industries is set at 11% while the applicable VAT rate of financial services and consumer services is set at 6% for general taxpayers.  For small scale taxpayers and also in some special situations, special collection rates of 3% or 5% will be applicable. 

This article highlights the key aspects of VAT Reform and the aspects for legal practitioners to take particular note of. 

I. Purpose of VAT Reform

The previous VAT regime, which established as a tax reform in 1994, applies to sale of goods, processing and repair services. BT applies to transactions of other services, intangible assets and real estate. These two taxes have coexisted since 1994. 

The characteristic of BT is “tax on gross revenue without any credit”. Although the tax rate is low at first sight (3%~5%), it doubles with more transactions. The tax burden is comparatively heavy for industries with more intermediate transaction flows taxed at BT. Compared with BT, the VAT regime offers an “input - output” credit mechanism which makes VAT creditable transaction-by-transaction and the tax base is the “value added” amount rather than the “full” amount.   

The main purpose of VAT Reform is to modify the different tax systems between manufacturing and services industries, to extend the use of the VAT credit mechanism to eliminate double taxation. By doing so, VAT Reform aims to facilitate the social division of industries and to enhance market efficiency.

II. General Comparison of BT and VAT.


Business tax

Value-added tax

Taxation principle

Each transaction is taxed at full revenue, which may trigger double taxation.



BT is inclusive in the price.

Each transaction is taxed at its “value added” amount, which generally eliminates double taxation.


VAT is exclusive in the price.

Tax base

Turnover amount = Revenue.

Turnover amount = Revenue - VAT payable = Revenue in the context of VAT.

Tax payable

Tax payable = turnover amount × tax rate.

Tax payable = output VAT - input VAT = turnover amount × tax rate - deductible cost and expense× tax rate-deductible asset investment × tax rate.

Tax rate

Generally lower (e.g. 3-5%).

Generally higher (e.g. 6-17%).




Category of invoice

No distinction between general and special invoices.

General and VAT invoices. VAT invoices must be issued by the specific machine assigned by tax bureau or, in the near future, through a network system.


VAT invoices are the only invoices that can be used to support the credit of VAT input from VAT output.

Tax administration

Simplified administration.

VAT requires a stricter compliance. Actions, such as illegal selling and purchasing VAT invoices, may lead to criminal liability.

III. Key issues of VAT Reform

VAT Reform is a crucial part of the Supply Reform nationwide.  It is expected that VAT Reform will have a significant impact on the operation and administration across most industries.  The challenges experienced regarding VAT on the sale of goods may also apply in relation to the services industry.  As lawyers are often involved in the compliance issues faced by clients, it is important to be equipped with a general understanding of the principles of VAT Reform. For lawyers who specialize in certain industries, i.e. financial industry., it will be helpful to pay more attention to the impact of VAT Reform on their specialties; such awareness may help to mitigate risks or add value when, for example, advising on transaction structures. 

i. The modification of the tax clause in contracts

Prior to VAT Reform, the BT was borne by the service provider or intangible assets transferor and was considered as included in the price which is not recoverable. By contrast, VAT is exclusive in the price. Due to the fact that the VAT rate is notably higher than BT, if the VAT cannot be transferred to a downstream counterparty or be recovered from the upstream purchase, the tax burden of the service provider or intangible assets transferor will rise drastically. Therefore, it is essential to alert clients to examine the tax clause in their contracts to make sure the VAT is administrated carefully.

It is prudent to advise clients to consider providing a VAT invoice as a contractual obligation for its counterparty. Further, it is advisable to make a connection between the VAT invoice and payment.  For instance, the payment will only be made when the VAT invoice was received from the supplier.

Under VAT Reform, what is considered as sale for service and intangible assets is a new question.  In drafting contracts going forward, lawyers should carefully consider the VAT issue in a situation of providing resources or services free of charge as they may be viewed as taxable transactions under VAT, and therefore require a proper understanding of the tax implication. 

ii. Improve the internal control and enhance in-house VAT invoice administration 

VAT invoices are more tightly regulated than general invoices. Issuing a false VAT invoice may constitute a criminal offence. Further, companies acquiring false VAT invoices may not be able to get the VAT credit.

Lawyers are advised to remind clients to consider VAT invoices in their internal company policies. All activities related to VAT invoices, such as claiming a VAT invoice, issuing a VAT invoice or acquiring a VAT invoice should be included in the company’s internal control process. The training of relevant staff is necessary to maintain awareness of the changes.  

Considering the special nature of a VAT invoice, lawyers should be aware how the invoice may be used as evidence in the case of litigation. 

iii. Deduction risk due to inconsistency

In order to prevent the issuing of false VAT invoices, the State Administration of Taxation enacted the Announcement of State Administration of Taxation on Issues Relating to Tax Administration of Value-added Tax (Guoshuifa No. 192 [1995]). Article 1 state that companies that receive a goods, services or transportation fee must be the companies who issue VAT invoices to the counterparties. Only in compliance with this requirement, the goods/services recipients can claim a VAT credit for its purchase. 

“Three flow consistencies” refers to that the requirement that the parties (provider and receiver) for cash flow (supported by the bank statement), invoice flow (supported by the information on the VAT invoice, such as issuer or receiver) and goods flow (or service flow) should be the same with each other[1].  In theory, all three must be all consistent although practically speaking, some discrepancy will be allowed based on reasonable commercial arrangement. 

However, in practice, there always exists an inconsistency between the aforementioned three flows due to reasons such as entrusted third parties payment/collection arrangements. For example, the transfer of receivables brings about the change of payment parties. The risks that arise under this kind of transaction should be carefully managed. For example, this risk may be mitigated by entering into third-party contracts, subject to a case-by-case analysis.

iv. Questions under the transitional period

Going forward, lawyers should be aware of the impact of the VAT Reform and advise clients to take proper measures, including analyzing any future transactions and obtaining the tax certificate of the special purpose vehicle (SPV).  For example, in view of the input VAT credit for newly acquired real estate, companies may encounter large amounts of input VAT. Lawyers should remind companies to take this impact into consideration when making relevant purchasing or selling plans. To optimize the tax burden, it is feasible to target the timeline of the transaction (in advance or after the event) by revisiting the payment and invoicing terms. Companies should also consider negotiating the contract changes with counterparties during the transition period where necessary. 

Many practical transaction arrangements involve a SPV. After VAT Reform, the registration of a SPV as a general taxpayer should be finalized as quickly as possible.  Otherwise, the VAT invoice issued by the SPV cannot be deducted and the tax burden of the transaction will increase.

The industry specific rules under the VAT Reform are critical; for example, the different calculating methods for interest income and financial commodity transfers in the financial services industry, the general and simplified levying and collection of VAT in the real estate industry and the VAT impact on the consumer business industry.  The details of this are beyond the scope of this article, however will be explored in future articles. 

[1]In other words, the payment receiver, the VAT invoice issuer, and the goods seller or services provider shall be the same party while, the VAT invoice receiver and goods buyer or services recipient shall also be the same party.

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