China’s VAT system a major source of risk and opportunity

June 4, 2013

The cost of China’s VAT

It is a myth that China’s VAT is simply a cash flow item with no P&L impact and a limited risk profile. On closer examination, VAT in China is far from neutral with sticking VAT, blocked input credits, cascading costs and other unique technical matters that can result in significant VAT-related costs hitting the bottom line. A number of recent examples include both foreign and Chinese companies having to make large provisions, or even restate financial statements, due to VAT-related errors or fraud.

Do you know enough about your China VAT?

  • How much VAT throughput is being processed by the organization on a monthly or annual basis?
  • What is the VAT position of the organization on a regular basis and do these positions seem reasonable for the business profile?
  • Are certain non-recoverable VAT costs incurred, either through non-VATable activities, export VAT “leakage,” VAT transfer out, etc? Are these amounts known, managed and possibly reduced?
  • How do company staff keep up to date with the rapid pace of regulatory change? Is anyone responsible for proactively reviewing new developments for impact to the company or does the company only respond reactively?
  • How are our VAT accounting transactions conducted in the system and by whom? Is the accounting system linked to the Golden Tax System (GTS)?
  • Who is managing the VAT return preparation and reporting obligations? Are they able to accumulate the necessary data to accurately complete the returns on a timely basis? Where is the source data gathered from and how is it analyzed prior to finding its way to a VAT return?

The abundant risk and opportunity profile means it is critical for companies to clearly understand how China’s VAT system works. While the risk profile may be higher than anticipated, companies also usually have opportunities to increase compliance, enhance cash flow efficiency and reduce costs.

Once you know about the complexities of China’s VAT regime, then it is clear that the “pass through” low risk myth cannot be true. That is, there are high levels of risk and opportunities that should be explored.

Not surprisingly, the VAT costs and risks rise with the complexity of the legal entity type and the quantity of daily transactional processing. This is exacerbated in China since many companies have “mega-entities” that are part of an intricate global supply chain, and which process huge volumes of transactions.

Each link in the supply chain may suffer VAT costs or “leakage” that results in a less efficient recovery of VAT. Unfortunately, this is a common, but less known, occurrence in China. Consider the following types of actual VAT costs incurred by a company operating in China that can impact the bottom line:

  • Export VAT “leakage”
  • VAT treated as non-creditable and required to be “transferred out”
  • Blocked VAT on certain non-creditable expenditures
  • VAT directly related to exempt BTable services
  • Deemed VAT sales amounts that are not passed on to customers
  • Input VAT paid but the invoice not verified prior to expiration (e.g., 180 days)
  • Input VAT invoices without proper documentation
  • City Construction Tax (CCT) and Education Surcharge (ES) taxes that are assessed on VAT payable amounts
  • Input VAT paid by a toll manufacturer
  • Cash flow funding costs on pending refunds or extended periods of input credit delays

Changing VAT regulatory landscape

Recent years have seen large and small regulatory changes. For example, there have been over 500 updates to regulations from different agencies in each of the last few years, so it not surprising that tax staff may miss an important VAT regulatory development that impacts the business.

The VAT Pilot is a start to addressing the challenges stemming from the inefficiencies of China’s indirect taxing system where services, intangibles and other items covered by the business tax (BT) regime do not interact with the items covered by the VAT regime. Many have asserted that these tax policies resulted in “double taxation” since BT and VAT are not creditable against each other. Unlike other countries with a merged GST regime, China has more cascading tax costs and blockage of VAT that otherwise would be creditable.

The VAT Pilot transitioned three categories of BTable items to the VAT regime and introduced two new rates along with a 0% rate for certain services. It is designed to test the outcomes arising from the transition of certain BT services to VAT. The Shanghai VAT Pilot was launched in January 2012 and has affected over 120,000 new “in-scope” VAT taxpayers.

Managing VAT

Based on our experience, it is challenging to fully understand and appreciate how China VAT affects a company. Especially since the governing regulations and VAT accounting treatment in China vary greatly from other internationally recognized systems.

VAT work in China requires more of everything — more transactions, more documentation, more paper, more invoices, more steps in the process, more data, more returns, more CTB involvement — which can overwhelm resources and lead to difficulty in maintaining compliance. In order to overcome the additional workload created by all the “more,” it is important to understand how the major components of VAT link together in the organization.

Most companies can benefit greatly from focused projects that help to bring VAT operations to the surface, such as VAT process reviews, discovery data analytics, and reconciliations between ERP and VAT data. Dedicated efforts at each legal entity will usually identify areas of strength, areas for improvement and potential savings opportunities that can set the agenda for future action to be taken by responsible VAT staff.

Notwithstanding this, Figure 3 below seeks to provide a high-level idea of how types of legal entities may be plotted along the continuum of variations of transactions and overall complexity to assign a priority of where to start. By diving into the depths of China VAT, companies will benefit greatly through reduced risks, improved compliance, decreased costs and greater cash flow efficiency which can help both the top and bottom line.

Read the full version of this article in the Ernst & Young Indirect Tax Briefing, issue 7 (pdf, 7.13 MB)

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