Establishing a VAT Monitoring System for China
China has rapidly implemented value-added tax reform over the last two years, and it has pledged to complete the reform by finally extending it even to the financial services and real estate industries by 2015.
While value-added tax systems have grown in popularity worldwide over the last thirty years as a new source of dependable tax revenue (reportedly even US presidents Barak Obama and Richard Nixon briefly considered it), the Chinese value-added tax (VAT) system is unique and far more intricate and resource-consuming than normal. It is heavily dependent upon printed VAT invoices that can only be issued and used by resort to elaborate verification processes designed to ensure tax collection and to curtail fraud.
Failure to effectively manage the system can result in substantial tax liabilities that may wholly consume already thin profit margins. Therefore, it is critical for every foreign invested enterprise in China (i) to plan for the impact of VAT from the very beginning, (ii) to establish an independent internal (or outsourced) system to monitor and manage the company’s VAT position, and (iii) for senior enterprise leaders to stay abreast of the company’s VAT position and to consider it when transacting business.
The Chinese VAT system has numerous hazards to ensnare an unwary foreign investor, and examples of several are briefly presented here. On a very foundational level, the most important initial step to effectively managing the Chinese VAT system is for a foreign invested enterprise to attain “general taxpayer status.” Value-added tax is intended to be imposed on nearly every business transaction not specifically exempted or otherwise excluded, and the tax ranges from 3% to 17%.
However, it is possible to reduce this substantial burden through a simple process whereby “input VAT” is used to offset “output VAT.” For instance, if a trading company or manufacturing company purchases goods (and shoulders the burden of a 17% VAT), it can qualify to use such paid-out VAT (“input VAT”) as a type of credit to offset its VAT liability when it sells goods.
Obtaining the qualification to use “input VAT” to offset “output VAT” is the key, and those companies obtaining this status are called “general taxpayers” or “general VAT taxpayers.” This status can be more freely obtained upon the establishment of a new foreign invested enterprise, provided the new company effectively manages the application process; otherwise, the opportunity to obtain such status is thereafter delayed until the enterprise’s annual sales turnover reaches a certain threshold.
As one might imagine, failure to obtain such status as early as possible could adversely impact a company’s cost structure and profits.
Besides the foundational step of obtaining “general taxpayer” status, foreign investors should consider another important factor to realizing tax savings from the Chinese VAT system, which is to effectively manage the process of obtaining and utilizing “input VAT” invoices. As mentioned, “input VAT” invoices are needed to offset “output VAT,” and these invoices are physical paper invoices printed with a special printer by specially trained and qualified employees of companies that have achieved “general taxpayer” status.
If a company’s business partner has not obtained such “general taxpayer” status, then such physical paper “input VAT” invoices will only be available by making special application to the Chinese tax bureau and, if not obtained, the company would bear a heavier burden of VAT; therefore, it is important to screen vendors or business partners to determine their taxpayer status or ability to obtain these invoices.
If and when such paper “input VAT” invoices can actually be obtained from vendors or partners, they must then first be officially verified by Chinese tax authorities through a formal process that is usually performed electronically over the Internet but that may sometimes require an in-person petition at the Chinese tax bureau. But the intricacies of the Chinese VAT system do not cease here; Timing is also an extremely important factor in effectively utilizing “input VAT.”
Input VAT invoice must be verified within 180 days of issuance. The purpose of the verification is to ensure that the VAT invoice is genuine. Upon verification, the company needs to fill in the input VAT amount in the VAT return form when conducting VAT filing. The VAT filing should take place within the stipulated VAT filing period, which is usually the first 15 days of the following month.
As an example, if the VAT invoice is verified in January, it must be included in the VAT filing for January, which should be completed before February 15. If the company does not have output VAT from which to offset input VAT, the input VAT being will be retained in the tax system of tax bureau and carried forward to the next period for offsetting.
As a foreign investor may readily see, effective management of the VAT system so as to reduce tax exposure requires focused attention and dedicated resources. Characteristics of an effective VAT monitoring and management system for China would likely include at least the following:
- Identity VAT compliance and efficient management as an enterprise priority
- Place responsibility and accountability with a senior level manager
- Outsource and/or hire sufficient dedicated and qualified specialists
- Establish processes for monitoring and reporting the VAT position to enterprise leaders
- Create a VAT position report that is included in management financial reports
- Monitor the effectiveness of obtaining and utilizing “input VAT” and aging balances
- Monitor VAT balances and fluctuations or variances and identify risks
- Establish standards and protocols that limit the risk of adverse exposure to VAT
- Create a risk and crisis resolution procedure to ensure problems are timely addressed
- Schedule and conduct VAT audits on a regular basis
- Stay abreast of a rapidly changing regulatory environment, including, for example, the availability of VAT refunds and exemptions, and adapt processes and policies accordingly
Because of the complexity of the Chinese value-added tax system and rapid rate of regulatory reform, foreign investors should anticipate a sharp learning curve and on-going need for professional support. Even a well-resourced and capable internal VAT management team may need to confer with industry experts to understand the latest changes and local interpretation or to draw upon additional manpower.
Dezan Shira & Associates is a specialist foreign direct investment practice, providing corporate establishment, business advisory, tax advisory and compliance, accounting, payroll, due diligence and financial review services to multinationals investing in emerging Asia. Since its establishment in 1992, the firm has grown into one of Asia’s most versatile full-service consultancies with operational offices across China, Hong Kong, India, Singapore and Vietnam as well as liaison offices in Italy and the United States.