Background Introduction

On the date of November 11th, 2008, Mr. Wen Jiabao, Premier of the State Council of the People’s Republic of China, convened and chaired the State Council’s Executive Conference, planning the further step of expanding domestic demand and boosting the stable economic development, upon which the continued reform of the Value Added Tax (hereinafter refers to the VAT) was one of the significant aspects. In order to improve the VAT system, the Interim Regulations of the People’s Republic of China on Value Added Tax was revised and approved by the State Council on the same day and would be effective on January 1st, 2009.

VAT transformation reform will take place in all areas and industries of the nation. It allows enterprises to deduct the VAT for new purchasing equipment; cancel policies related to the Importing Equipment Exempt from Taxation and Tax Refund of VAT to Foreign-funded Enterprises for Their Purchase of Home Equipment programmes; and reduce the VAT rate for small taxpayers to 3 percent while resuming the VAT tax rate of 17 percent for mineral products.

Types of VAT

Value Added Tax is a consumption tax which is levied on each stage of production based on the value added to the product at that stage. Broadly speaking, there are three major types of value added taxes in the world corresponding to the gross national product, net national product, and consumption basis. They are the GNP type, income type and the consumption type.

The GNP type of VAT
The GNP type of VAT is also called the production-type of VAT. The GNP type VAT system does not allow any deduction (or credit) of the VAT for the purchased capital equipment against the output VAT. The tax base is equal to the GDP amount. It is the biggest tax base and double tax is highest. Before the VAT system reform of 2009 in China, the type of VAT was the GNP type. That is to say, the input tax of fixed-assets, such as houses, construction and equipment, could not be deducted from the output tax when computing the tax payable. The VAT of GNP type ensured that the government could get more tax revenue, but would limit the increase of investment.

The income type of VAT
The income type of VAT is also called the revenue-type of VAT. The revenue-type VAT system allows the deduction of VAT for purchased capital equipment against the output VAT to the extent of the input VAT in relation to the depreciation amount charged to the income statement for the current period. The tax base equals to the national income and the tax burden is not as heavy as that under production-type VAT system.

The consumption type
The consumption type VAT system allows the deductions of the whole amount of the input VAT for the purchased capital equipment in one go. The tax base here equals the consumption in the GDP. Its tax burden is the lightest and it can completely eliminate double taxation. There are more than 140 countries in the world over that adopt the consumption type VAT system.

How VAT Functions

The standard way to implement a VAT is to say a business owes some percentage on the price of the product minus all taxes previously paid on the good. If VAT rates were 10%, an orange juice maker would pay 10% of the $5 per gallon price ($0.50) minus taxes previously paid by the orange farmer (maybe $0.20). In this example, the orange juice maker would have a $0.30 tax liability. Each business has a strong incentive for its suppliers to pay their taxes, allowing VAT rates to be higher with less tax evasion than a retail sales tax.

The Development Process of VAT in China

In 1994, China adopted the GNP type of VAT system because of two reasons. On one hand, the GNP type of VAT could help increase the fiscal revenue; on the other, it could help restrain investment inflation. However, with the rapid development of the global economy and gradual perfection of the socialist market economy system in China, it was increasingly prominent that taking the VAT transformation reform system was necessary.

After that, the third plenary session of the 16th Central Committee of the Communist Party of China (hereinafter refers to the CPC) pointed out that the reform should be taken in a proper time, and the reform must be completed during the period of the 11th five-year plan in China. Since July 1st, 2004, the experimental reform had been taken in the Northeast area and Central part of China, as a result of which a success was achieved and the expected goals were fulfilled.

In 2008, the work report of the State Council pointed out that a VAT transformation reform proposal must be made. In the same year the 11th Session of the National People’s Congress examined and approved the report of the fiscal budget committee of the 11th Session of the NPC, which provides that the reform shall commence in 2009.

Major Contents of the VAT Transformation Reform

The contents of the VAT transformation reform include the following: where the taxpayer throughout the nation (irrespective of regions and industries) has paid VAT for the purchase of capital equipment, the input VAT can be offset against the output VAT. If the input VAT is not yet fully offset, the balances can be carried forward for use in future periods. To plug any tax loophole, the tax rules shall exclude the VAT paid for small passenger vehicles, motorcycles and yachts that are subject to consumption tax. As a measure to implement the transformation reform the following policies shall be put into effect at the same time: the VAT exemption policy for the imported capital equipment and the VAT refund for the purchase of domestically manufactured capital equipment shall be axed; the levy rate for small scale taxpayer engaged in production and non-production business shall be reduced to a uniform rate of 3%; the VAT rate for mineral products shall be increased to 17%.

Affects On the Enterprises

The transformation reform targets the VAT general taxpayer. After the reform the taxpayer will have a lower tax burden. On the other hand, the small-scale taxpayer (including the individual business trader) is taxed by reference to the sale amount and the levy rate. The small-scale taxpayer is not entitled to input credit. Therefore, their tax burden will not be lowered as a result of the transformation reform.
Currently small-scale taxpayers who carry on manufacturing activities and non-manufacturing activities pay VAT at 6% and 4% respectively. To balance the tax burden between VAT general taxpayer and small-scale taxpayer and promote the development of the SME and increase employment, the tax burden for small-scale taxpayer should be lowered accordingly. To take into account the fact that small-scale taxpayer very often carry on different lines of business in real economic life, it is difficult to draw a line to show whether the small-scale taxpayer carry on the manufacturing and non-manufacturing business. The application of two different tax rates to those small-scale taxpayers doing manufacturing business and those doing non-manufacturing business will be discontinued. The levy rate for the small-scale taxpayer will be lowered to 3% across the board.
The decrease in levy rate for small-scale taxpayer will lower the tax burden of the SME. That will provide for a more favorable environment for the development of the SME. In addition, the Ministry of Finance and State Administration of Taxation will further encourage the development and growth of the SME by raising the threshold for VAT and business tax.

Conclusion

Under the current economic situation, the VAT transformation reform has a major significance in sustaining the steady and relatively fast development of our country’s economy. The VAT transformation reform allows enterprises to offset input credit for the purchase of capital equipment against the output VAT, which will eliminate the double taxation generating from the GNP-type of VAT adopted in China, and reduce the taxation burden of the equipment investment of enterprises. As a result, the VAT transformation reform is a meaningful tax-cutting policy on the premises that the current tax rate is maintained unchanged. Due to the fact that the reform can eliminate the double taxation for the equipment purchase of the enterprises, it can not only help encourage investment and stimulate domestic demand, but also help enterprises make progress on technology, make adjustment on industry structure and make transformation on the mode of economic gains. At present, the financial crisis triggered by the American subprime mortgage crisis has spread to Europe, Asia, and Latin America, as a result of which the growth rate of the global economy has been slowed down apparently. What’s worse, some countries are even confronted with signs of economic recessions. That is to say, the financial crisis has triggered unfavorable influence to the global economy.

Under these circumstances, the VAT transformation reform is of great significance to the further development of the enterprises, enhancement of competition and anti-risk ability of the enterprises. According to the estimation, the fiscal budget of this reform will drop by over RMB120 billion, which is the single largest tax cut in the history of the PRC. Thus, it is believed that the reform policy will have a positive impact on the continuous stable and fast development for our country’s economy.