AS of January 1, more than 120,000 businesses in selected industries in Shanghai became the first participants in the Indirect Tax Reform Pilot Program.

There is already speculation that these Shanghai participants will be joined by counterparts in Beijing later this year and potentially by other regions and industries in the future. This is certainly consistent with the view that the pilot program is the first step in the gradual transformation of the indirect tax system here in China.

In this article, we will provide a quick recap of the details of the program, examine where the benefits lie from the change and discuss some considerations for the future.

Key details

From January 1, Shanghai businesses in the "transportation" and certain "modern services" industries, such as research and development, information technology, leasing and consulting, began accounting for value-added tax (VAT) instead of the business tax on the services they provide.

The types of businesses covered by the pilot program are broad and include corporations, both public and private, branches of non-Shanghai based entities, wholly owned foreign entities and state-owned enterprises.

The VAT rates applicable to each of the selected industries are 17 percent (leasing), 11 percent (transportation) and 6 percent (modern services, except leasing).

Services that are exported will be either exempt from VAT or subject to a rate of zero percent. Businesses that make "zero-rated" exports would be entitled to refunds of any VAT paid on costs arising from export activities.

The participants are entitled to credit any VAT paid on business-related costs. Additionally, general VAT payers across China would also be entitled to credit VAT on purchases from participants.

Businesses with annual sales of 5 million yuan (US$794,000) or more would be required to register as general VAT payers, while businesses below this threshold can either opt to register as a general VAT payer - provided they have sound accounting records - or register as a small-scale VAT payer.

Since November, the authorities have released over 10 circulars or announcements addressing various technical and administrative issues relating to the pilot program.

Key benefits of the Reform

Business and consumer friendly

The current business tax (BT) system is not business friendly. There is no "credit mechanism" for the tax, and any cost needs to be absorbed by the business. These "embedded" costs get built into the pricing of businesses and increase at each stage of the supply chain. The resulting effect is that these costs are ultimately squeezing profit margins for businesses and increasing the cost of goods and services for consumers.

The VAT, on the other hand, generally allows businesses to credit any VAT incurred on business costs. As a result, the VAT is not a cost to business.

The resulting impact should also be good for consumers because VAT taxes only the "value added" at each stage of the supply chain and doesn't contain the "multiplier effect" that we have currently with the business tax being added at each stage of the chain. The transition to VAT will mean that these embedded costs will be removed, which will likely reduce the overall tax paid by consumers in purchasing goods and services. This is certainly a welcome change given current pressures in terms of affordability and levels of tax borne by the public.

From a government policy perspective, this is also a positive move because the VAT has been implemented in over 150 countries and has been generally accepted as a fair and efficient tax system. The greater reliance on VAT and the removal of inefficient taxes will not only make it easier for local businesses, but will also provide familiarity for foreign businesses investing into China. As a result, these reforms should encourage further investment and the continued growth of the Chinese economy.

Export friendly

The BT generally taxes exports, which effectively increases the cost of providing those services. It is common among most countries that have a VAT for such services to be exempt from tax, and, as a consequence, the current business tax system impacts the competitiveness of Chinese exporters.

However, participants in the pilot program will have the benefit of either a zero-rated or tax-exempt treatment of their export of services. While both statuses result in no VAT being charged, only businesses that make "zero-rated" exports would be entitled to claim credits for VAT on business costs and be entitled to a refund of the VAT. Non-exporters are generally not entitled to refunds under China's indirect tax system, and instead excess input VAT credits are carried forward to the next period.

The services eligible for zero-rating are international transportation services and export of research and development and design services to foreign entities.

Exported services exempt from VAT include, among others, certification and consulting, advertising, leasing and logistics services, where those services are either performed outside of China or provided to a foreign entity (the condition will vary depending on the type of service in question).

The broad range of zero-rated and VAT-exempt services under the pilot program is a good outcome for businesses and will do a lot to assist the competitiveness of China's exporters.

Practically speaking, it is important to note that there are conditions that need to be satisfied in order to qualify for the zero-rated and exempt treatment, and businesses should assess each transaction individually to ensure that it meets the requirements.

Further considerations

While we expect most Shanghai participants to be well into their transition plans, it is important that the following strategies are incorporated as part of any plans to ensure a smooth transition:

Assess the impact to your operations, processes and finances. This will tell you what your key risk and focus areas should be and, importantly, what your cost impact will be.

Develop an implementation plan. Our experience has shown that having a plan in place will assist greatly in managing your transition.

Upgrade your IT systems. Is your system VAT ready and, if not, what will you need to do to make it VAT ready?

Undertake a review of your contracts. Determine the impact to your existing contracts and identify what changes you need to make to future contracts.

Communications strategy. Have a plan in place to inform your customers, suppliers and other related parties on what the changes are and how they will be impacted.

Implement a training program for all affected staff. Ensuring that adequate training is provided will reduce the risk of errors being made.

As we noted at the start of this article, there are clear signs that the pilot program will expand into other cities and other industries. We would recommend all businesses start assessing what the impact will be. Addressing these issues early can put you in a position not only to manage potential problems but also to take advantage of any potential opportunities that may arise.

Alan Wu is PwC China National Indirect Tax Leader. Senthuran Elalingam is PwC China Indirect Tax Senior Manager.

VAT development and coverage

1954: VAT was first used in France to eliminate duplicated taxation.

1979: VAT system was first introduced in China and a trial program was launched in cities including Shanghai, Xiangfan and Liuzhou, covering five manufacturing industries.

1984: VAT was implemented nationwide in 12 industries including machinery, automotive and steel.

1994: VAT was expanded to companies that manufacture, trade, process and amend goods.

2012: VAT was expanded to some service companies to lower taxes and boost the service industries.