CHINA'S opaque, sometimes onerous tax system has long been viewed by many foreign business leaders as an impairment to Shanghai's competitiveness with Hong Kong, Singapore and other Asian cities.

That may be slowly changing. Some tax relief may be on the way for certain businesses in the services sector.

On November 17, the Ministry of Finance and China's taxation bureau outlined a pilot program for Shanghai aimed at "structurally cutting tax" on transportation companies, research and development work, information technology, consulting and leasing services.

Under the program, which was approved by the State Council in October, affected companies will be taken off the business tax rolls and instead be required to pay a value added tax ranging from 6 to 17 percent, beginning in January.

The VAT currently applies only to companies and individuals within China who sell merchandise, provide processing, repair or assembly services, or import goods.

"It is an important structural tax cut that will help eliminate repeated taxation on goods and services through both VAT and business tax," the Ministry of Finance said. "By improving the tax structure and easing the tax burden, these measures will accelerate development of a modern service industry and reform the economic structure."

Shanghai Party Secretary Yu Zhengsheng yesterday urged companies in Shanghai to make full use of the opportunities brought by the VAT trial that will be a breakthrough for services in the city.

Rise in revenue

"It is the greatest tax reform since 1993," he said. "How can the service industries develop without first sorting out the tax issues? With service industries expanded, the city's tax revenue will also rise."

VAT was introduced for the first time in China at the end of 1993 and applied mainly on manufacturers. This was followed by a boom in manufacturing and exporting industries nationwide.

Economists noted that the proposal, though it won't necessarily reduce taxes for every affected company, will help streamline the tax system and aid the services sector as it did for manufacturers all those years ago.

"The introduction of VAT in 1993 was a great help to manufacturing industries as the new tax system helped to streamline costs," said Robert Smith, a senior partner and leader of the Asia-Pacific indirect tax team at Ernst & Young.

"VAT has been applied to facilitate and encourage companies to move and distribute goods, and with the application of VAT widened to the services sector, we can see China aiming to encourage the distribution of services."

From next year, an 11 percent VAT will be imposed on a variety of transport industries, including road, water, air and pipeline transport. A VAT of 6 percent will be imposed on other service industries, including research and development technology, IT, logistics support and forensics consulting services. Tangible personal property leasing services will be taxed at a rate of 17 percent.

Unlike the business tax, which is between 3 and 5 percent for services included in the pilot program, and applies to a company's total revenue without consideration of costs, the VAT plan will allow companies to claim "input VAT credits" on operating costs, such as the purchase of machines, fuel and other goods and services subject to VAT.

"Previously, the transportation and modern service businesses would not have been entitled to these credits and would have incurred them as an additional cost," said Alan Wu, national indirect tax leader of PricewaterhouseCoopers China. "The pilot program, however, may not automatically mean an increase or decrease in the tax burden for those businesses."

Some businesses will benefit from this change because they will now be entitled to claim an "input VAT credit" on any purchases from other participants in the program, he added.

Research by Chu Hai, an analyst with Ping'an Securities, shows that a transportation company would be able to lower its taxes if its deductible costs comprise 73 percent or more of the company's revenue. A warehousing company would benefit if 55 percent or more of its revenue is deductible.

Chu reached the conclusion that not all companies will meet the criteria, and for modern service providers such as technological companies and consulting firms, the deductibles could be even less.

But Smith said the new policy would boost his company's business even though his company might have to pay a higher tax itself.

Lower costs

Ernst & Young, he said, would be able to issue VAT invoices that could be used as "input VAT credits" by its customers who also pay VAT.

"In this way, customers generally may be more willing to use our services because the cost for them would be lower," Smith said.

"Similarly, we hope that the service industry in Shanghai will get a lift. The VAT has been applied to facilitate and encourage companies to move and distribute goods, and with the application of VAT widened to the services sector, we can see China aiming to encourage the distribution of services."

For some small business owners, the possibility that some companies may end up paying higher taxes under the new program is worrisome.

Take Brian Song, for example. He runs a software company that was eligible for a tax-break program implemented two years ago. But the program got snarled up in inefficient bureaucratic implementation.

He said the company's current tax burden is actually higher because he cannot get through the formalities to obtain entitled tax discounts.

"Our company last year paid value added tax at 17 percent instead of a business tax of around 5 percent," he said. "We do sometimes buy computers that can be deducted, but our major cost is salaries, which are not."

He added: "The bureau allows tax exemptions for research, which makes up about 8 percent of our revenue, but the accounting regulations have prevented us from separating that spending from other costs. Sometimes the regulations conflict."

Smith shrugged off the anomalies as the price of reform and said some cannot be avoided.

"Time is quite limited for both companies and the tax bureau to ascertain how much a company should pay under the new plan," he said. "It would be better if the government allowed three or more months for companies to prepare."

The headaches multiply for companies operating across provincial borders.

Companies with branches in Shanghai and other cities, even Shanghai's closest neighbors such as Kunshan and Taicang, will face different tax rules.

Even if the pilot program succeeds in reducing the tax burden for many companies, consumers may not feel any direct benefits. Ultimately, VAT and other taxes are passed on to consumers. Smith noted that VAT rates in China are still higher than in developed countries in Asia, such as Singapore, Korea and Japan, but are lower than in most European countries.

"We believe the program is progress toward a more modern, fairer tax system in China," he said. "There can be problems with a pilot program, but that's exactly why we need one. We test and test, and then we can make things better."