STARTING September 1, Beijing has become China's second city to expand the value-added-tax to the service sector. Like Shanghai, which started the tax reform at the beginning this year, Beijing will charge a 17 percent VAT rate for leasing tangible assets, 11 percent for transport, and 6 percent for selected modern services. For small businesses with annual revenue of 5 million yuan (US$78.9 million) or less, the preferential rate is 3 percent.

The VAT is designed to replace the business tax, which taxes the gross revenue of most businesses. The VAT approach is considered fairer because the tax is levied at each stage of production and services when value is added to a product. By the end of this year, the transition from business tax to VAT will be expanded to Tianjin city and six more provinces.

Consultant and advisory firm KPMG China has been tracking the changes and what they mean for businesses. Lachlan Wolfers, a KPMG China partner, sat down with Shanghai Daily to discuss some of benefits and challenges of the move to a VAT system.

Why is cutting, or reforming, taxes so difficult?

When you want to cut taxes, the question becomes: Who should get the benefit? Companies? Individuals? Wealthy individuals? The middle class? There are a lot of different issues that arise.

The difficulty of cutting taxes in China, as elsewhere, is trying to target the changes to produce the economic consequences you want. You want to ensure a tax cut actually boosts the economy, and in a way which delivers long term economic benefits.

One way is to change corporate tax rates or VAT rates because that can sometimes stimulate an economy. Another way is to encourage businesses to invest in infrastructure.

Back in the financial crisis in 2008, China allowed manufacturers to claim VAT credits for fixed assets they bought. This meant they could get 17 percent VAT credits they could not get before. It was designed to encourage companies to spend more on infrastructure and capital assets when economic conditions were difficult.

It is a common technique used not only in China but in other countries as well.

Will introducing VAT reforms during a time of economic difficulties add to the challenges facing companies?

In China, the purpose of the VAT pilot program is not to increase government revenue -- instead, it's designed to simplify the tax system. Data from the Shanghai Statistics Bureau show that tax revenue from VAT taxpayers decreased by around 4.5 billion yuan in the first six months. The fact the reforms are happening during difficult economic conditions is actually a good thing because it helps stimulate the economy.

It's not just the companies in selected industries that will be affected. Many manufacturers can now claim VAT credits for the services they buy. They couldn't do that before. It is also an example of how businesses can benefit even though they are not part of the program.

When Shanghai began the tax reform program, provinces surrounding Shanghai wanted to join, too, because businesses in those cities said it would be helpful.

Most multinational companies, in particular, are more familiar with VAT because it is applied in more than 150 countries around the world. By having a VAT system in China across both goods and services, you get a system far more familiar to international businesses.

Authorities said that the VAT reforms in Shanghai have cut the tax burden for about 100,000 participants, but there are also companies that end up paying higher taxes. Also, the compliance cost for companies can be high. Do you think that the current VAT reform has been helpful to companies?

Yes, it has been beneficial. From the experience in Shanghai, most businesses have a reduced tax burden.

However, whenever you undertake significant tax reforms like this one, there will always be challenges in the short term. For multinationals and many large businesses, these reforms impact a broad cross section of people across the company, including information technology, finance, sales, procurement and legal. It highlights the challenges in implementing these reforms in a short period of time.

Because you've got VAT in Shanghai and Beijing but still retain the business tax in other cities, the changes will create some additional complexities, especially in the next 12 to 18 months. But in a longer term, when all business nationwide are paying VAT instead of the business tax, the whole system will actually become a lot simpler.

There are some companies, in particular transportation and logistics sectors, that have a higher tax burden as a result of the reforms. The government is giving subsidies to many businesses with higher tax burdens.

The government started this reform with a pilot program that allowed them to test the changes. It gives them the flexibility to make alterations through the process. I know that the Chinese tax authorities are closely monitoring the impact of what is happening in Shanghai, and it's possible in some sectors that we may see some further changes.

The VAT program will expand to six more provinces and Tianjin city this year. Do you expect the rules to be the same throughout China?

The rules for Beijing, six provinces and Tianjin city that will join this year are the same as for Shanghai. Where some differences may occur is because Shanghai has a single state and local tax authority. In other cities, the state and local tax authorities are separate. So they may take some time to adjust to the reforms, potentially a little longer than in Shanghai. The other point is that the industries dominant in Shanghai may be different from those in other cities.

For example, Beijing has a very strong IT sector and a bigger cultural sector. There will be different issues within different cities.

How can China deal with conflicts between central and local governments during the transition from the business tax to a VAT?

The Chinese officials preparing for the pilot VAT program actually went to Australia (and other countries) to see how the system there works. In Australia, we have the central government and state governments collecting different taxes.

Australia dealt with this problem by having the central government levy the goods and services tax (GST) and then disperse the money collected to state governments. In exchange, the state governments had to stop levying sales and other minor taxes.

It is quite a unique way to try to minimize conflicts between the central and local governments. It's not yet known how China will deal with the problem in the long term, but having a centralized VAT system is better able to facilitate China's future development.

China's VAT system

China first introduced value-added-tax in 1979 and applied on goods manufacturers, merchandises and traders.

The streamlined tax system has given China's goods industries a boost and helped China to become world's largest manufacturer. The State Council, or the cabinet, last year chose Shanghai as a pilot city to expand VAT to the service sector, as part of the country's efforts to boost the services industries, and to shift China's dependence from investment to consumption.

Under the VAT system, service companies are able to deduct the VAT incurred on their purchase of goods and other services.