The Chinese government is embarking on an ambitious reform program for its indirect tax system. The objective is to replace the current dual system of indirect taxes - value added tax (VAT) and business tax (BT) - with a single VAT system, which applies to the entire goods and services sector.

The reform will be implemented progressively over a period of time, with BT being replaced by VAT on a sector-by-sector and province-by-province basis. It started in Shanghai on Jan 1, 2012, with the transition to VAT for "modern services" and transportation sectors, before being extended to the rest of the country on Aug 1, 2013.

The first phase of the VAT pilot program has been implemented relatively smoothly, with many businesses reporting overall easing of their tax burden. Since the initial phase of the VAT pilot program has been completed, attention is now turning to the remaining sectors of the economy that are yet to transition to VAT.

VAT (or a similar goods and services tax) now applies to more than 160 countries. International experience shows that the next phases of the VAT pilot program, due to start in 2014, will be far more challenging. In 2014 (and early 2015), it is expected that VAT will replace BT in several critical sectors, including telecommunications, construction and real estate, and financial services and insurance.

For the telecommunications sector, it is widely speculated that an 11 percent VAT rate will apply. This VAT rate contrasts with the 17 percent VAT rate applicable to the sale of mobile telephone equipment (that is, handsets), and the 6 percent VAT rate currently applicable to certain IT and data services. Not surprisingly, complexities can arise in a number of areas - classifying certain telecommunications services and applying the correct VAT rate, determining how VAT should apply to global roaming and other cross-border services, and implementing the golden tax system for such a large and diverse customer base across all provinces of China.

The growth of e-commerce and the increasing delivery of services electronically also pose a challenge for policymakers in ensuring the new system is suitable to withstand modern technological developments.

In the construction and real estate sector, an 11 percent VAT rate is expected to be introduced, to replace the current 3 percent and 5 percent BT rates. Not surprisingly, industry participants want to understand the impact this change will have on their tax burden, given that any VAT on inputs into real estate development, its ongoing operation, and sale or leasing is expected to be creditable for general VAT taxpayers.

The challenges are in designing a VAT system that serves to promote the continued growth of these key sectors. The current BT system essentially taxes transactions affecting most real estate asset classes, from residential to retail to office to industrial property, and to transactions by both businesses and consumers.

Internationally, most tax systems either exempt real estate transactions or sales of secondhand houses by the general public from VAT. It would be interesting to see whether China's VAT system will be as broadly based.

Further challenges arise in managing the transition to VAT, so as to ensure that existing real estate transactions, or those partly completed, are subject to VAT on the "value added" system only, and not effectively taxed under BT and VAT both.

The financial and insurance sectors in China have shown resilience to recent global economic turmoil, which is envied by many other countries. A stable and internationally competitive tax system is a key ingredient to secure its ongoing growth and development.

European Union member states exempt financial and insurance services from VAT because of the difficulty in measuring the "value-added" content on a transaction-by-transaction basis. China seems likely to follow more modern VAT systems around the world, which increasingly seek to tax financial and insurance services under VAT. However, through the system of giving input VAT credits, such a reform would benefit many businesses that are general VAT taxpayers, as compared with the existing BT system in which a 5 percent BT cost is embedded as real cost.

Chinese officials are testing a unique approach to taxing financial services such as interest income under VAT. This is a system that is not broadly used worldwide. Their objective is to ensure that China's VAT system meets both current and future needs as these sectors develop increasingly sophisticated products and services, and extend their reach to overseas markets.

While the introduction of VAT for each of these sectors is challenging, it is clear that officials from the Ministry of Finance and the State Administration of Taxation are ready for the challenge. They have studied international systems and shown a willingness to adopt key principles beneficial to business, and to use international principles to meet the needs of the Chinese economy.

International experience highlights that while the transition to VAT can create ripples in the short-term, the longer-term transition to VAT is expected to be collectively beneficial both to businesses and the economy. China's new VAT rates of 6 percent and 11 percent, coupled with its existing VAT rate of 17 percent, are all lower than the OECD global average rate of VAT, which now exceeds 18 percent.

The shift to a more modern tax system is consistent with international norms, will help alleviate indirect tax liabilities in B2B transactions, and promote export services. It is an important step in promoting the development of the services sector as part of the government's 12th Five-Year Plan (2011-15).

Lachlan Wolfers is partner, and Shirley Shen is senior manager at KPMG China.

(China Daily 10/31/2013 page9)