All eyes on China’s ap­proach to VAT base

Business Day - Business Law and Tax Review - - BUSINESS LAW & TAX REVIEW - Ferdie Sch­nei­der

Indi­ca­tions are China’s fi­nan­cial ser­vices in­dus­try will have the widest ap­pli­ca­tion yet of this tax

SOUTH Africa has been among the front-run­ners in spread­ing its value-added tax (VAT) on fi­nan­cial ser­vices net as wide as pos­si­ble. In the mid-1990’s the Katz Tax Com­mis­sion ap­pointed a VAT com­mit­tee un­der the chair­man­ship of The­unie Late­gan. It in­cluded ex­perts in in­dus­try and from the gov­ern­ment, to in­ves­ti­gate VAT on fi­nan­cial ser­vices, specif­i­cally with a view to widen­ing the VAT base. Var­i­ous VAT or gen­eral sales tax sys­tems and re­search were taken into ac­count. The pub­li­ca­tion of their find­ings led to a fur­ther widen­ing of the VAT base.

The VAT com­mit­tee also con­sid­ered the eco­nomic make-up of in­ter­est and whether in­ter­est lents it­self to be taxed un­der a VAT sys­tem. The com­mit­tee con­cluded that al­though in­ter­est com­prises of, among oth­ers, three com­po­nents, the only com­po­nent that should eco­nom­i­cally be taxed is in­ter­me­di­a­tion ser­vices. As it is dif­fi­cult to dis­sect the in­ter­me­di­a­tion por­tion of in­ter­est, it was de­cided not to fur­ther this dis­cus­sion.

This de­bate has not nec­es­sar­ily ended and any eco­nom­i­cally sound ap­proach could be looked at in an at­tempt to widen the VAT net. China may be such a source. China opted to im­ple­ment VAT in a staged ap­proach. The first stages of in­tro­duc­ing VAT in­cludes a fo­cus on the trans­port and “mod­ern ser­vice” in­dus­tries, with ef­fect from 1 Jan­uary 2012.

China (through its min­istry of fi­nance) is also now aim­ing to broaden the VAT base to the fi­nan­cial ser­vices in­dus­try. Indi­ca­tions are that VAT will be ap­plied more broadly to this sec­tor than in any other ju­ris­dic­tion to date. Given that four of the world’s largest banks are based in China, it is cru­cial to es­tab­lish the likely im­pact of China’s pro­pos­als.

Fi­nan­cial in­sti­tu­tions cur­rently pay busi­ness tax at a rate of 5%, cal­cu­lated on net prof­its. The ma­jor dif­fer­ence be­tween this tax and VAT is that it is a tax on busi­nesses whereas VAT is mainly borne by end con­sumers.

China pro­poses that VAT should be ap­plied to fi­nan­cial in­ter­me­di­a­tion ser­vices (eg lend­ing and de­posit­tak­ing); fee-based ser­vices (eg agency ser­vices, set­tle­ment ser­vices, ad­vi­sory and con­sult­ing ser­vices, elec­tronic bank­ing, as­set man­age­ment, cus­tody ser­vices); mar­gin-based fi­nan­cial ser­vices (eg trad­ing in shares, bonds, de­riv­a­tives, for­eign ex­change); and gen­eral com­modi­ties trad­ing ser­vices (eg pre­cious met­als trad­ing).

China aims to po­ten­tially ap­ply VAT to an even wider base than the South African VAT sys­tem by ap­ply­ing VAT to fi­nan­cial ser­vices by tax­ing in­ter­est in­come.

A 2012 bank­ing sur­vey of 197 banks in China (ap­prox­i­mately 88% of all bank­ing as­sets in China) showed that more than 80% of all rev­enue de­rived by the banks com­prised in­ter­est.

The in­tro­duc­tion of VAT could ad­dress the po­ten­tial loss to the Chi­nese fis­cus since busi­ness tax at 5% is ap­plied to fi­nan­cial in­sti­tu­tions’ in­ter­est in­come.

It would still need to be con­sid­ered whether VAT on lend­ing ac­tiv­i­ties would be taxed at gross or net mar­gin level. Sound VAT prin­ci­ples would have VAT ap­plied to net mar­gin. Var­i­ous meth­ods could be con­sid­ered to achieve this. It would also need to be con­sid­ered how VAT should be ap­plied to cross­bor­der trans­ac­tions. In this re­gard, the im­pact of in­tro­duc­ing zero rated or ex­empt pro­vi­sions would have to be con­sid­ered to en­sure that Chi­nese banks are not com­mer­cially dis­ad­van­taged, com­pared to in­ter­na­tional lenders.

SA and Aus­tralia do ap­ply VAT to fee-based in­come re­ceived from fi­nan­cial ser­vices and China will most likely fol­low the same route, ie con­sis­tently ap­ply­ing nor­mal VAT rules to fi­nan­cial type ser­vices.

Typ­i­cal ser­vices that would fall within this cat­e­gory would be ar­range­ment, agency and bro­ker­age, trust, as­set man­age­ment and con­sul­tancy ser­vices. busi­ness tax cur­rently taxes gains from fi­nan­cial trad­ing ac­tiv­i­ties (ie trade in fi­nan­cial in­stru­ments) on a net mar­gin ba­sis. Th­ese fi­nan­cial ser­vices in­clude fi­nan­cial de­riv­a­tives, bonds and for­eign ex­change trans­ac­tions.

Ap­ply­ing VAT to th­ese types of trans­ac­tions would be chal­leng­ing as var­i­ous con­sid­er­a­tions would need to be con­sid­ered, eg the lo­ca­tion of the sell­ers and pur­chasers, the VAT reg­is­tra­tion sta­tus of the sell­ers, the im­pact on busi­nesses, etc.

Gen­er­ally, most VAT ju­ris­dic­tions sub­ject the trade in com­modi­ties to

China aims to po­ten­tially ap­ply VAT to an even wider base than the South African VAT sys­tem by ap­ply­ing VAT to fi­nan­cial ser­vices by tax­ing in­ter­est in­come

VAT, whereas the trade in fi­nan­cial in­stru­ments (eg de­riv­a­tives such as fu­tures and op­tions) is ex­empt from VAT. It re­mains to be seen whether China will fol­low the global ap­proach in re­la­tion to com­mod­ity de­riv­a­tives.

A fur­ther is­sue that would need to be con­sid­ered is choos­ing the ap­pro­pri­ate VAT rate to be ap­plied, tak­ing into con­sid­er­a­tion the rate of busi­ness tax (5%), the cur­rent VAT rates on mod­ern ser­vices (6%), the trans­porta­tion in­dus­try (11%) and leas­ing of mov­able goods (17%). It is dif­fi­cult to pre­dict the rate that would be ap­plied but log­i­cally the 6% or 11% rate ap­pear to be the most ob­vi­ous. The­o­ret­i­cally a multi-rate VAT sys­tem is not pre­ferred.

Var­i­ous other is­sues would also need to be fac­tored in be­fore China could in­tro­duce VAT on fi­nan­cial ser­vices. Tran­si­tional mea­sures would, for ex­am­ple, have to be con­sid­ered to al­low fi­nan­cial in­sti­tu­tions to com­ply with VAT rules, IT sys­tem changes, in­voic­ing and in­put tax cred­its, etc.

Should China opt to ex­empt cer­tain fi­nan­cial ser­vices from VAT, fi­nan­cial in­sti­tu­tions would need to de­ter­mine the level of al­low­able in­put tax de­duc­tions. The prin­ci­ple of di­rect at­tri­bu­tion of tax­able ver­sus ex­empt ex­pen­di­ture would need to be ap­plied as well as the ap­por­tion­ment of dual use costs in line with the VAT rules that will be im­ple­mented.

Al­though early days, China’s ap­proach to VAT on fi­nan­cial ser­vices may be very in­sight­ful for SA.

Hope­fully China will draw from the South African ex­pe­ri­ence in de­vis­ing a VAT sys­tem to tax fi­nan­cial ser­vices.

Ferdie Sch­nei­der is tax part­ner for value-added tax at KPMG.

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