All eyes on China’s approach to VAT base
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.