VAT is the major source of fiscal revenue for the government of China, particularly the central government. In 2007, the revenue from VAT amounted to RMB15.47 billion, accounting for 33.9 percent of China?s total tax revenue for the year ? it accounted for the largest percentage of the China?s annual tax revenues.

The Chinese government rules that all enterprises and individuals engaged in the sale of goods, provision of processing, repairs and replacement services, and import of goods within China shall pay VAT. There are a few exemptions, such as self-produced agricultural products sold by agricultural producers, contraceptive medicines and devices, antique books, importation of instruments and equipment directly used in scientific research, experiment and education, importation of materials and equipment from foreign governments and international organizations as assistance free of charge, articles imported directly by the organizations of the disabled for special use by the disabled, and sale of goods which have been used by the sellers. However, pretty much every business will be liable for this tax.

The VAT rate for general taxpayers is generally 17 percent, or 13 percent for some goods (see table below). For taxpayers who deal in goods or provide taxable services with different tax rates, the sale amounts for the different tax rates shall be accounted for separately. If this is not done, the higher tax rate shall apply.

China VAT calculation for general taxpayers

The VAT payable shall be the balance of output tax for the period, after deducting the input tax for the period. The formula required:

VAT Payable = Output VAT ? Input VAT

Output VAT is calculated based on the value of the taxpayer?s sales, namely
Output VAT = A × B, where A = sales value and B = tax rate

A general taxpayer will usually purchase goods or receive taxable labor services during the course of doing business. The VAT paid by the general taxpayer is Input VAT. The Input VAT is used as a credit against the output tax levied on selling the goods.
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China?s value-added taxes contribute a large percentage of China?s annual tax revenue and account for a significant proportion of tax liabilities for many Chinese enterprises. They affect companies that sell, manufacture, process or repair tangible goods in China and can be quite complex. In 2003, China began a massive reformation of its VAT system, launching pilot programs in Northeast China. Following the program?s success in the provinces of Heilongjiang, Jilin, and Liaoning, the central government implemented the VAT reforms nationally in 2009.

China started to implement VAT in 1984 on 24 specified taxable items and on December 13, 1993, the State Council promulgated “The Provisional Regulation of the People’s Republic of China on Value Added Tax” with the intent of ?unifying taxation management, equalizing the tax burden, simplifying the tax system, and guaranteeing financial revenue.? This law, which codified China?s VAT system, has been in use ever since.

In 2004, China introduced VAT reforms in the provinces of Heilongjiang, Jilin and Liaoning in an effort to revitalize the old industrial base of Northeast China. The method of ?increment deduction? was adopted and the scope of the reform confined to eight industries: equipment manufacturing, petrochemical, metallurgy, automobile, shipbuilding, new- and high-tech industries, and agricultural products processing. Following the success of the pilot reform in the Northeast, it was extended in 2007 to 26 old industrial base cities in the Central Chinese provinces of Henan, Hunan, Hubei, Shanxi, Anhui and Jiangxi. In the second half of 2008, five areas of eastern Inner Mongolia and the earthquake devastated region of Wenchuan in Sichuan Province were also designated as VAT reform pilot areas.

China?s move from a production?based VAT system to a consumption-based one began in earnest in 2009 when the government implemented VAT reform nationwide. With the exception of specific industries that the state has mandated are to be restricted, all industries in China now fall under the VAT reform system and companies are able to offset the full amount of input VAT paid on newly purchased machinery and equipment against VAT collected when they sell their products.

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VAT is a liability to the tax bureau within a month of the sales invoice being issued. Typically 17% of the sales total, it is supposed to be settled at each month end. Fair enough. However ? when in China does anyone pay within 30 days ? Receivables run into months. There is risk of bad debt. So ? the mere fact of incurring a VAT liability means an immediate reaction to this ? often resulting in the following behavior:

1) Goods being shipped / delivered with no supporting invoices
2) Inventory discrepancies

So you are already out of whack between recorded sales and inventory management just there. Then, let?s assume payment for the goods is received in stages rather than immediate settlement, as is common in China with many businesses trying to cover up operational inefficiencies through manipulating cash flow. There is STILL a reluctance to issue the invoice and acquire the full VAT burden as full payment for the goods has yet to be received.

Common practice therefore is for the Accounting Manager, or General Manager, to open a private bank account, and for the customer?s money to be transferred to this account, instead of the company account. When the total amount of receivables has finally been transferred ? the manager then issues the official company invoice to the customer and transfers the monies in his accounts to the company (or should do), who can then in turn settle the VAT portion at the month end without risk. So ? here we uncover a quandary. Is this fraud ? Is it understandable? Does it cause financial / stock control problems? Does it cause audit problems? Is it in compliance ?

When assessing, either your own internal financial controls, or certainly when conducting due diligence on a Chinese business, the likelihood of uncovering such activity is extremely high. So ? what are the risks ?

VAT Cash Flow Risk versus Late Payment Risk

If you invoice upon delivery ? you either get in compliance with the tax regulations and settle at the month end ? and then swallow that burden until the client pays, or you delay payment of VAT. That carries the risk of late payment penalties. Or you enact the scenario above. These can be categorized:

VAT cash flow
I fund the tax bureau 17% until I can collect on the debt in full.

VAT late payment
I delay payment until the client settles. I risk getting into trouble and incurring late payment fines of up to a maximum of 5 times the amount due, plus the original VAT amount.

Chinese style management
I incorporate the system above to minimize 1 and 2, but create financial reporting and audit problems in doing so.

So ? now we begin to see the difficulties of being in compliance in China ? as well as start to understand some of the rationale behind Chinese style management accounting.

To know more, the whole issue is available (after a free subscription) on China Briefing website with others archives
For more information on China’s legal and tax issues or to ask for professional advices in related matters, please write to info@dezshira.com