China: VAT reforms for the Telecommunications Sector
20 May 2014
Posted by: Author: Khoonming Ho
Author: Khoonming Ho (KPMG)
On 29 April 2014 China's Ministry of Finance and State Administration of Taxation jointly issued Circular Caishui  43 ("Circular 43") which provides for the entry into the Value Added Tax ("VAT") reforms of the telecommunications sector.
The transition from Business Tax ("BT") to VAT for the telecommunications sector has been much anticipated. However, the release of Circular 43 provides for a very short timeframe for transition, with VAT to commence from 1 June 2014. This will prove challenging given the complexities associated with having multiple VAT rates in the one industry – Circular 43 provides for an 11% VAT rate for basic telecommunications services and a 6% VAT rate for value-added telecommunications services. Furthermore, the discontinuance of a number of concessions which existed under the BT system means that the scope of these reforms now affect a broader group of taxpayers, including foreign telecommunications providers, as well as new forms of telecommunications service providers such as the digitised services industry.
With the largest fixed-line and mobile network in the world in terms of network capacity and numbers of subscribers, the challenges of VAT implementation in China should not be underestimated.
The telecommunications sector in China is heavily regulated, and many had expected that the scope of Circular 43 would largely be limited in its application to the three major State owned enterprises, China Mobile, China Telecom and China Unicom. However, Circular 43 is significantly broader in its application, and includes key rules which impact on (amongst others):
- Foreign telecommunications providers; and
- The digitised services industry
In June 2013, KPMG released its detailed publication entitled " VAT Reforms for Telecommunications Services". In that report we sought to anticipate many of the policies the government may implement, and many of the issues the industry would face in its preparation for the VAT reforms. Many of the predictions we made in that publication have been validated by Circular 43, but yet a number of the issues we identified as requiring clarification are yet to be addressed.
From an overall policy perspective, the introduction of the VAT rules for the telecommunications sector serve as a time to reflect and consider what it reveals in terms of key trends for the VAT reforms as a whole:
- As new industries join the VAT pilot program, the expansion is occurring on a national basis, not a province-by-province basis as had previously occurred.
- New industries joining the VAT pilot program are more likely to be subject to an 11% VAT rate, rather than the lower 6% VAT rate. This will potentially affect industries such as real estate and construction, and financial services and insurance, which are yet to join the VAT reforms.
- The policy of having multiple VAT rates can give rise to uncertainties, with similar services often being subject to VAT at different rates. There is also an impact on businesses claiming input VAT credits, with different types of expenses generating different levels of credit. This can distort the operation of the VAT system as compared with how many VAT/GST systems operate internationally.
- The sooner the VAT reforms are expanded to all services sectors, the better. The current approach of having to determine whether services fall within the scope of VAT, or whether they remain subject to Business Tax (BT), is problematic.
- The timeframes for implementation remain very short, and challenging, particularly for sectors which are very 'systems driven' such as the telecommunications sector. This highlights the need for businesses to take steps prior to the release of the rules, so as to split implementation projects into pre-announcement steps and post-announcement steps, the former not being as sensitive to the detail of specific VAT policies.
- The initial rules for the telecommunications sector are incomplete in some respects. Businesses yet to join the VAT reforms should therefore recognise that the release of the rules will not resolve all issues. Further rules, including local implementation rules, are likely to evolve over time. This highlights the need to engage early in dialogue with the MOF and the SAT so as to have a better understanding of the broader policy intentions which sit behind the rules.
Circular 43 – key details at a glance
In Circular 43, the MOF and the SAT announced the following:
As noted previously, one of the concerns with Circular 43 is that it is relatively light on detail. There are a number of aspects of the Circular likely to give rise to interpretational uncertainties, and there are a number of key technical and industry issues not yet dealt with in the Circular. It is therefore likely, in our view, that further Circulars, whether by the MOF and SAT, or local Circulars to provide local implementation or interpretational rules, will be issued over time. This does not diminish, but rather adds to, the challenges industry will have in implementing the transition to VAT in the short term.
VAT rates and the tax burden impact
The 11% VAT rate for basic telecommunications services and the 6% VAT rate for value-added telecommunications services both replace the current 3% BT rate for telecommunications services. The theory as to why different rates have been used is that basic telecommunications services utilise more significant infrastructure and require more substantial capital equipment investment as compared with value-added telecommunications services. Consequently, providers of basic telecommunications services can benefit comparatively more from being eligible to claim input VAT credits for their investment costs over time.
The adoption of an 11% VAT rate for basic telecommunications services is likely to cause an increase in the overall tax burden for the major telecommunications carriers, at least in the short term. That is because they will be subject to output VAT at the rate of 11% on their revenue with effect from 1 June 2014, but the full benefit of input VAT credits (typically at 17%) for their capital expenditure costs may take several years to be fully realised, as they replace or repair their infrastructure.
The question as to whether this increased tax burden is likely to result in higher prices to consumers is more complex. The telecommunications sector in China is subject to regulated pricing, so the potential flow-on effect to consumers will be awaited with interest.
The question of whether the replacement of a 3% BT rate with a 6% VAT rate for value-added telecommunications services is likely to increase or decrease the tax burden impact will likely depend on a range of factors, such as the extent of capital inputs relative to staff costs, and whether their customer base are VAT taxpayers or end-consumers.
Distinction between basic telecommunications services and value-added telecommunications services
The distinction between "basic" telecommunications services and "value-added" telecommunications services is, in part, based on similar distinctions which exist in the general regulatory environment in China. That is, basic telecommunications services are effectively a heavily restricted industry, which is limited to the three major Stated owned carriers, whereas value-added telecommunications services is an area where some foreign ownership is permitted (commonly through Chinese foreign joint ventures).
In practice, a key aspect of the difference is that basic telecommunications services refer to voice communications services only (by virtually any means), whereas value-added telecommunications services refer to SMS, MMS, data usage etc. The problem with this distinction is that it does not necessarily mirror the pricing methods under which telecommunications services are provided in the marketplace. For example:
- Many consumers pay a fixed package fee, which will incorporate some call usage allowances, and some data usage allowances. Apportioning those fixed fees will be challenging and may be a key area of focus by the tax authorities;
- Where consumers use the internet to make voice calls, and to use SMS or MMS, it is unclear how the carriers systems will be able to detect this and apply the appropriate VAT rates.
Curiously, calls made by way of the internet (for example, by VOIP) would be regarded as a basic telecommunications service, whereas general internet access and downloads are subject to VAT as a value-added telecommunications service. This is difficult to understand from a policy perspective given essentially the same technology is involved.
Businesses incurring telecommunications expenses
Virtually every business incurs telecommunications expenses, whether it be from fixed lines, mobile phones or internet services. Under the general VAT rules, businesses which are general VAT taxpayers are eligible to claim input VAT credits for their expenses.
Under the previous BT system, whenever a business incurred expenses for telecommunications services, there was an implicit BT cost of 3% embedded in the price. However, with the availability of input VAT credits for telecommunications services purchased by businesses which are general VAT taxpayers, it may be expected that the real costs of those services may fall. Affected businesses will need to obtain special VAT invoices for their telecommunications costs in order to claim input VAT credits.
One issue which arises from the transition to VAT is that it raises the prospect of tax planning in having employers purchase fixed lines, incur mobile phone bills, or internet connections for their employees. Strictly speaking, where those costs are incurred for business purposes an input VAT credit should be available to those employers registered as general VAT taxpayers. However, there is a general exclusion which prevents input VAT credits from being claimed for costs associated with activities for "group welfare or personal consumption". How that will be interpreted in the context of telecommunications services acquired by employers for the benefit of their employees will be awaited with interest. Whether it leads to apportionment between private and domestic usage will also be awaited with interest.
Global roaming and other cross border transactions – impacts on foreign telecommunications providers
Circular 43 contains a specific provision under which telecommunications services (both basic and value-added) provided by Chinese entities to overseas entities is exempt from VAT. Unlike the OECD's recently released International VAT/GST Guidelines (dated 17-18 April 2014) which recommends zero rating, the concession granted for outbound telecommunications services in China is one of exemption from VAT. This means that Chinese telecommunications carriers need to identify its costs and expenses specifically relating to its exempt supplies and deny (or transfer out) any related input VAT credits, and apportion its input VAT credits for its general overhead costs. The distinction between exemption from VAT in China and zero rating is not as pronounced as it is internationally, due to a specific concession which preserves the entitlement to claim full input VAT credits for fixed assets used in a business of making only partially taxable sales.
A further issue is how any exemption from VAT will be administered. The experience of taxpayers with the VAT pilot program so far show that extensive documentation is often needed to validate exemption claims; many taxpayers were required to pay VAT and wait in some cases up to 2 years before a refund was provided; and generally the criteria for accessing refunds has been interpreted narrowly.
Importantly though, Circular 43 contains no comparable exemption provision relating to telecommunications services provided by overseas entities to Chinese entities. This comes as a real surprise.
The previous BT system had specific exemptions which applied to both outbound and inbound telecommunications services – they were contained in Circular Guoshuihan  300 and Circular Caishui  111. The omission of a specific exemption for inbound telecommunications services under the VAT reforms raises a potential legal and commercial minefield for foreign telecommunications carriers. In the absence of a specific exemption, it means that when they provide their services to Chinese entities, VAT must be withheld at the rate of 11% (for basic telecommunications services) and 6% (for value-added telecommunications services).
It is important to recognise that the VAT system in China is a withholding system, not a reverse charge system as is commonly used internationally. The key differences are:
It should be noted that there is a general exemption from VAT under Circular Caishui  106 which applies to services which are wholly performed outside of China. However, where a service is provided from overseas to an entity in China it may be very difficult to successfully convince the tax authorities that the service is performed wholly outside of China.
In terms of what this means to services such as global roaming, this may be summarised as follows:
Chinese customers travelling abroad
The implications of Circular 43 should be very clear to foreign telecommunications providers. They must urgently review their contracts, or seek to renegotiate them to include VAT withholding tax gross up provisions. Otherwise, they will potentially be short paid by 11% or 6% of the price from 1 June 2014. This issue is not limited to foreign telecommunications carriers providing telecommunications services under interconnection agreements. It applies broadly wherever any foreign provider is providing telecommunications services to entities in China.
A further issue which this raises is how domestic Chinese entities will know whether they are required to withhold VAT at 11% or 6%. Given that the 11% VAT rate is essentially limited to voice communications, it is presently unclear whether the pricing under interconnection agreements is sufficiently detailed to enable the correct rate of withholding to be properly determined.
Finally, there is a close parallel between this policy and recent experiences in the transportation sector. In the transportation sector the VAT rules led to some unwelcome outcomes for foreign transportation providers, who also suffered from an 11% VAT withholding. This led to some fairly drastic re-arrangements in commercial transactions to mitigate the impact while lobbying took place to seek a reversal of those policies. Eventually some changes were made to the applicable policies, but not necessarily in a way which fully restored the original position. One anticipates a similar period of uncertainty.
Increasingly, businesses and consumers are able to purchase services in a digitised form. For example, by downloading music, games, videos, e-books on devices such mobile phones, tablets, laptops and desktop computers, as well as the provision of data storage by means such as cloud computing.
What makes the digital revolution so challenging from a tax perspective for governments is that many of these services can be provided by service providers outside of the jurisdiction. Thus, collection and enforcement difficulties can arise.
Circular 43 provides that "transmitting and applying electronic data and information services" fall within the scope of VAT at a 6% VAT rate. This would seem to include the provision of digitised services such as music and video downloads as well as e-books, online gaming and arguably even cloud computing services. Consequently, where a Chinese provider of digitised services sells music or video downloads or e-books, or provides online gaming services or cloud computing storage, then VAT may be payable. However, the position of foreign providers remains unclear as a matter of practice.
The challenge of collecting and enforcing the VAT is not an issue unique to China – governments around the world are grappling with these issues. For example, the European Union has had rules in place for several years to facilitate non-EU businesses accounting for VAT in a single location for all of the electronically supplied services they sell to EU customers. Those rules are to be extended from 1 January 2015 to EU businesses selling these services through the creation of a 'one stop shop'.
By contrast, the VAT system in China generally does not facilitate foreign businesses registering and remitting output VAT, and furthermore, collection and enforcement from consumers is challenging. It remains to be seen whether specific measures will be introduced in China to facilitate the ease of collection and enforcement from foreign providers.
A significant issue which arises from the use of multiple VAT rates in China is the appropriate treatment of mixed sales – that is, where services are bundled with goods, or different services are bundled together, each component of which may have a different VAT rate applicable. This issue is likely to take on even greater significance in the telecommunications sector given the distinction between basic telecommunications services and value-added telecommunications services.
Circular 43 contains a specific rule which requires taxpayers to account for revenue from the provision of telecommunication services separately from the provision of free goods such as handsets, or free telecommunications services. Even this provision raises significant interpretational uncertainties, as may be demonstrated by an example of a customer being given a free mobile phone handset under a contract obliging them to purchase a minimum amount of telecommunications services. The issue is:
- Whether the total price for the telecommunications services must be allocated between the different components (on a fair market value basis) with VAT being payable on each component at the different VAT rates; or
- Whether VAT must be levied on the fair market value of the handset, in addition to which VAT must be paid on the price of the telecommunications services purchased. This effectively results in VAT being levied on an amount greater than what the carrier has been paid, with the additional VAT liability being a real cost to the carrier.
In addition to this, there are general rules already contained in Circular Caishui  106 which effectively require the highest applicable VAT rate to apply where goods and services, or different services, are bundled together without any separate pricing allocation.
Many of these same issues are mirrored in respect of price rebates and discounts – for example, in determining whether they reduce the VAT payable, and if so, at what rate.
Gifts, rewards schemes and donations
Unlike the current BT system, the VAT system has a 'deemed sales' rule which means that output VAT is payable at market value where 'free' gifts are given. Circular 43 provides a specific exception for free telecommunications services provided by redeeming points. Where this occurs, those free services are not subject to VAT.
The difficulty with this provision is that it appears limited to the provision of free telecommunications services. However, where free gifts of goods, or discounted products such as handsets are provided, then arguably no exception from VAT applies.
Circular 43 also contains a specific provision dealing with the situation where the three Chinese carriers accept donations through SMS on behalf of specific non-profit organisations. Where this occurs, the revenue upon which VAT is levied does not include those donation amounts.
Consolidated VAT filing
One issue which had been expected to be included in the rules was a specific provision to allow for consolidated filing. Commercially, the need for this arises because many of the large telecommunications carriers centralise their procurement functions at a provincial level, to enhance bargaining power and to maintain purchasing controls. In the absence of rules allowing for consolidated filing, they may have large input VAT credit balances incurred at the head office or provincial level, which cannot be offset by output VAT paid on sales at a local level.
It is hoped that consolidated VAT filing rules will be introduced shortly by way of a separate Circular.
Prepaid phone cards
A further industry issue which had been expected to be dealt with in the new rules relates to sales of prepaid phone cards. The current position under the BT system is that BT is paid on the discounted price of phone cards where the invoicing system of a telecommunications provider cannot recognise the difference. Circular 43 is silent on this issue in a VAT context. As the VAT regimes in many countries highlight, the treatment of discounted prepaid phone cards can present challenging technical and policy issues.
The Chinese VAT system imposes strict controls over the issuance of special VAT invoices (which can be used to claim input VAT credits) and general VAT invoices (which cannot be used to claim input VAT credits). These invoices are issued through the 'Golden Tax System'.
The issuance of invoices in China is a very time-consuming, labour intensive process, which requires strict controls. The sheer volume of invoices that the major Chinese carriers will need to issue, even at an individual provincial level, can literally be in the millions.
Having two VAT rates for the one sector will also create difficult issues in invoicing since the existing system only allows taxpayers to apply one VAT rate for each VAT invoice.
Circular 43 contains no specific exceptions or concessions on the general invoicing rules. It had been hoped that some modifications, or even modernisation in the form of electronic invoicing, may have been introduced for the telecommunications sector. The absence of such policies is troubling for other sectors which are similarly affected by volumes of invoices, such as the financial services and insurance sectors. We are expecting that the SAT will shortly issue another circular containing implementation rules with detailed guidance on administration issues such as invoicing issues.
VAT reform implementation assistance
For further information in relation to the steps to consider in transitioning to VAT, please refer to KPMG's "VAT Reforms for Telecommunications Services" publication dated June 2013.
This article first appeared on mondaq.com.