VAT is the most widespread form of indirect tax around the world with 162 economies having such a system. And, it continues to mainstream with more countries introducing such systems within the next couple of years. In our new series, we have a monthly look at the countries which have recently introduced or will introduce VAT. Today, we put China in the spotlight.
China underwent a vast reform of its indirect tax regime. In 2016, VAT was implemented as the sole indirect tax, replacing completely the former business tax (BT) applicable to services. The underlying purpose was a shift away of the BT fiscal burden on companies to VAT on consumers. This shift is also known as the ‘B2V Reform’. The implementation of VAT helped to decrease tax payments by a total of US$77 billion last year.
China – a broad-based tax system
China is using a broad-based tax system. In other words, there’s no such thing as exemptions, or so. Indeed, China has VAT preferential treatments, e.g. export sales VAT refund/exemption and software service VAT refund. Therefore, companies can benefit by far more of a full-recovery ratio. Beyond that, a vast majority of transactions in China is subject to tax, including B2C Real Estate or financial transactions.
As there’s no variable-ratio, China considerably simplified its approach. Indeed, it requires fewer analysis of the VAT treatment since companies have a 100% ratio. Previously, the BT tax didn’t allow to deduct and to pay the collected amount of VAT as the European system permits. In that case, they had to bear all the costs. Hence, the B2V reform to reduce the tax burden of businesses active in the service industry.
How it applies to real estate
How this system applies to the real estate industry is slightly different from the European model. In fact, businesses have to register to the relevant tax authority under a regime, i.e. general taxpayers or small-scale taxpayers. Choosing the right regime is capital as it affects a company’s performance. Indeed, these two types of taxpayers are not subject to the same VAT rate. For small-scale taxpayers, the rate stands at 3%. Yet, certain categories of real estate activities are subject to a 5% rate. This rate was implemented first for certain transactions of Real Estate and to ease the transition from BT to VAT.
What’s more, implementing such a reduced VAT rate has major economic impacts in China. Any individual who sells a residential property will be subject to a 3% VAT unless they own the property for more than two years. The overall objective was to encourage long-term property investment to avoid speculation. It was also a way for China to improve its tax revenues.
The General Taxpayers in Real Estate are subject to an 11% rate. Applying this VAT rate, businesses can issue a « Special VAT invoice » allowing them to deduct VAT. This is called the “China’s Golden Tax System” which allows businesses to register and to issue special invoices to reconcile Input and Output VAT.
How the European VAT system compares
In Europe, the registration process and regimes are quite similar to those in China. For instance, a property company which expects to rent or to sell part of its building has to register with the relevant authorities and under the right regime, based on the amount of its turnover and the area of the activity.
Conversely, the VAT treatment across European Union differs dramatically because of the recovery ratio. To make a long story short, the turnover allowing a deduction is divided by the total turnover. Taxpayers need to calculate the ratio on an annual basis.
In Luxembourg, the VAT deduction right of property companies is controversial, and there are still various approaches. Let’s take the example of a property company established in Luxembourg which holds immovable assets in a foreign country. The “Luxembourg Test” needs to be applied to be granted a deduction right. The aim is to determine whether the company would have taken advantage of a VAT option if the building was in Luxembourg. Then, if the results of the test prove the company would have been eligible in Luxembourg, the authorities will admit to apply the same VAT treatment to deduct VAT regardless of the foreign VAT application. However, some offices seem to base their analysis on other criteria like the foreign VAT application to allow input VAT recovery.
In Luxembourg, the principle is also that a Taxpayer who buys a building under construction is subject to VAT. However, whether it is a purchase or a rent the taxpayer is exempt if the immovable asset is built. Then, the buyer or the tenant can decide to opt for VAT to give up the exemptions and then to deduct VAT. According to article 45 of the Luxembourg VAT law, there is a condition to opt for VAT. The buyer has to prove that he has at least a 50% recovery ratio, which means for authorities that the property will be mainly used for activities allowing the recovery of input VAT.
What we think
Exemptions create complexity. This is mainly due to the recovery ratio related to this VAT principle. Unlike the Chinese system, which triggers (automatically) a full recovery ratio due to the few existing exemptions, the European recovery ratio is variable. In other words, it should be calculated each year based on the annual activity of a business. This creates administrative burden.