Since 1994, China has operated a dual system of indirect taxation: a system of value-added tax (VAT) applicable to goods and a Business Tax applicable to services. As part of the Chinese authorities’ policy of streamlining and modernizing their tax regime, their aim is to replace Business Tax for the services industry with VAT. While economic growth in recent years has been heavily focused on manufacturing and exports, one of the aims of the new reforms is to promote China’s services market, both domestically and to the wider global economy.
Pilot programs to implement the first stage of the reforms commenced in 2012, in Shanghai, Beijing and several other major commercial centers. In the first stage, the pilot program did not apply to the financial services sector, however, four different regulators from the Chinese Government have engaged KPMG in China to advise them on expanding the reforms to the financial services and insurance sectors across the whole of mainland China. The inclusion of financial and insurance services within the VAT regime is anticipated from early 2014.
Impact on financial services
As far as the financial services sector is concerned, these reforms will be widely welcomed. The current system of Business Tax leads to tax cascading and is generally ill-suited to a modern dynamic economy seeking to become a leading global financial center. For example:
- five percent Business Tax is payable on most financial services – that is, 5 percent of gross turnover, rather than net interest margins or other margins
- the 5 percent Business Tax applies not only to B2C transactions, but also to many B2B transactions
- inputs of financial institutions are subject to tax, in many cases at 17 percent with no input tax relief
- interbank lending between financial institutions registered in China are relieved from Business Tax, but technically not interbank lending involving foreign banks
- cross border financial services are also subject to Business Tax – there is no zero rating or other general form of relief.
Modernizing the indirect tax system, and applying many of the concessions and exemptions applicable in other VAT regimes used internationally would, if implemented, help to secure the international competitiveness of China’s fast growing banking and insurance markets. It would represent a further step in opening up an important market, which is already the subject of gradual deregulation, to international providers.
China’s financial services market has historically reflected its status as a developing economy – most income is derived from net interest margins on consumer and business lending. However, that is changing. As the income of China’s middle class grows, the financial services market is expected to expand in terms of size and complexity very quickly – for example:
- transaction volumes on credit and debit cards increased 74.2 percent during 2010
- mobile payment systems look set to grow, with over 920 million mobile phone users in China, and an estimated growth rate in payments over the last 12 months of 309 percent
- financial leasing increased 25-fold between 2007 and 2010
- the gradual internationalization of the renminbi
- the potential market growth in credit cards, with only 242 million credit cards on issue in China at present (this represents a market penetration rate of 1 credit card for every 5.5 members of the population, compared with an estimated 2.2 credit cards issued for every single member of the population in the United States).
Although foreign banks in China account for only 1.9 percent of the total banking sector, their huge investment in China in recent years is set to deliver rapid growth over the next few years on the back of a range of structural changes in the market.
There are a number of key issues for the Chinese authorities to resolve in planning the transition to the new regime. The current Business Tax on financial services brings in substantial revenues to the Chinese government, especially from the bank lending market. However, these services are typically exempt from indirect taxation in the VAT systems common in the West. So the authorities face a dilemma: to impose equivalent rates of taxation within the new VAT structure thereby maintaining existing taxation revenues; or to exempt financial services from the new VAT system and create an internationally competitive financial services sector.
It has been argued that the regulatory environment applicable to deposit-taking and lending activities by banks in China effectively guarantees a level of profitability and that they could therefore afford to absorb the costs of a VAT without passing them on. Others argue, however, that if the fundamental aim is to build a VAT system which is suitable for a Chinese financial services system which is more lightly regulated and more integrated with the global economy, then reform has to be implemented thoroughly.
Active discussions between the Chinese authorities and the financial sector are exploring issues such as the likely scope of financial services: will some financial services be taxed and some exempt? Will this necessitate partial exemption type methods? What will be the likely compliance costs? Is there is an opportunity for relief on cross border transactions?
While detailed proposals are being formulated, there is an opportunity for significant players in the industry to make a contribution to the debate. There are various options for reform which the government may consider, each with pros and cons and with different practical implementation issues. Constructive engagement is likely to lead to a more balanced outcome and a greater degree of certainty under the new rules.
Financial institutions and insurers which are active in China, or aspire to growth there, need to consider the potential impacts on their own business and operating models. Once settled, reforms in China are typically implemented rapidly, within a matter of months or even weeks. Companies may have little time to prepare, and should start now. Key issues will include the impacts on systems and processes, cost and investment consequences, and legal and other contractual implications. The precise implications may not be clear for some months, but project planning, financial impact assessments, identification of IT system issues, and future proofing of contracts can all start now.
For further information, please contact:
KPMG’s Asia Pacific Regional Leader, Indirect Tax Services
Leader of the Indirect Taxes Centre of Excellence for China KPMG in China
Partner, KPMG in the UK
+44 20 73112837