3 June, 2013

Legal News & Analysis – Asia Pacific – China – Tax

Background

Under China’s current tax regime, ‘foreign contractors’ generally refers to foreign enterprises engaged in engineering or the provision of labour services in China for the exploration and development of natural resources, including oil and gas. Due to the distinct nature of the oil and gas industry in China, special fiscal and tax policies have applied to foreign contractors in the past. For example, foreign contractors are subject to Business Tax (BT) at the rate of three or five percent, based on the type of services provided.

Between 1 January and 31 December 2012, the Value Added Tax (VAT) pilot program was expanded to 11 cities and provinces (‘the pilot locations’) including Shanghai, Beijing, Tianjin, Jiangsu, Zhejiang, Anhui, Fujian, Hubei, Guangdong, Xiamen and Shenzhen. Currently most foreign contractors who provide labour services for cooperative exploitation of oil and gas pay indirect taxes to the offshore oil tax bureau, some of which are located in pilot locations (specifically Tianjin, Shanghai, Guangzhou, Shenzhen and Zhanjiang). In addition, some foreign contractors, which provide services for onshore oil and gas projects, also pay indirect taxes in pilot locations such as Beijing and Tianjin.

On 1 April 2013, the State Council in China announced that the VAT pilot program will be expanded nationwide from 1 August 2013. Therefore, urgent clarification should be given as to whether the VAT pilot program should apply to foreign contractors and if so, how it should be achieved.
 

Scope of services under the VAT pilot program 

In 1997, the SAT issued Circular of Applicable Items and Rates of the BT to the Taxable Services Provided in Cooperative Exploitation of Oil and Gas (Guo Shui Fa [1997] No.42 (Circular 42)). Circular 42 stated that the engineering activities of geophysical exploration, positioning, mud logging, logging, well cementing and completion, scuba diving, casing and pipe laying are incorporated into the ‘construction industry’ and are subject to BT as ‘the other engineering activities’at the rate of three percent .

On 16 November 2011, the MoF and the SAT jointly issued Cai Shui [2011] No. 110 (Circular 110) which separates the construction industry from ‘modern services’ and subjects construction services to 11 percent VAT. However, the VAT pilot program has not yet been expanded to construction services. Taking into account other conditions, the construction industry is not yet ready to be included in the scope of taxable services subject to the current VAT pilot program.

Following Cai Shui [2011] No.111 (Circular 111), ‘engineering exploration 
services’ should be included in research and development services and 
‘technical consulting services’ classified under modern services, which are both subject to six percent VAT. ‘Engineering exploration services’ specifically includes “field surveys conducted on terrains, geological structure, and underground resources conditions prior to mining and project construction".

The classification and definition of ‘engineering exploration services’ provided by Circular 111 is not completely consistent with that provided in Circular 42. By definition, geophysical exploration services supplied by foreign contractors should be classified within the VAT pilot program. However, it is difficult to conclude whether engineering activities, other than geophysical explorationservices listed in Circular 42, should be included. Also, Circular 111 only includes services supplied “prior to mining and project construction", and excludes services provided after the construction commences.

Therefore, it is uncertain whether foreign contractors should be liable for BT forthe provision of engineering services, or pay VAT for those services which are specifically listed in Circular 111 and BT for the others.

In addition to engineering services, foreign contractors also provide technicalconsulting services, which are defined as ”performance of feasibility study, technical forecast, specialised technical investigation, analysis and evaluation reporting, and expertise consulting to particular theoretical project” in Circular 111 and subject to six percent VAT.

KPMG understands that the tax authorities in the pilot locations including 
Shanghai, Guangzhou, Zhanjiang, Shenzhen and Tianjin have failed to reach a consensus regarding the application of the VAT pilot program to foreign contractors in China. Currently the majority of foreign contractors follow the previous provisions and pay BT for technical consulting and engineering exploration services.

Where to pay the tax

The application of the VAT pilot program to engineering exploration servicesprovided by foreign contractors not only affects the type of indirect tax to be paid,but also where the tax should be paid. In Circular 111, the MoF and the SATstipulate the tax payment location as follows:

• A taxpayer with a fixed base shall file VAT returns and settle the tax payment with the tax authorities where it is registered.
• A taxpayer without a fixed base who provides taxable services shall file VAT returns and settle the tax payment with the tax authorities where the service takes place; if it fails to do so, the tax authorities where it is registered shall collect the tax.
• A taxpayer without a fixed base who is registered in a pilot location, but provides taxable services in a non-pilot location shall file VAT returns and settle the tax payment with the tax authorities where it is registered.

Neither of the existing VAT regulations norCircular 111 provides a definition or interpretation of “taxpayers with a fixed base”. However, Circular 111 establishes the fundamental principle that enterprises registered in a pilot location that provide taxable services covered by the VAT pilot program shall file VAT returns and settle the tax payment with the tax authorities where it is registered. Such a literal meaning and actual tax practices may give rise to conflicts with the current BT regime. According to the BT regulations, taxpayers engaged in the construction industry should file BT returns and settle the tax payment with the tax authorities where the services take place (i.e., where the construction project is located). Currently, foreign contractors engaged in offshore oil projects pay BT to the offshore oil tax bureau where the oil blocks are located, while foreign contractors engaged in onshore oil and gas projects pay BT to the tax authorities in the inland province where the oil block is located.

Practically, the conflicting provisions may lead to differing opinions regarding the tax source amongst the tax authorities. For instance, a foreign contractor that has registered in a pilot location may face a dilemma if it is engaged in engineering exploration services in a non-pilot location. The foreign contractor may be required to file both BT returns with the tax authority where the service takesplace and VAT returns with the tax authority where it is registered.

Application for general VAT taxpayer status

Under the VAT pilot program, if the supplier does not have a business 
establishment in China, the withholding agent or recipient should withhold VAT if they are established or reside in a pilot location. Therefore, if foreign enterprises have a business establishment in China, they should file VAT returns and pay VAT themselves. When the VAT pilot program applies to foreign contractors, a practical issue to resolve would be whether foreign contractors with business and tax registration could be deemed to have a business establishment in China.If so, they could register as a general VAT taxpayer, in order to be able to issue 
special VAT invoices and claim input VAT credits. 

Most foreign contractors would exceed the annual revenue threshold of VAT taxable services as stipulated by the MoF and the SAT in Circular 111. Therefore, theoretically foreign contractors should be able to apply for general VAT taxpayer status with the tax authorities. Where foreign contractors in the pilot locations are registered as a general VAT taxpayer and pay VAT for technical consultingand engineering exploration services provided, their indirect tax cost may increase slightly, without taking into consideration input VAT credits. The indirect tax rate for technical consulting services will increase from five percent BT to six percent VAT and from three percent BT to six percent VAT for engineering exploration services.

Some foreign contractors complete temporary tax registration only, and do not have any business registration in China. All of their taxes are withheld and paid by their agent or the service recipient in China. The internal control requirementsfor registration as a general VAT taxpayer may create a barrier for these foreign contractors. 

Foreign contractors typically have few employees in China, and are unable to keep accurate accounting and tax records. Given the complexity of their business, it may be difficult for a foreign contractor to prove effective internal controls to support the general VAT taxpayer qualification, even if the foreign contractor has completed its business and tax registration and opened a bank account in China. Foreign contractors who are unable to register as a general VAT taxpayer, should pay three percent VAT as a small-scale taxpayer, their indirect tax burden may be slightly lower than the current level under BT.

Trends of reforms

Foreign contractors were initially introduced to serve the cooperative development of offshore oil and gas resources. This subsequently expanded to onshore oil and gas projects along with development in the exploitation of oil and gas resources. The fiscal and tax regime applicable to foreign contractors is closely tied with that applicable to offshore oil exploitation and cooperative development of oil and gas resources. Currently, offshore oil exploitation and cooperative development of oil and gas resources are subject to a five percent VAT levy rate.

As the project owner of the exploitation activities is unable to claim input VAT credits, foreign contractors may encounter greater resistance when they are trying to pass the increased indirect tax burden (if any) onto customers by adjusting the price. Due to legislative hierarchy, the VAT pilot program (stipulated by the MoF and the SAT) cannot include offshore oil exploitation and cooperative development of offshore oil and gas resources. According to the legislative plan, such business activities may in the future be incorporated into the existing collection and management mechanism for the VAT general taxpayer. However, during the current transitional period, the question remains as to how to balance the indirect tax burden and mitigate the compliance risk for foreign contractors.

We suggest that foreign contractors consider the impact of the VAT reforms when concluding new contracts, by specifying the applicable tax provisions in advance in order to avoid disputes and to mitigate tax risks.