China's Tax Overhaul Pinches Small Businesses

Move to Ease Financial Burden Has Unintended Consequences

An overhaul to China´s tax system that is intended to ease the financial burden on small companies is actually hurting some of them—just as they are being hit by a sluggish economy.

China this month expanded its value-added tax system to some parts of its service and transportation sectors. The change could be fully in place by the end of next year, a year ahead of schedule, according to an adviser to the Finance Ministry.

The plan is to replace a more burdensome business tax on the service sector. The VAT is a central plank of China´s attempts to rebalance the economy away from capital-intensive manufacturing toward services.

But some small businesses say the new system has increased their tax obligations.

Under the overhaul, companies pay tax only on the value added during the business process. The previous business tax was set at 5% of a company´s total sales.

But business practices here have been a hurdle to the new system. An accounting manager at a Beijing-based consulting firm says it has been difficult to prove what portion of sales was value-added, since many suppliers don´t like to offer official receipts—a way to keep earnings outside the view of tax collectors.

She says her firm´s tax burden has increased since Beijing instituted a VAT pilot program last year. "For us, it means a hike in tax rates," she says. "We don´t really have any options. We just have to pay more tax."

Other companies say the tax is shifting cost increases to customers.

Huang Xiangfu, a manager at Guangxi Wuzhou Tongda International Logistics Co., says shipping companies have begun charging up to 7% more for freight if companies ask them for VAT invoices.

"That put us at a huge disadvantage compared with international rates," Mr. Huang says. "The entire logistics industry will suffer."

The government touted the overhaul as a way to cut taxes by about 120 billion yuan, or roughly $20 billion, this year. The tax reduction is aimed at boosting an economy that is expected to grow around 7.5% this year, which would be its slowest pace since 1990.

China´s manufacturing sector has long used the VAT. The extension to cover services, creating a unified tax system, was heralded as an economic step forward. The government hopes the move will give a fillip to the job-intensive services sector—which accounts for about 45% of the country´s economy. The change also shifts more tax revenue into the central government´s coffers, at the expense of local tax bureaus.

The Finance Ministry says the new system yielded a tax cut of more than 80 billion yuan by the end of June, benefiting 95% of the companies that participated in the pilot program.

Experts say that some of the additional costs small business have described are likely temporary and will disappear as more suppliers report earnings in detail. The Finance Ministry didn´t respond to requests for comment.

For companies with sales less than five million yuan a year, the new system sets the tax at 3% of total sales. For companies with higher sales, the tax is calculated on the value-added portion of sales at rates ranging from 6% for companies in consulting, advertising and many other parts of the services sector to 17% for leasing companies.

The tax is expected to be expanded next year to the rest of the services sector, including telecommunications, property, construction and financial services. Rates for telecom, property and construction likely will be 11%, says KPMG partner Lachlan Wolfers, who advised the Finance Ministry on the reforms.

"We hear some businesses raise concerns about the short-term challenges in implementing the reforms, but in the long run, a unified tax system is expected to relieve the tax burden on businesses in China," he says.

SOURCE: THE WALL STREET JOURNAL