China's VAT reform to impact developers in cooling market

Property and construction sectors likely to see introduction of 11pc value added tax next July, forcing them to overhaul business practices

PUBLISHED : Monday, 22 September, 2014, 4:28am
UPDATED : Monday, 22 September, 2014, 6:25am

The mainland's plan to replace the current business tax with value added tax on property and construction firms next year will not only increase the burden for developers in a cooling market but also change how they do business.

VAT reform started with a trial run in Shanghai two years ago, which was then broadened across the mainland and to more industries last year. This year, the central government has implemented it in railway, postal and telecommunications services. The tough sectors to come are property and construction as well as finance and insurance. The deadline for the reform to cover all sectors is the end of next year.

Lachlan Wolfers, a tax partner at KPMG China who has been in talks with mainland tax authorities and developers, said the property and construction sectors would probably start VAT next July, most likely at an 11 per cent rate.

"The experience in other countries is that it's very difficult to introduce VAT in a falling market," Lachlan told the South China Morning Post, citing the example of Malaysia, which has deferred the reform twice and now pushed it back to next April.

An 11 per cent VAT to replace the current 5 per cent business tax would mean a small increase in tax burden for many developers, while a higher rate of 17 per cent - the figure reported by some mainland media - would add significant pressure, Lachlan said.

"The impact on [developers'] cash flow can be just as significant as the impact on overall tax burden," Lachlan added. "It will affect the way developers do business."

Property companies will need to reconsider whether they should continue pre-selling their projects or start selling when construction is completed, sell all projects or hold the assets to rent them out.

The authorities have to make sure the tax reform does not become the last straw for developers, already struggling in a cooling market.

Lachlan said he had expected the government would offer some relief measures to make the transition easier, such as allowing the deduction of land appreciation or lowering the initial tax rate for projects started before VAT implementation.

Officials are also yet to lay down in detail how they intend to avoid double taxation of projects that are half-finished or for long-term leases on office and commercial buildings when VAT is introduced.

The government also has to guard against any impact on its own coffers, already hit hard by the property downturn. A 7.4 per cent year-on-year decline in property business tax slowed the growth of the mainland's fiscal revenue to 6.1 per cent in August.

The VAT reform is estimated to have cost the government about 140 billion yuan (HK$176 billion) last year.

"We have been in close contact with tax authorities and we see a trend of reduced burden for companies already involved in reforms in the past two years," said Shen Xiaowei, financial controller of Wuxi-based logistics property developer Wuzhou International.

Some developers predict the real estate correction could last until 2016 as record sales in the past few years have almost exhausted end-user demand and it would take some time to sell down the inventory that has built up. And contrary to past downturns, the top leadership in Beijing has so far displayed no inclination to initiate measures to reverse the trend.

The VAT will push up home prices if developers fully pass it on to buyers. If not, their profit margins will get even more squeezed.

The latter was more likely, Lachlan said. "The market will pay what the market will pay."

For developers, the most troubling part is the uncertainty. "We wish to be given more time for transition," said a senior financial department executive at Hong Kong-listed Cofco Land, who asked not to be identified.

Apart from VAT, other pending reforms include property-related taxes such as a punitive levy against multiple home owners.

The Cofco Land executive also expressed concern over the cash-flow impact as developers would be required to pay out long before they reaped any benefits.

The Beijing-based developer of Joy City malls, along with some of the mainland's biggest property firms including China Vanke and Wanda, carried out a simulation on sample projects and concluded the tax reform would be a negative for the company.

Cofco Land's estimate is based on a value added tax rate of 11 per cent for its construction contractors, 6 per cent for design firms, 3 per cent for funding from the financial sector and no deduction on land appreciation.

As local governments are not expected to pay VAT on land appreciation, developers whose land cost accounts for a higher proportion of their property selling price will suffer more. The ratio is at least 10 per cent but can be 50 per cent or even higher for some projects.

That, said Shen, would mean a lower tax burden for his company and heavier taxes for residential developers in first-tier cities. "The reform is positive for us."