VAT reform will have far-reaching impact on China’s real estate market and property valuations

Value-added tax (VAT) has been in effect since May 1 this year for China’s real estate sector . All real estate stakeholders, including developers, owners, investors, asset managers and consultants, and especially auditors and tax advisors, have been learning the ropes to advise clients of its impact, as it reshapes market practise and affects after-tax net operating income (NOI). This in turn impacts valuations and return on investments and how investment decisions are concluded. The VAT system is complex and there are still grey and uncertain areas, which are yet to be tested and refined upon actual implementation.

Under the new VAT regime, income from property for lease is subject to 11 per cent tax, whereas the previous business tax (BT) was typically levied at 5 per cent. While this is a big leap in the tax rate, VAT is only chargeable on the incremental value add of goods, and is also transferable with input credit and output deduction. Tenants can utilise the input VAT, using the fapiao (invoice) issued by the lessor to offset the output VAT, assuming the tenant is a general taxpayer.

Existing projects, broadly defined as projects with construction permits issued before May 1 this year, can opt for either general or simplified VAT. The latter is a preferential treatment granted for the real estate and construction sectors, applicable only to existing projects. General VAT refers to typical VAT arrangements, whilst simplified VAT means the VAT is levied at 5 per cent of income, at which absolute amount of dues payable would be similar to the previous BT regime. Generally speaking, upon selection of the simplified VAT option, projects are locked up for a certain period (not clearly stated in Circular 36, but reportedly for three years) and VAT credit or deductions are not available.

Stakeholders need to make a toss-up between general VAT and simplified VAT. The reform clearly brings about adjustments to pricing models and asset management plans for industry players, warranting detailed study of tenants’ profiles and the conducting of financial simulation models.

We have observed that most companies with existing income-generating projects opt for simplified VAT, despite foregoing the chance to leverage the potential tax savings, the intended fundamental essence of the reform. This allows these companies a window to ‘wait-and-see’ until they are more comfortable with switching into the new set of rules. From a NOI perspective, landlords will not be worse off, given that the rate is similar to previous BT.