VAT for PPP projects: Impact on construction companies

As approved by the State Council, comprehensive roll-out of the pilot programme to replace business tax with value added tax (VAT) has been implemented since 1 May 2016. The construction industry, real estate industry and all other business taxpayers are included in the pilot programme and must pay VAT instead of business tax.

In recent years, construction enterprises have always been the main force of public-private partnership (PPP) projects, and participated in or even led the design, investment and financing, construction, operation, maintenance and other aspects of PPPs. Construction enterprises, as social investors, are generally the shareholders of the PPP project companies, as well as the general contractors of the construction/engineering of the PPP projects.

Since there are many processes and aspects in PPP projects, and their tax-related behaviours are complicated, tax calculation and planning of PPP projects involving construction enterprises has always been a focus of attention. After the replacement of business tax with VAT, the impact of the new tax policy on construction enterprises joining in PPP projects, and its tax calculation and planning etc., is becoming more important.

Replacing business tax with VAT means VAT must be paid now for taxable items that were levied with business tax before. Specifically, business taxpayers in the construction industry must pay a VAT rate of 11% instead of a business tax rate of 3%.

Theoretically, the replacement of business tax with VAT may lessen the tax burden on construction enterprises participating in PPP projects, if there is a complete chain of VAT deductible and sufficient deduction of input tax. However, in practice, due to the traditional extensive financial management and operation model of construction enterprises, matching problems between output tax and input tax of PPP projects and other issues, tax payments and deductions for construction enterprises to participate in PPP projects are not as simple as they are in theory.

Impact of replacement of business tax with VAT. 1 May 2016 is a watershed date for converting business tax to VAT. In the construction industry, the VAT rate changed greatly after replacing the business tax, and levy management requirements of them both are not the same, so replacement of the business tax with VAT has had a tremendous impact on PPP projects since 1 May. Several PPP projects operated by the authors have encountered problems.

The government had prepared the budget for PPP projects, and investors had participated in the bidding before 1 May, and the budget was based on a business tax rate of 3%. But the implementation of the projects took place after 1 May and the VAT rate must be applied, which means if there is not enough deductible input tax, the tax burden on the project companies or investors may increase.

In PPP projects, project companies usually bear the costs of land acquisitions and resettlement, and the government can only issue administrative receipts instead of VAT invoices, therefore input tax deduction can’t be generated; labour subcontractors and gravel suppliers of construction enterprises are usually small-scale taxpayers who are unable to issue VAT invoices, therefore input tax deduction can’t be generated. After replacement of business tax with VAT, if the new 11% tax rate can’t be transferred or handled properly, the tax burden on project companies or investors must increase.

Apart from ongoing PPP projects, replacement of business tax with VAT will also have a tremendous impact on PPP projects in the future. Business tax is a kind of tax included in price and is usually included in the construction costs, while VAT is a kind of tax excluded in price. According to a notice from the Ministry of Housing and Urban-Rural Development on “Making Good Preparations for the Replacement of Business Tax with VAT in Construction Industry and the Adjustment of Construction Projects Pricing Basis”, construction costs must be the sum of pretax construction costs and VAT payable after replacement of business tax with VAT.

Pre-tax construction costs are equal to the sum of labour costs, material costs, running costs of construction equipment, enterprise management fees, profits and stipulated fees, all of which are calculated at prices excluding VAT deductible input tax. Therefore, what the input tax deductible is, and how to deduct it, are crucial for construction companies. Furthermore, in PPP projects, project companies always have large amounts of input tax and a lack of output tax during the lengthy construction period, while during the operational period, they may have large amounts of output tax and a lack of input tax. Therefore, provisions for input and output taxes and mutual matching of time, subject etc., also affect the tax deduction and payment of PPP projects.

Reflections and suggestions. During the implementation of PPP projects, in order to avoid a possible tax burden arising from the replacement of business tax with VAT, the authors suggest that clients specify in the PPP agreement or supplementary agreement that during a co-operation period of PPP projects, where the tax burden on project companies or social investors or general contractors is increased compared with the same at the time of getting project budget approval due to tax policy changes (such as replacement of business tax with VAT), the increased tax must be credited into project investment costs upon confirmation of both parties. Any increased tax that can’t be credited to project investment costs must be borne by the government.

However, compared with business tax, calculation and collection of VAT is more complex, and collection and management is more stringent. Therefore, the risks arising from replacing business tax with VAT cannot be fully covered by the above-mentioned. For the purpose of avoiding possible adverse effects, the authors also suggest that construction enterprises must have a comprehensive and thorough understanding of policy requirements for the replacement of business tax with VAT, and its impact on every aspect of PPP projects. They must also conduct accurate and timely tax planning and financial forecasts, and take into full account the costs and benefits of PPP projects, while strengthening internal controls and management.

Wang Jihong is a partner and Han Jiangyu is an associate with Zhong Lun Law Firm