China's Value-Added Tax (VAT) Law was passed on 25 December 2024 and will take effect on 1 January 2026. The law maintains the current three-tier tax rate system (13%, 9%, and 6%) while introducing significant policy changes and improvements in international alignment.

Background

China's VAT system, initially introduced in 1994 with the implementation of VAT provisional regulations, has since undergone a significant transformation. Over the past three decades, several game-changing reforms have shaped the system we see today — from shifting to a consumption-based model in 2009, to gradually rolling out VAT pilot reforms in various service sectors from 2012 and finally achieving full implementation in 2016. The system was further streamlined with simplified tax rates in 2017 and enhanced through additional reforms in 2018 and 2019. The VAT law's implementation not only symbolizes the growth and establishment of VAT as China's largest tax category but also reflects its crucial role in driving economic growth and optimizing the tax structure. The revenue from VAT accounted for approximately 38% of China's total tax revenue in 2023, showcasing its central position in the country's tax system.

Continuing the three-tier tax rate system

The People's Republic of China (PRC) VAT Law largely retains the existing tax system framework and the current three-tier tax rate structure:

• 13% for general goods sales and imports
• 9% for services like transportation, post, telecommunications, water, gas, publication of books, etc.
• 6% mainly for modern services

The law also continues the existing 3% simplified calculation method for specific scenarios, while preserving special regulatory arrangements for sectors like offshore oil and gas extraction projects.

Improvements to the existing VAT system

The PRC VAT Law strikes a balance between VAT international best practices and China's economic landscape, bringing several noteworthy improvements as described in this section.

Clearer legal framework

The VAT Law enhances clarity by explicitly defining the scope of VAT, its rates and tax incentives. Further, the Law integrates a comprehensive approach to "taxable transactions," covered goods, services to intangible assets and real estate.

Article 3 of the Law establishes the fundamental scope of VAT, stating that "Entities and individuals (including sole proprietorships) that sell goods, services, intangible assets, or real estate (collectively referred to as taxable transactions) within the People's Republic of China (hereinafter referred to as 'domestic') or import goods are VAT taxpayers and shall pay VAT in accordance with the provisions of this law."

Cross-border transactions and place-of-consumption principle

Taking a step toward alignment with international VAT rules, the PRC VAT law refines rules for cross-border transactions by enhancing the "place-of-consumption" principle ensuring tax jurisdiction aligns with where the transaction occurs.

Article 4 of the Law provides comprehensive criteria for determining domestic taxable transactions, stating:

Taxable transactions occurring in China refer to:

1. For the sale of goods, the origin or location of the goods is inside China;
2. For the sale or lease of real estate or transfer of natural resource usage rights, the real estate or natural resources are located in China;
3. For financial products, the financial products are issued in China, or the seller is a domestic entity or individual;
4. For the sale of other services or intangible assets, except for Items 2 and 3 of this article, the services or intangible assets are consumed in China, or the seller is a domestic entity or individual.

The specific updates include:

• Clarification on the scope of transactions. The new Law explicitly stipulates that "except for the sale or lease of immovable property, the transfer of rights to natural resources, and the sale of financial products, the consumption of services and intangible assets occurs domestically, or the seller is a domestic entity or individual." This means that for transactions involving services and intangible assets, "domestic consumption" will serve as the primary criterion, replacing legacy from the Business Tax era, such as "taxable services provided within the territory" or "seller or buyer located within the territory."
• New provisions for financial-product transactions. The place of issuance or the location of the seller will now serve as the determining criterion for the location of financial-product transactions.

Optimizing the definition of sales revenue

The PRC VAT Law refines the definition of taxable sales revenue to include nonmonetary forms of economic benefits. Article 17provides a comprehensive definition, stating that "Sales revenue refers to the total consideration received by taxpayers from taxable transactions, including all monetary and non-monetary economic benefits, excluding the output tax calculated under the general tax calculation method and the tax payable calculated under the simplified method."

Article 19 of the Law also states that "for non-monetary transactions, taxpayers shall determine the sales revenue based on market prices." This allows market prices to be used for transactions involving nonmonetary consideration, aligning with international standards.

In addition, Article 20 of the VAT Law stipulates that if the sales amount is significantly low or high without a valid reason, the tax authorities may assess the sales amount in accordance with PRC law on the Administration of Tax Collection and relevant administrative regulations. Compared to the current regulations, this anti-tax-avoidance provision is expanded to include scenarios in which the sales amount is significantly high without a valid reason.

Input tax deduction adjustments

The PRC VAT Law removes the restrictive provision in Circular 36, which prohibited the deduction of "purchased loan services." This adjustment creates opportunity for subsequent supporting documents to improve the VAT deduction chain in the financial services sector.

Another change affects catering services, daily living services and entertainment services by adding a restriction on "purchases directly used for consumption." In other words, transactions in which a business purchases catering services, daily living services or entertainment services for taxable purposes or resale are not subject to this restriction. However, businesses will need to retain relevant documentation to prove the purpose of such expenses.

The updated scope of nondeductible input VAT item are stated in Article 22 as follows:

1. Input tax corresponding to items taxed under the simplified method
2. Input tax corresponding to VAT-exempt items
3. Input tax corresponding to items with abnormal losses
4. Input tax corresponding to goods, services, intangible assets, or real estate purchased for collective welfare or personal consumption
5. Input tax corresponding to directly consumed catering services, household services and entertainment services
6. Other input taxes as specified by the State Council

Excess Input VAT Credit Refund system (Carry-Forward and Refund System)

The PRC VAT Law elevates the Excess Input VAT Credit Refund System to a statutory level for the first time, establishing it as a universal entitlement rather than an industry-specific policy. Under the new framework, taxpayers have the discretion to either carry forward or apply for refunds of excess credits; detailed requirements will be released in Implementation Rules. This legislative foundation should help enhance both policy stability and business cash flow management.

Key policy points and potential implications

Several key provisions in the VAT Law could have significant implications for businesses and taxpayers, as highlighted in this section.

Mixed sales vs. composite sales

The distinction between "mixed sales" (i.e., a single taxable transaction involves multiple tax rates or levy rates) and "composite sales" (i.e., a taxpayer conducts multiple taxable transactions with different rates) is crucial for VAT determination. The new law brings welcome clarity to these scenarios, especially when dealing with mixed sales that involve varying tax rates.

Streamlined rules for deemed taxable transactions

The law simplifies the rules around "deemed taxable transactions," limiting them to three basic scenarios: (1) goods used for collective welfare or personal consumption, (2) transfers of goods by taxpayers without consideration (i.e., gifts), and (3) transfers of intangible assets, real estate or financial products by taxpayers without consideration.

Notably, the PRC VAT law takes a different approach from current regulations by excluding several previously covered scenarios from deemed taxable transactions — consignment sales, transfers between branches in different provinces and cities, in-kind capital contributions, distributions to shareholders, and provision of services without consideration.

Out-of-scope income

The VAT Law clearly defines what constitutes nontaxable income, such as wages, administrative fees, government funds and interest income, and removes certain exemption items in prior regulations, further clarifying tax obligations for businesses.

The detailed clear criteria for nontaxable transactions are stated in Article 6 of the Law as follows:

1. Employees provide services to employers in exchange for wages or salaries
2. Administrative or government funds are collected
3. Compensation is obtained for requisition or expropriation in accordance with the law
4. Interest income derived from deposit

Looking ahead

While the PRC VAT Law establishes a comprehensive framework, its practical implementation will require detailed guidance through subsequent regulations. As businesses prepare for the 1 January 2026 effective date, attention now shifts to the critical transitional and implementation phases. Developing detailed implementation rules and supporting regulations will be pivotal in translating this landmark legislation into operational reality. These forthcoming guidelines will significantly affect businesses' compliance strategies and operational decisions. Businesses should stay tuned for these developments and consider proactively reviewing their current VAT processes to identify areas that may need adjustment under the new framework.