China Changes The Basis Of Taxation Of Insurance
AIG’s Peter Paternostro examines China’s new VAT system, explaining the background to the change, the treatment of reinsurance, and the potential impact on ceding commissions.
China has completed the expansion of its Value Added Tax (VAT) system to all industries, replacing its business tax (BT), with effect from 1 May, 2016. For many years China’s tax system has been bifurcated with VAT broadly applying to the goods sector and the business tax based on revenue, applying to the services sector.
China’s new VAT system is one of the broadest based systems among the over 160 countries in the world which have implemented such a tax. Although the value added in financial services can be difficult to measure and is the reason why most countries exempt them from this tax, China’s VAT system will cover virtually all financial services including insurance and reinsurance. The new VAT rate on financial services is 6% (the tax rate under the BT was 5%).
“The taxation of insurance will change from a 5% business tax imposed on insurance companies to a 6% VAT imposed on the insured.”
How VAT is different
VAT is a fundamentally different tax than the BT in that it is usually “creditable” in the hands of most Chinese businesses; that is, they can claim a credit on their VAT return for the VAT they paid. Consequently, for most business-to-business transactions, the VAT should be tax neutral and not an absolute cost as was the situation under the BT regime. The fundamental nature of a VAT is that it is not a tax on business; rather it is a tax which is collected by business, but is imposed on the end consumer.
Consistent with the essential nature of the VAT, the taxation of insurance will change from a 5% business tax imposed on insurance companies to a 6% VAT imposed on the insured. Certain insurance coverage is exempt from VAT including: term life insurance that exceeds a period of one year; term health insurance that exceeds a period of one year; and insurance covering export risks and export credit insurance.
The initial rules implementing the new regime contained no comment on the treatment of reinsurance. On June 18, 2016, the Ministry of Finance and the State Administration of Taxation jointly issued Circular 68 which provides guidance on VAT in respect of reinsurance (the notice retroactively applies from 1 May, 2016). Reinsurance provided by an insurance company which is established within mainland China to another insurance company established outside mainland China is exempt. However, cross border reinsurance to an insurance company located outside of China, will be subject to the new tax. For in-country reinsurance, if the underlying insurance contract is subject to VAT, so is the reinsurance contract. If the underlying insurance contract is exempt, the reinsurance contract follows suit.
The issue of ceding commissions
One area of reinsurance which was not addressed in Circular 68, relates to the taxation of “ceding commissions”. Ceding commission refers to the remuneration paid to the ceding insurer by the assuming reinsurer compensating the cedent for various expenses it incurs (such as underwriting and business acquisition expenses). The VAT treatment of ceding commissions is particularly important for reinsurers located outside China because if the commissions are taxable, these reinsurers would not be in a position to get VAT credit and therefore would incur the full economic impact of the tax. While this is still an area of uncertainty, it is my understanding that the major insurance companies operating in China have taken the position, pending further guidance, that ceding commissions are not subject to VAT.