Every WFOE in China is registered as either a small-scale taxpayer or a general taxpayer for VAT purposes. The classification determines the VAT rate the company charges its customers, the input VAT it can credit, and the administrative burden of VAT compliance. A new WFOE starts as a small-scale taxpayer by default and can apply to upgrade to general taxpayer status when it’s ready — or it may be mandatory to upgrade when its revenue exceeds the statutory threshold.
The choice of VAT classification is one of the most important operational decisions a WFOE makes in its first year. Choosing wrong can increase the company’s tax cost, reduce its competitiveness, and create an administrative burden that the company is not prepared for. Here’s how to think about the choice.
Small-Scale Taxpayer
A small-scale taxpayer is a VAT registration that’s designed for smaller businesses. The small-scale taxpayer applies a single VAT rate to its sales revenue — 3% under the standard rate, with various temporary reductions that may apply — and cannot credit input VAT paid on its purchases against the output VAT on its sales. The input VAT is not recoverable and becomes a cost to the business.
The 3% rate is significantly lower than the general taxpayer rates — 6% for services, 9% for transportation and certain goods, 13% for most goods — and the small-scale taxpayer’s inability to credit input VAT is significant for businesses that buy goods and services from general taxpayers. A small-scale taxpayer that buys 100,000 RMB of supplies from a general taxpayer pays 13,000 RMB of input VAT — or 6,000 RMB for services — and cannot recover any of it. The input VAT is a dead cost.
The small-scale taxpayer’s VAT return is relatively simple. The company reports its sales revenue for the period and pays VAT at the applicable rate on the total revenue. There’s no input VAT credit calculation, no invoice matching, no reconciliation of input and output VAT. The administrative burden is low, which is why the classification is designed for smaller businesses.
The small-scale taxpayer issues ordinary VAT invoices — general invoices — not special VAT invoices. A special VAT invoice — the zēngzhíshuì zhuānyòng fāpiào — is the invoice that allows the buyer to credit the input VAT. A buyer that purchases from a small-scale taxpayer receives an ordinary invoice that doesn’t carry an input VAT credit. The buyer pays the VAT-inclusive price and can’t recover the VAT.
This creates a competitive disadvantage for the small-scale taxpayer. A buyer that’s a general taxpayer wants to purchase from a general taxpayer so that the buyer can credit the input VAT. A small-scale taxpayer that sells to general taxpayer customers is effectively charging 3% more — the unrecoverable VAT — than a general taxpayer competitor who charges the same pre-VAT price. The small-scale taxpayer must either absorb the VAT cost — by reducing its pre-VAT price — or lose the business to a general taxpayer competitor.
General Taxpayer
A general taxpayer charges VAT at the general taxpayer rate — 6%, 9%, or 13% depending on the type of goods or services — and issues special VAT invoices to its customers. The customer who buys from a general taxpayer receives a special invoice that carries an input VAT credit for the full amount of the VAT charged. The customer can credit the input VAT against the output VAT on its own sales, so the VAT is a pass-through for the customer.
The general taxpayer credits input VAT paid on its purchases against the output VAT collected on its sales. The net VAT payable to the tax bureau is the output VAT minus the creditable input VAT for the period. A general taxpayer that has more input VAT than output VAT carries the excess input VAT forward to the next period as a credit — the excess is not refundable routinely, though certain export-oriented businesses and certain qualifying businesses can apply for a VAT refund.
The general taxpayer can credit input VAT on purchases of goods, services, and fixed assets — including the purchase or construction of buildings, the purchase of machinery and equipment, and the purchase of vehicles for business use. The input VAT credit on fixed assets is significant for a manufacturing WFOE that’s buying production equipment or for any WFOE that’s renovating an office — the input VAT on the equipment or the renovation can be credited against output VAT over time.
The general taxpayer’s VAT return is more complex than the small-scale taxpayer’s return. The company must track input VAT by invoice, verify the input VAT invoices against the tax bureau’s database — the invoice verification requirement — and reconcile the input VAT credits with the output VAT reported on the company’s own sales invoices. The reconciliation must be accurate because the tax bureau’s system cross-checks the seller’s output VAT reporting against the buyer’s input VAT credit claim.
The general taxpayer’s VAT compliance requires a competent accounting function. The accounting staff must understand the VAT invoice system, the invoice verification procedure, the input VAT credit rules — some input VAT is not creditable, such as VAT on employee benefits, entertainment expenses, and purchases for non-business use — and the VAT return filing process. A company that doesn’t have the accounting capability to manage general taxpayer compliance should upgrade its accounting function before upgrading its VAT classification.
When to Switch
A new WFOE starts as a small-scale taxpayer unless it applies for general taxpayer status at the time of registration or shortly after. A company that expects to have significant revenue — and significant input VAT — from the start should apply for general taxpayer status immediately. A manufacturing WFOE that will buy production equipment with significant input VAT — 13% on the purchase price — should be a general taxpayer from the start so that it can credit the input VAT on the equipment.
A company that exceeds the small-scale taxpayer revenue threshold — 5 million RMB of annual taxable revenue — must upgrade to general taxpayer status. The upgrade is mandatory, not optional, and the company must apply for the upgrade within a specified period after exceeding the threshold. A company that exceeds the threshold and doesn’t upgrade is subject to the general taxpayer VAT rate on its sales — 6%, 9%, or 13% — without the right to credit input VAT. The result is a significantly higher VAT burden as a penalty for non-compliance.
A company that’s below the threshold can voluntarily upgrade to general taxpayer status at any time. The voluntary upgrade is a business decision that depends on whether the company’s input VAT exceeds the additional VAT cost of the higher rate. A company that sells services — 6% general taxpayer rate, 3% small-scale taxpayer rate — and that has significant input VAT on its purchases should upgrade. A company that sells goods — 13% general taxpayer rate, 3% small-scale taxpayer rate — should upgrade only if its input VAT is high enough to offset the 10-percentage-point rate differential.
The rate differential analysis compares the effective VAT rate under the two classifications. Under the small-scale taxpayer classification, the effective VAT rate on sales is 3% minus any reduction — as low as 1% under temporary reductions — and input VAT is a cost. Under the general taxpayer classification, the effective VAT rate on sales is the rate differential between the rate charged to customers and the rate on inputs, weighted by the input-to-output ratio. A service company with a 6% output rate and 50% input VAT to output VAT has an effective VAT rate of approximately 3% — not 6% — because it credits the input VAT. The 3% effective rate is the same as the small-scale taxpayer rate, but the general taxpayer’s ability to issue special VAT invoices makes it more attractive to customers who are general taxpayers.
The Invoice Factor
The most important operational factor is whether the company’s customers are general taxpayers. Business-to-business sales in China are almost always to general taxpayers who require special VAT invoices. A company that sells to other businesses and that’s classified as a small-scale taxpayer is effectively barred from business-to-business sales because the buyer can’t credit the input VAT.
The small-scale taxpayer can apply to the tax bureau to issue a special VAT invoice for a specific transaction, but the process is cumbersome and the rate is the small-scale taxpayer rate — 3%, not the 6%, 9%, or 13% rate that the buyer would get from a general taxpayer. The buyer is better off buying from a general taxpayer competitor who issues a special invoice at the full VAT rate.
A company that sells to consumers — retail, restaurants, consumer services — doesn’t need to issue special VAT invoices because consumers don’t credit input VAT. A consumer-facing business may prefer the small-scale taxpayer classification because the lower VAT rate reduces the price to the consumer, and the inability to issue special VAT invoices is irrelevant.
The Upgrade Process
The upgrade from small-scale taxpayer to general taxpayer requires an application to the tax bureau. The application includes the company’s business license, the tax registration certificate, the financial statements — showing the revenue, the assets, and the accounting system — and a description of the company’s business operations and the expected revenue.
The tax bureau reviews the application and may conduct a site visit to confirm that the company has an accounting function capable of managing general taxpayer compliance. The bureau is looking for qualified accounting staff — or a qualified external accounting service provider — and an accounting system that can track input and output VAT and produce the general taxpayer VAT returns.
The upgrade is effective from the beginning of the month following the approval, or from a date specified by the tax bureau. The company must start issuing special VAT invoices from the effective date and must file its first general taxpayer VAT return for the period that includes the effective date.
The upgrade is effectively permanent. A company that upgrades from small-scale taxpayer to general taxpayer cannot downgrade back to small-scale taxpayer. The decision to upgrade should be made with the understanding that the company is committing to general taxpayer compliance for the duration of its operation.
