Chinese telcos' tax burden to rise with VAT reform

Fitch Ratings said on Friday that the latest extension of China's value-added tax (VAT) pilot program to the telecoms sector will initially increase enterprises' tax burden. The program will reduce Chinese telecoms operators' EBITDA (earnings before interest, taxes, depreciation and amortization) and free cash flow for the next two to three years, lowering their rating headroom, said Fitch in a research note. "However, as VAT is extended to other industries in the coming years, Fitch believes that the adverse impact on telecoms operators will diminish," the note said. The rating agency expects VAT to raise China Mobile's and China Telecom's overall tax burden in the next two to three years, cutting their annual EBITDA by as much as 8 to 10 percent initially. It did not mention China Unicom, one of the three major operators. Taking effect from June 1, the VAT rates of 11 percent and 6 percent for basic telecoms services and value-added services respectively will replace the current 3 percent business tax. Staff costs and depreciation make up a substantial part of telecoms operators' cost structures, but these are not VAT deductible. In addition, only a small proportion of operators' distribution and marketing expenses is tax deductible, according to the research note. "This situation will be exacerbated during the initial period of the VAT reform as some telcos' suppliers may not be included", said Fitch. However, Fitch believed that the telcos' profitability is likely to start to recover in the third or fourth years after the VAT implementation, when VAT deductible items are likely to increase as the VAT reform expands to capture more industries. China aims to expand VAT to cover all sectors that are still subject to business tax before the end of the 12th five-year plan period (2011-2015). Before the extension to the telecoms sector, China's VAT pilot program had covered transportation, postal and some modern service sectors with rates ranging from 6 percent to 17 percent. The VAT reform is expected to reduce double taxation and lift tax burdens for enterprises. As of the end of March, the VAT reform had covered nearly three million businesses and saved them 220 billion yuan (35.5 billion U.S. dollars).