In recent years, an increasing number of large infrastructure, resource and energy enterprises have adopted the EPC (engineering, procurement and construction) model in building their projects.
Under the EPC model, the issue of how to leverage the advantages of this model to the greatest extent while controlling costs as much as possible has consistently vexed owners. The implementation of the value-added tax (VAT) deduction policy has also caused large enterprises to begin to pay attention to how they can lawfully enhance their profit margins through the use of VAT deductions under the EPC construction model.
The applicable VAT rate for general payers is 17%. Accordingly, for large infrastructure, resource and energy enterprises whose projects call for huge investments, the deduction of VAT can bring significant benefits.
Why is planning necessary?
In an EPC project, the general contractor is required to procure a large volume of equipment and materials in the course of project construction. With respect to the VAT arising as a result, if the general contractor can issue the owner VAT invoices and if the owner is a general taxpayer, such tax can be deducted as input tax, saving the owner a great deal in taxes. Particularly in large infrastructure construction, and resource and energy projects, if reasonable tax planning can be carried out in the procurement of construction equipment and materials and/or processing equipment and materials, the savings can be quite significant.
In certain large enterprises with which we have had dealings, the group head offices have expressly made known to their subsidiaries, branches and project departments requirements in respect of VAT deduction and specific amount targets.
Requirements and obstacles
To deduct VAT, an owner must obtain VAT invoices. In practice, tax authorities strictly implement the principle of “consistency of the flow of things, of documentation and of money” – consistency of the three flows – in respect of the issuance of VAT invoices. In other words, tax authorities require that the parties to the procurement of material and equipment, the parties to the VAT invoice and the parties involved in the payment and receipt of the moneys all be fully consistent.
When determining whether the “flow of things is consistent”, tax authorities generally rely on the procurement contract executed by the parties. Clearly, although the flow of documentation and money in an EPC project contract is consistent, procurement is not the principal subject matter of such contracts, and the specified contract amount is not consistent with the sales taxable amount for VAT purposes, thus failing to satisfy the requirements of tax authorities and making it impossible to issue VAT invoices. Under normal circumstances, it is impossible for the general contractor to issue VAT invoices to the owner, and instead it issues construction business tax invoices, making it impossible for the owner to carry out VAT deduction.
In practice, in certain construction projects, the issue of the deduction of VAT is not considered in advance, at the outset of the design of the framework of the contracting contract, in which case the only possible solution is usually to take remedial measures in the course of the performance of the contract. For example, to satisfy the requirements of the “consistency of the three flows”, the owner will execute a procurement contract with the general contractor that is separate from the general contract, thereby satisfying the requirements of tax authorities.
Such a practice model presents some relatively large risks: (1) such retroactive handling of matters and backdating of contracts can give rise to a suspicion of tax evasion, potentially exposing the contractor, owner and relevant personnel to criminal and administrative penalties; (2) failure to execute the contract in accordance with the EPC project bid invitation documents and the winning bid documents violates the Law on the Invitation and Submission of Bids, and could expose the enterprise to administrative penalties; and (3) the simultaneous existence of procurement provisions in the EPC contract and a separate procurement contract can easily lead to unclear allocation of the rights and responsibilities of the contractor and owner in/for procurement, ultimately resulting in disputes.
An unclear demarcation of rights and responsibilities in/for procurement will directly affect control over the quality of materials and equipment procured, which may ultimately affect the safe operation of the project facilities. Once a safety-related accident occurs in a large project, the losses can be difficult to estimate. Such non-compliant remedial measures should be avoided, particularly in large EPC projects.
How to plan
The author believes that the characteristic of the EPC model of combining engineering, procurement and construction, and the actual requirements in respect of VAT deduction, are fundamental reasons that give rise to obstacles to VAT deduction in the course of EPC project practice. In view of this, the author has attempted, from the perspective of contract framework, to explore a solution for this problem, namely: an owner may consider executing a D-B (design-build) contract with the general contractor, and then execute a separate entrusted procurement contract, applying both comprehensively.
Under such an arrangement, the entrusted procurement contract should fulfil two roles: (1) as the sale and purchase contract for materials and equipment, satisfying the contractual requirements for VAT deduction and the principle of consistency of flow of things; and (2) as a supplement to the D-B contract, specifying the procurement responsibilities and obligations bearable by the general contractor under the EPC contract.
The contractor and owner need to set certain special provisions in the entrusted procurement contract, e.g.: (1) the general contractor being solely responsible for model selection, transport, acceptance, installation, trial operation and quality assurance of the materials and equipment, based on the technical requirements and schedule of the D-B project; (2) to achieve the objective of EPC cost control, a maximum procurement amount should be set in the procurement contract, with any portion exceeding the budget to be borne solely by the general contractor.
For the sake of prudence, before an owner adopts this method, it should do the necessary liaison with the tax authority in advance concerning this model and matters relating to the deduction of VAT.
Wang Jihong is deputy director of the Environment, Resource and Energy Law Committee, All China Lawyers Association；Fang Xing also contributed to this article
Environment, Resource and Energy Law Committee
All China Lawyers Association
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