Fitch: Chinese Telcos' Tax Burden to Rise With VAT Implementation

Thu May 1, 2014 10:22pm EDT

(The following statement was released by the rating agency) HONG KONG/SYDNEY, May 01 (Fitch) Fitch Ratings says that the latest extension of China's value-added tax (VAT) pilot programme to the telecoms sector will reduce Chinese telecom operators' EBITDA and free cash flow (FCF) in the next two to three years, lowering their rating headroom. However, as VAT is extended to other industries in the coming years, Fitch believes that the adverse impact on telecoms operators will diminish. We expect that the implementation of VAT will raise China Mobile Limited's (CML, A+/Stable) and China Telecom Corporation Limited's (CTCL, A+/Stable) overall tax burden in the next two to three years, cutting their annual EBITDA by as much as 8-10% initially. With effect from 1 June 2014, the VAT rates of 11% and 6% for basic telecom services and value-added services (VAS) respectively will replace the current 3% business tax. Fitch believes that the VAT on the telecom sector will not simply be a neutral pass-through tax to be borne by the consumer. We think that Chinese telecom operators will find it difficult to pass on the additional tax burden to customers through higher tariffs - encumbering consumers is not the purpose of China's VAT reform. In addition, China's VAT reform will be rolled out in phases. Telecom operators will not be able to completely offset their output VAT liabilities with their input VAT credits because these will be limited initially. China's VAT pilot programme has to-date covered transportation, postal, broadcasting, logistics, information technology, finance leasing and certain other service sectors and rates have ranged from 6%-17%. The telecom sector is the latest to be added to the pilot programme. In March 2014, the Ministry of Finance said that it aims to steadily expand the VAT programme to cover all sectors that are still subject to business tax before the end of the 12th Five-Year Plan period (2011-2015). Staff costs and depreciation make up a substantial part of telecom operators' cost structures, but these are not VAT deductible. In addition, only a small proportion of operators' distribution and marketing expenses is tax deductible. This situation will be exacerbated during the initial period of the VAT reform as some telcos' suppliers may not be included in the VAT pilot programme. In 2013, staff costs and depreciation accounted for 28% and 39% of CML's and CTCL's total operating costs respectively. Fitch believes 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. We also believe that telcos will try to reduce their overall output VAT liabilities by raising revenue from value-added services and adjusting their marketing strategies. In addition, Fitch expects telecom operators to see some capex savings, partially mitigating FCF pressure. This is because some equipment purchase will enjoy input VAT credits. In general, equipment tends to account for about 50% of telecoms operators' capex. We expect CML's capex to be CNY225bn in 2014 while CTCL's capex to reach CNY90-100bn, assuming CTCL secures a frequency division duplex-long-term evolution (FDD LTE) licence in 2014. Fitch expects the VAT reform will not materially impact CML's and CTCL's financial position. We expect that CML will maintain its strong net cash position. CML's liquidity is strong: at end-December 2013 its unrestricted cash balance of CNY420bn significantly exceeded total debt of CNY5bn. Similarly, CTCL has only modest leverage. We expect that CTCL's funds from operations (FFO)-adjusted net leverage ratio to stay below 2x in the next two to three years, even after taking 4G capex and VAT reform into account. Contact: Kelvin Ho Director +852 2263 9940 Fitch (Hong Kong) Limited 2801, Tower Two, Lippo Centre 89 Queensway, Hong Kong Steve Durose Senior Director Deputy Head Asia-Pacific Corporate Ratings Group +61 2 8256 0307 Media Relations: Iselle Gonzalez, Sydney, Tel: +61 2 8256 0326, Email: iselle.gonzalez@fitchratings.com; Wai-Lun Wan, Hong Kong, Tel: +852 2263 9935, Email: wailun.wan@fitchratings.com. Additional information is available on www.fitchratings.com ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: here. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. 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