Reinstatement of VAT on Bond Interest Income: Implications for the Bond Market, Fiscal Policy, Banks, and Individual Investors

On August 1, the Ministry of Finance and the State Taxation Administration announced that effective August 8, 2025, interest income derived from newly issued government, local government, and financial bonds will be subject to value-added tax (VAT). Bonds issued prior to this date, including any that are reissued afterward, will continue to benefit from VAT exemption until their respective maturities.

Interviews conducted by Jiemian News suggest that the reinstatement of VAT on bond interest is aligned with the principle of tax neutrality. While the measure may pose challenges for the broader bond market, its effects vary across asset classes, favoring outstanding bonds, credit instruments, and government bonds with high reissuance frequency.

Commercial banks—key investors in government debt—may face negative financial implications. They will incur VAT obligations on new acquisitions and encounter elevated interest rates when issuing their own financial bonds. On the fiscal front, the reform could bolster tax revenues and alleviate budgetary stress. From a regulatory standpoint, current VAT exemptions for public funds may also undergo future revision.

The People’s Bank of China reported that in 2024, the combined issuance of government, local government, and financial bonds totaled RMB 32.6 trillion. This included RMB 12.4 trillion in government bonds, RMB 9.8 trillion in local government bonds, and RMB 10.4 trillion in financial bonds. With expansionary fiscal policies prevailing, further increases in issuance volumes are anticipated.

Historically, interest income from government bonds was exempt from business tax. Following the 2016 transition to VAT, exemptions were extended to interest earned from local government and financial bonds held by financial entities.

As specified in the 2016 Circular on the Full Implementation of the Business Tax-to-VAT Reform Pilot, the VAT rate stands at 6%. This circular also affirmed VAT exemptions on interest income from government and local government bonds and certain interbank transactions. Additional clarifications expanded the scope to include negotiable certificates of deposit (NCDs) and financial bonds.
The recent policy clarification affirms that interest income from government, local government, and financial bonds issued on or after August 8, 2025, will be taxable under VAT regulations.

Meanwhile, interest income derived from interbank deposits, loans, and NCDs will continue to be exempt. Central bank figures show that NCD issuance in 2024 amounted to RMB 31.5 trillion.
According to a China Fiscal News article released by the Ministry of Finance on August 1, the VAT exemption for bond interest income has served its intended purpose. The reintroduction of VAT fosters consistency across instruments, supports the legal foundation of the tax system, and advances financial market development through more standardized incentives.

Credit bonds have historically been subject to VAT, and bringing government bonds under the same framework helps restore parity. The previous VAT exemption disrupted price signaling and eroded the yield curve’s benchmark function. Removing this distortion may strengthen the yield curve as a reference point for pricing.

This reform is also viewed as a reaction to irrational trading activity. A steep drop in government bond yields last year—partially attributable to tax-free interest income—raised concerns about market stability. In its Q1 2025 Monetary Policy Report, the People’s Bank of China emphasized the importance of tax policy, investor behavior, and pricing efficiency in shaping interest rate mechanisms.

Investor appetite for new bonds may dampen, given changes in post-tax returns and evolving preferences. A fixed-income analyst at a prominent Shanghai brokerage stated that relative bond value is likely to diminish. Meanwhile, a banking analyst in Beijing projected that new bonds could require coupon rate hikes of 15–20 basis points to maintain competitiveness—mirroring patterns observed in 2020 when similar exemptions were rescinded.

Despite the announcement, bond trading activity remained robust on the evening of August 1. Government bond yields initially rose before falling, signaling differentiated effects across bond types. Analysts indicated that outstanding bonds might benefit from scarcity premiums, while newly issued instruments could necessitate higher yields.

A fixed-income fund director in Beijing observed that the updated policy favors existing bonds while presenting headwinds for new issues post-August 8. Reissuance of government bonds—where fresh tranches are merged with existing ones—may retain relative advantages in liquidity and benchmark integrity. In contrast, new local and financial bond issues, lacking such flexibility, could be more vulnerable.

Commercial banks face profitability pressures, as the VAT will apply to both newly acquired government bonds and their own financial bond issuances. Data from China Central Depository & Clearing indicates that by year-end 2024, commercial banks (including credit unions) held RMB 57 trillion in government bonds—70% of the outstanding total. Based on this ratio, RMB 15 trillion in government bonds were purchased in 2024. Assuming RMB 10 trillion in annual local government bond issuance at an average yield of 1.8%, VAT costs could rise by RMB 7.5 billion annually for banks. Analysts highlight that smaller banks—more dependent on tax-exempt income streams—may encounter greater margin compression.

Retail investors are expected to see negligible effects, given their limited participation in the bond market. Moreover, small-scale taxpayers earning less than RMB 100,000 monthly remain eligible for VAT exemptions.

Revisions to the VAT exemption framework for public mutual funds are also under consideration. A Shanghai-based analyst noted that if exemptions remain intact, investor interest may shift toward mutual fund-based exposure. Presently, mutual funds benefit from VAT and corporate income tax relief on government bond interest, and banks have leveraged these vehicles for credit bond investments.

To optimize post-tax yields, banks occasionally partner with asset managers to form tailored outsourced funds dedicated to specific credit bond acquisitions. Should mutual fund exemptions remain, similar strategies might be applied to government bond investments, although such approaches would be constrained by market and regulatory boundaries.

Under the new policy, VAT applied to mutual fund investments in government bonds will increase to 3%, compared to the 6% applicable to direct bank investments. After adjusting for fund management fees, the effective benefit narrows to approximately 2 percentage points—potentially diminishing the appeal of mutual fund channels.

Regulatory revisions to mutual fund tax exemptions may follow. A Beijing-based fund manager indicated that efforts to promote fairness and eliminate loopholes could prompt further updates.
Huaxi Securities noted in a recent report that mutual fund exemptions stem from policies in the Circular on Preferential Corporate Income Tax Policies and securities investment fund VAT guidance. These exemptions are tied to equity instruments and may function independently from broader VAT changes. With no formal revocation noted in the latest rules, current mutual fund tax benefits are expected to remain in the near term.

From the Ministry of Finance’s perspective, while increased coupon rates may elevate borrowing costs, VAT revenue from bond interest could offset these expenditures and improve fiscal sustainability. Huaxi Securities estimates that VAT on financial bond interest in 2024 could generate RMB 6.7–13.5 billion annually, based on RMB 10 trillion in new issuance and RMB 224.9 billion in coupon income taxed at 3% to 6%.

Official figures show that China’s total tax revenue for H1 2025 reached RMB 9.29 trillion—a 1.2% decline year-on-year. Domestic VAT collections amounted to RMB 3.6 trillion, reflecting a 2.8% increase over the previous period.