China’s New Thin Capitalization Rules

Excerpt from Practical China Tax and Finance Strategies by Peter Guang Chen (Deloitte Tax LLP, New York City). From http://www.wtexecutive.com/

Article 46 of China’s new Enterprise Income Tax Law (EITL) provides that a Chinese enterprise’s ability to deduct interest payments on borrowings from related parties is subject to a “prescribed standard.” However, the EITL, which became effective January 1, 2008, did not address what this “prescribed standard” would be. Without a clear answer on an acceptable debt-to-equity ratio in China, many financing and tax planning plans had to be put on hold, particularly for those multinational corporate groups doing cross-border intercompany financing of their subsidiary operations in China.
This important issue was addressed September 19, 2008 in a circular issued jointly by the Ministry of Finance (MOF) and the State Administration of Taxation (SAT) (Caishui [2008] 121). Entitled “Notice on the Tax Deductibility of Related Party Interest Payments,” the circular defines the “prescribed standard,” by setting out the debt-to-equity ratio for related party borrowings.
Circular 121 affects all companies in China that borrow from affiliated parties (such as a parent company or a brother-sister company).
Circular 121 provides two sets of debt-to-equity ratios for related party borrowings: one for financial institutions, another for all other
enterprises:
• For financial institutions, the debt-to-equity ratio cannot exceed 5:1; and
• For all other enterprises, the debt-to-equity ratio cannot exceed 2:1.
Any related party interest payment exceeding the specified ratios is not allowed as a deduction in the current or subsequent years on the borrower’s Enterprise Income Tax (EIT) return, unless an exception applies. Under the exception, interest expense may be deducted if the enterprise can produce supporting documentation demonstrating that the financing was at arm's length or that the effective tax rate of the borrowing entity is not higher than the tax rate of the domestic related party that receives the interest.