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3. TAXATION IN THE MAINLAND CHINA
3.4 THIN CAPITALIZATION RULES
These are the rules set up to govern the related party loans and control the ratio of debt -to -equity subject to foreign investment enterprise ("FIE") in order to maintain the reasonable deductibility of loan interest and the availability of sufficient capital funds from those foreign investors.
Article 46 of new CIT law mentions that interest expenses related to the related party loans do not meet the stipulated debt-to-equity ratio are not deductible; The criteria of arm-length debts is applicable.
Accordingly, careful tax planning idea should be made in this regard to make sure that the interest expense incurred in respect of the related party loan can be fully deductible and thus the risk of the possibility of the tax adjustment raised by the PRC Tax Bureau can be minimized.
According to the Caishui [2008] No. 121, both the Ministry of finance and the State Administration of Taxation (SAT) have recently issued ˇ§Notice regarding the Tax-deductibility policy of interest payment to related partiesˇ¨, it highlights the standard ratio thresholds to allow the extent of deductibility of interest expenses if the debt to the capital structure (DER) of these enterprises can fulfils the following ratio:
(i) For financial enterprise: 5:1
(ii) For non-financial enterprise and all other enterprises: 2:1
In alternative, if the enterprise is currently engaged in both financial and non-financial business at a mix, the amount of the actual interest expenses incurred in respect of the related parties shall be separately considered and calculated for 2 different categories of businesses under a reasonable basis approach.
The interest expenses may be deductible if the enterprise can adopt the arm-length principles for such financing and also produce a detailed supportive documentation to show that the effective tax rate of the borrower is not higher than that of the domestic related party that receive the interest.
Regardless of the whether the deductibility of the interest expense, in the recipientˇ¦s perspective, the interest income derived from the related party is subject to the Company Income Tax (CIT) Regime.
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