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13.2. Thin-capitalization and other Restrictions to Interest Deduction

Thin-capitalization rules in China are designed to disallow the deduction of excessive related party interest expenses based on a debt-to-equity ratio. For this purpose debt refers to financing that is directly or indirectly obtained from an enterprise’s related parties, and is to be repaid in principal or interest or compensated in ways similar to paying interest. Such debt investments include:

  • Debt investments offered by a related party through an unrelated third party
  • Debt investments provided by an unrelated third party, with a related party guaranteeing underlying debts and assuming joint liability
  • Other debt investments, having substance as such, obtained indirectly from related parties

Equity refers to investments received by an enterprise without the obligation to repay principal and interest, and through which investors have ownership rights in the net assets of the enterprise.

The debt-to-equity ratio is specified as 5:1 for financial institutions and 2:1 in all other cases. Interest expense exceeding these thresholds is nondeductible in current and subsequent periods.

However, the rules stipulate that if the borrowing enterprise can produce supporting documentation demonstrating that the financing is at arm's length or that the effective tax rate of the borrowing entity is not higher than the rate of the related party that receives the interest, then excessive interest that exceeds the ratio thresholds can be deducted if approved.

In cases where the excessive interest is non-deductible, the interest expense paid to overseas related parties would be deemed to be a dividend distribution and subject to withholding tax at the higher of the applicable withholding tax rate on interest or the withholding tax rate on dividends.

The documentation required in order to deduct excessive interest expense should include the following to demonstrate that the related party financing arrangements conform to the arm’s-length principle:

  • Analysis of the taxpayer’s repayment capacity and borrowing capacity
  • Analysis of the group’s borrowing capacity and financing structure
  • Description of changes to equity investment of the taxpayer, such as changes in the registered capital, etc.
  • Nature and objectives of debt investment from related parties, and the market conditions at the time the debt investment was obtained
  • Currency, amount, interest rate, term and financing terms of the debt investment from related parties
  • Collaterals provided by the enterprise and the relevant terms
  • Details of the guarantor and the terms of guarantee
  • Interest rate and financing terms of similar loans contemporaneous to the debt investment from related parties
  • Terms of conversion of convertible bonds
  • Other information that can support the conformity with the arm’s-length principle

In addition, in order to obtain deductibility of interest expenses incurred in related party loans, enterprises are required to document that interest payments for loans to non-financial borrowers are reasonable, including standard interest rates for similar loans by financial institutions within the same province in China that the borrowing enterprise is located.