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Observation on China's thin capitalisation rules for banks operating in China
Introduction
The China's new Corporate Income Tax ("CIT") Law has introduced the concept of thin capitalisation. The deduction of interest expenses is not allowed when the ratio of debt to equity from related parties exceeds a certain prescribed debt/equity ratio as stipulated in Caishui [2008] no.121 ("Circular 121"). For details of Circular 121 and our comments, please refer to the October 2008, Issue 10 of our News Flash.
Most overseas banking groups operating in China are now aware of their obligation to apply transfer pricing principles to their related party transactions, to file the nine related party transaction forms with their annual CIT returns, and to compile transfer pricing documentation unless exempted. However, we note that many of them may not have given enough consideration to the thin capitalisation rules incorporated into the CIT law and the subsequent implementation notices, or to the tax authorities' plans to enforce these rules.
This Issue of News Flash is designed to highlight the key aspects of the thin capitalisation rules and to share the likely approach of Chinese local-level tax bureaus to investigate the thin capitalisation issues of taxpayers.
Thin capitalisation issues for banks in China
China's thin capitalisation rules state that financial institutions (including banks) with related party debt/equity ratios exceeding the 5:1 ratio (commonly known as the "safe-harbour ratio") shall not be allowed a tax deduction for the portion of the interest expenses relating to excess debt ("excess interest"). There are two exceptions.
- Firstly, where a bank borrows from domestic related parties (domestic debts), and if the tax burden of the borrower bank is not higher than the tax burden of the lender, then that bank can continue to take a tax deduction for the interest relating to debt from those related parties.
- Secondly, if a bank can demonstrate and document that the amount, interest rate, terms, financial terms and debt/equity ratio comply with the arm's length principle, then it can also continue to take a tax deduction for the excess interest.
We observe that thin capitalisation is a common issue for Chinese branches of foreign banks. However, it is rarely an issue for incorporated subsidiaries of foreign banks in China because they do not normally exceed the thin capitalisation safe-harbour ratio. Yet, even these incorporated subsidiaries normally have a transitional retained branch structure that operates concurrently with the incorporated bank for a couple of years and these transitional structures may have thin capitalisation exposures.
Likely investigation on thin capitalisation issues
Recently we are aware that one of the tax bureaus in Shanghai was planning to investigate the thin capitalisation issues in banks with a view to disallowing interest deductions exceeding the thin capitalisation safe-harbour ratio. However, that tax bureau's plan has now been postponed until after the 31 December 2009 transfer pricing documentation deadline and we understand that at that time it plans to review taxpayers' documentation before determining whether thin capitalisation adjustments are required.
PwC observations
Although this particular tax bureau's plans have been postponed, their original intent strongly signifies that the Shanghai tax authorities have not overlooked the thin-capitalisation issues for banks. Furthermore, it is possible that Chinese local-level tax bureaus in other cities may also start scrutinising the thin capitalisation positions of banks by reviewing the relevant information submitted in their 2008 annual CIT returns and their transfer pricing documentation.
Common exposures
We realise that some taxpayers in the banking industry and their advisors are mistakenly assuming that if they are able to demonstrate that the interest rate that the taxpayer paid on related party debt was set at an arm's length interest rate (e.g. same as the prevailing bank rate), then thin capitalisation is not an issue. Such mistakes perhaps originate from Article 38 of the CIT's Detailed Implementation Rules ("DIR") which states that "The following interest expense ... are allowed to be deductible: (1) ... interest expense on ... inter-bank borrowings as incurred by financial institutions, ... ". However, it is imperative to note that in particular, Articles 89 and 90 of Guo Shui Fa [2009] No.2 have stated clearly that besides demonstrating the arm's length nature of the interest rate, the taxpayer (including banks) must also demonstrate the arm's length nature of the amount, term, financing terms and debt/equity ratio of the related party debt. The State Administration of Taxation ("SAT") has reiterated the requirements of Articles 89 and 90 in recent discussions with PricewaterhouseCoopers and noted that interest rate benchmarking is not enough to secure a tax deduction for the entire amount of related party interest expenses.
Thin capitalisation is eventually connected to ensuring an arm's length interest expense deduction but its principal focus is on whether there is too much interest bearing debt, rather than necessarily whether the interest rate is itself arm's length. To this end, it is possible that a thin capitalisation adjustment could be required even where an interest rate is priced on an arm's length basis, if the taxpayer has borrowed an excessive amount of debt.
Another common exposure results from the mistaken assumption that because a Chinese branch of a foreign bank has complied with the capital requirements set by the China Banking Regulatory Committee ("CBRC") it does not have to consider the thin capitalisation requirement. Again, it is imperative to note that the thin capitalisation (tax) rules and regulatory rules are distinct from each other and the Chinese tax authorities are unlikely to accept the argument that regulatory compliance implies thin capitalisation compliance.
For example, one difference that could lead the regulators and tax authorities to inconsistent conclusions is their approach to evaluating the relationship between a branch and its head office. The CBRC recognises that a branch is legally a part of the same entity as its head office, which is why branches are subject to less onerous capital requirements than incorporated banks. Transfer pricing and thin capitalisation rules, however, require the taxpayer to hypothesise the branch of an overseas company (i.e. foreign bank) as a separate entity from the head office for China tax purposes.
What should the banks do now?
Given the possibility for significant interest deductions to be disallowed, plus interest levy and penalties to be applied, the banks, including the Chinese branches of foreign banks should heighten their awareness of the magnitude of their related party debts. They have to ensure that such debts do not cross the line of the 5:1 safe-harbour ratio going forwards. If this is not feasible for business reasons, they should ensure that they have prepared sufficiently detailed thin capitalisation documentation to support their arm's length arguments.
Technically, we have been aware that some of the thin-capitalisation rules and requirements as per Guo Shui Fa (2009) No. 2 are not very clear. We have already approached the SAT to seek further clarification to help our clients to achieve full compliance and manage their risks. In due course, we will further share the intelligence and information.
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