China updates guidance on hybrid mismatch arrangements and convertible bonds

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China updates guidance on hybrid mismatch arrangements and convertible bonds

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China has relatively limited guidance on the tax classification

Lewis Lu of KPMG China looks at how the Chinese STA have sought to clarify the application of corporate income tax.

The Chinese State Taxation Administration (STA), in its ongoing efforts to improve tax certainty and the overall business environment, recently made several clarifications on corporate income tax (CIT) rule implementation (STA Announcement No. 17 [2021]), effective for filings from 2021 onwards.

Tax treatment of cross-border hybrid financial instruments

China has relatively limited guidance on the tax classification and treatment of hybrid financial instruments, i.e. those with features of both debt and equity. For example, China did not adopt the BEPS Action 2 rules [2015] to deal with hybrid mismatch tax planning.

The principal piece of guidance, STA Announcement No. 41 [2013], set out a list of criteria which must be met for the pay outs on a financial instrument to be recognised as tax deductible interest (rather than non-deductible distributions). This includes that there are periodical payments of interest at the rate agreed in the relevant contracts, that the investing enterprise does not have an ownership interest in the net assets of the investee enterprise, as well as other factors.

It was however considered that the existing rules did not adequately deal with cross-border situations, in particular the tax arbitrage possible where a foreign enterprise invests in an instrument issued by a Chinese company. Under the existing guidance it was possible for an instrument’s terms to be tailored such that the Chinese enterprise would have its payments treated as deductible interest but the foreign enterprise could, under the tax law of its jurisdiction, treat the payment as an exempt dividend.

Under the latest guidance, the STA provide that if the two enterprises are associated (i.e. 25% and above common shareholding relationship or effective control relationship) and if the investment return (capital gains or dividends) would be exempted in the hands of the foreign enterprise, then no tax deduction will be granted in China.

CIT deduction for donations-in-kind

During the COVID-19 disruption period many taxpayers made donations with their self-produced or purchased goods.

The STA has now clarified what documents can be used as support for CIT deductions, including receipts issued by government agencies and social organisations.

Tax treatment of debt converted to equity

China’s CIT law exempts dividend income from domestic enterprises but taxes interest. The STA has now clarified how convertible bonds are to be treated pre- and post-conversion.

Where an investor in convertible bonds has accrued interest, but before it is paid the bonds (plus unpaid interest) are converted to equity, the STA state that this interest will still be taxable. This is regardless of whether the interest has been recognised as revenue under the accounting rules. For the purposes of the future sale of this equity, the cost base for tax purposes is clarified to consist of the purchase price of the convertible bonds, the quantum of the unreceived interest and the associated tax.

For an issuer of convertible bonds, the interest arising from the convertible bonds can be deducted for CIT purposes. Where the issuer converts both the bonds and accrued interest payable into shares, the accrued interest payable will be deemed as having been paid and be deductible.

Tax treatment of assets where CIT determination method changes

Chinese companies without robust accounting systems are permitted to calculate their CIT on a deemed basis rather than an accounting books basis, which can lead to higher tax burdens.

With China’s ongoing economic development, many enterprises have adopted or enhanced their accounting systems and processes and have moved from the deemed basis to the accounting books basis. For companies making this transition, the STA has now clarified how to determine tax basis of purchased assets for depreciation/amortisation and capital gains tax purposes.

Separately of these STA clarifications in Announcement 17, a simplified procedure for cross-border payments has been rolled out from June 29 2021. Prior to this, the STA and the State Administration of Foreign Exchange (SAFE) sought public opinions on the draft (see previous article for more details). Compared to the draft version, no significant changes were made.

 

 

Lewis Lu

Partner, KPMG China

E: lewis.lu@kpmg.com

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