Thin capitalization ratios

    
    Thin capitalization rules are an anti-tax avoidance measure, commonly adopted by many tax jurisdictions to counter the abusive use of loan-finance in order to jet up the interest deduction and hence reduce taxable income of the borrowing enterprise.  Prescribed debt/equity ratios form an important part of the thin capitalization rules.
      
The new China Corporate Income Tax Law ("CIT") has introduced the concept of thin capitalization.  The purpose is to disallow the deduction of interest expenses pertaining to debts from related parties when the ratio of debt to equity exceeds a certain prescribed debt/equity ratio.  The ratio, however, was not stipulated in the CIT Law or its Detailed Implementation Regulations.  Last week, the Ministry of Finance ("MOF") and State Administration of Taxation ("SAT") have jointly published a circular, Caishui [2008] No.121 ("Circular 121") recently setting out the prescribed debt/equity ratio and other relevant rules.
    
We summarize below the salient points of Circular 121:

1. There are two prescribed debt/equity ratios - one for enterprises in the financial industry and the other one for non-financial enterprises.  The former is set at 5:1, while the latter at 2:1.  Where the ratio of the debts from related parties to the equity exceeds the certain prescribed debt/equity ratio in a year, the interest expense pertaining to the debts from related parties shall not be deductible in that year (and no carry-forward to future years), except in situations where the criteria set out in Point 2 below is met.  The prescribed ratio for enterprises in the financial industry is higher than that for non-financial enterprises as financial arrangements in finance industry have their particular features.
       
2. The excessive interest expenses may still be deductible if an enterprise can provide documentation to support that the inter-company financing arrangements comply with the arm's length principle; or if the effective tax rate of the borrowing enterprise is not higher than that of the domestic lending enterprise.
      
3. If an enterprise carries on both financial business and non-financial business, it has to segregate the related party interest expenses between the two businesses on a reasonable basis; otherwise, it has to follow the prescribed debt/equity ratio for non-finance industry.  i.e., the 2:1 ratio, in calculating its deduction threshold for related party interest expense.
        
4. The lending enterprise shall be subject to CIT on the full amount of interest income (including the non-deductible portion of the borrowing enterprise) in accordance with the relevant tax regulations.