China has relatively limited guidance on tax classification
The Chinese State Tax Administration (STA) has recently made several clarifications on the implementation of the Corporate Income Tax Regime (CIT) in its ongoing efforts to improve tax security and the general business environment (STA Notice No. 17 ), valid for submissions from 2021.
Tax treatment of cross-border hybrid financial instruments
China has relatively limited guidance on the tax classification and treatment of hybrid financial instruments, that is, those that have both debt and equity characteristics. For example, China has not adopted the rules of BEPS Action 2  to manage the tax structure of hybrid structures.
The main guide, STA Communication No. 41 , contain a list of criteria that must be met for the payments from a financial instrument to be recognized as tax-deductible interest (rather than non-deductible distributions). This includes that periodic interest payments are made at the rate agreed in the respective contracts, that the investing company has no participation in the net assets of the investee, and other factors.
However, it was considered that the existing rules did not adequately address cross-border situations, in particular the potential tax arbitrage when a foreign company invests in an instrument issued by a Chinese company. Under the existing guidelines, it was possible to structure the terms of an instrument so that the payments made by the Chinese company would be treated as deductible interest, but the foreign company could treat the payment as tax-exempt dividend under the tax law of its jurisdiction.
According to the latest guidelines, the STA stipulates that if the two companies are affiliated (i.e. 25% and more joint ownership or effective control) and if the investment income (capital gains or dividends) in the hands of the foreign company is excluded, then in China does not grant any tax deduction.
CIT deduction for donations in kind
During the COVID-19 disruption period, many taxpayers donated with their homemade or purchased goods.
The STA has now clarified which documents can be used to support CIT withdrawal, including receipts issued by government agencies and social organizations.
Tax treatment of debt converted into equity
China’s CIT law exempts dividend income from domestic companies, but taxes interest. The STA has now clarified how convertible bonds are to be treated before and after conversion.
If an investor in convertibles has accrued interest but the bonds (plus unpaid interest) are converted into equity prior to disbursement, the STA states that that interest is still taxable. This applies regardless of whether the interest was recognized as income under the accounting regulations. For the purposes of the future sale of this equity, it is made clear that the tax cost basis consists of the purchase price of the convertible bonds, the amount of interest not yet received and the associated tax.
For an issuer of convertible bonds, the interest can be deducted from the convertible bonds for CIT purposes. If the issuer converts both the bonds and the accrued interest into stocks, the accrued interest is deemed paid and deductible.
Chinese companies without solid accounting systems are allowed to calculate their CIT based on accounting rather than accounting, which can lead to higher tax burdens.
With China’s continued economic development, many companies have adopted or improved their accounting systems and processes, moving from the adopted base to the accounting base. For companies making this transition, the STA has now clarified how to determine the tax base for assets acquired for depreciation and capital gains tax purposes.
Separated from these STA Clarifications in Announcement 17, a simplified one
The procedure for cross-border payments was introduced from June 29, 2021. Previously, the STA and the State Administration of Foreign Exchange (SAFE) sought public opinions on the draft (see previous article for more details). No significant changes have been made to the draft version.
Partner, KPMG China
© 2021 Euromoney Institutional Investor PLC. You can find help in our FAQ.