China updates pointers on hybrid mismatches and convertibles

China has relatively limited guidance on tax classification

The Chinese State Tax Administration (STA), in its ongoing efforts to improve tax security and the general business environment, recently made several clarifications on the implementation of Corporate Income Tax (CIT) rules (STA Notice No. 17 (2021)) that are effective for the filings are from 2021.

tax

Treatment of cross-border hybrid financial instruments

China has relatively limited guidelines for that

tax classification and treatment of hybrid financial instruments, i.e.

with characteristics of debt and equity. China, for example, has the

BEPS-Action-2-Rules (2015) for dealing with tax planning for hybrid arrangements.

The main guide, STA

Announcement No. 41 (2013) contains a list of criteria that must be met for

the payments from a tax-deductible financial instrument

Interest (instead of non-deductible distributions). That includes it

are periodic interest payments in the amount of the respective

Contracts in which the investing company is not involved

the net worth of the investee; and other factors.

However, it was assumed that the existing

Regulations inadequate to cross-border situations, especially those

Tax arbitrage possible when a foreign company invests in an instrument

issued by a Chinese company. Under the existing guidance it was possible for one

the terms of the instrument can be adjusted so that the Chinese company

its payments were treated as deductible interest, but the foreign company was

treat the payment as a tax-exempt dividend under the tax law of its jurisdiction.

According to the latest guidelines, the STA offers this

if the two companies are related (i.e. 25% and more of the share capital)

Relationship or effective control relationship) and if the return on investment

(Capital gains or dividends) would be tax-free in the hands of the foreign company,

then no tax deduction will be granted in China.

CIT deduction for donations in kind

During the COVID-19

Downtime period many taxpayers donated with their self-produced or

purchased goods.

The STA has now clarified which documents can be

used to support CIT deductions, including government-issued receipts

Agencies and social organizations.

tax

Treatment of debt converted into equity

China's CIT law exempt

Dividend income from domestic companies, but taxes on interest. The SDA has now

clarified how convertible bonds are to be treated before and after conversion.

Has an investor in convertibles

accrued interest, but before disbursement the bonds (plus unpaid interest)

Converted to equity, the STA states that this interest is still taxable.

This is true regardless of whether the interest rate is below sales

the accounting rules
. For the purpose of future sales of this

Equity, the tax cost base consists of the acquisition

Price of the convertible bond, the amount of interest not received and the

related tax.

For an issuer of

Convertible bonds can amount to the interest from the convertible bonds

deducted for CIT purposes. When the issuer both converts the bonds and accrues

Interest payable on shares, the accrued interest counts as

paid and deductible.

Chinese companies with no robust

Accounting systems are allowed to calculate their CIT on an assumed basis

rather than on an accounting basis, which can lead to higher tax burdens.

With China's continued economic

Development, many companies have adopted or improved their accounting systems

and processes and have moved from the assumed basis to the account books

Base. For companies making this transition, the STA has now made it clear how they

Determination of the tax base of the acquired assets for depreciation and

Purposes of capital gains tax.

Separated from these STA Clarifications in Announcement 17, a simplified one

The procedure for cross-border payments was introduced on June 29th

2021. Previously the STA and the state foreign exchange administration

(SAFE) sought public opinion on the draft (see previous article for more details). No significant compared to the draft version

Changes have been made.

Lewis Lu

Partner, KPMG China

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