New CIT Rules for Combination Investments of Enterprises

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Jul. 30 – On July 15, China’s State Administration of Taxation (SAT) promulgated the “Announcement on the Corporate Income Tax (CIT) Treatment for Enterprises Engaged in Combination Investments (SAT Announcement [2013] No. 41, hereinafter referred to as the ‘Announcement’).” The Announcement will enter into force on September 1, 2013 without retroactive effect.

Combination investments refer to investments with the dual features of equity and creditor’s right, according to the Announcement. In practice, an example would be the purchase of preferred stocks or convertible bonds.

The Announcement states that investments subject to the CIT treatment discussed below are those that fulfill all of the following conditions:

  • After the investee enterprise receives the investment, it has to pay interests (or guaranteed interests, fixed profits, fixed dividends) regularly based on the interest rate agreed in the investment contract or agreement;
  • There is a specific investment horizon or set of investment conditions, and when the investment horizon expires or the investment terms are fulfilled, the investee will redeem the investment or repay the principal;
  • The investor does not hold any ownership rights to the net assets of the investee;
  • The investor does not have the right to vote or be elected; and
  • The investor does not participate in the daily business operation of the investee.

For those investments meeting the above requirements, the interest paid by the investee enterprise and earned by the investor are subject to CIT. Investors should recognize the income and incorporate it into its current taxable income on the date that the interests are payable. Meanwhile, the investee should recognize the interest expense on the date the interests are due, and deduct the interest payment from its taxable income.

The deduction should comply with the first provision of the “Announcement Concerning Issues on CIT” (SAT Announcement [2011] No. 34), which stipulates that the portion of the interest payment exceeding the amount calculated based on the lending interest rate released by financial institutions (i.e. banks, financial companies, trust companies, etc.) of the same period within the same category is not deductible. The investee should provide a statement to tax authorities to justify the reasonableness of the interest expense.

In addition, at the time that the investee redeems the investment, the Announcement requires that both parties recognize the difference between the redemption price and the investment cost as gains or losses from debt restructuring in their respective current taxable income.

The practical implication under the Announcement is that fixed profit distributions will no longer be treated as dividends and thus exempted from CIT, but will instead only be entitled to deductions from taxable income. Experts expect the Announcement to have an impact on a large number of investments with guaranteed minimum returns.

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