Global Tax Alert | 12 August 2013

China issues clarifying guidance on corporate income tax treatment of hybrid investments

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On 15 July 2013, China’s State Administration of Taxation (SAT) released SAT Announcement [2013] No. 41 (Announcement 41). Announcement 41 sets forth the Corporate Income Tax (CIT) treatment of hybrid investments and becomes effective on 1 September 2013. The SAT also released explanatory notes to Announcement 41 (Explanation of Announcement 41) on 29 July 2013 to provide further clarification of Announcement 41.

Hybrid investments are forms of investment that contain both equity and debt features. The CIT treatment set forth by Announcement 41 applies to hybrid investments that meet all of the following five conditions:

Conditions

Clarification as contained in Explanation of Announcement 41

1. The enterprise that is the recipient of a hybrid investment (investee) must make regular interest payments (including minimum interest, fixed profit or fixed dividends) as agreed in the investment contract/agreement.

  • The returns of the hybrid investment are not:
  • linked to the business performance of the investee;
  • distributed according to investment achievements; and
  • calculated based on the investor’s proportion of shares in the investee.
  • Hybrid investments are in nature a form of financing in which the investor bears little or no investment risk.

2. There is a clearly defined investment period or specific investment conditions. Once the term of investment expires or specific investment conditions are met, the investee must redeem the investment according to the price agreed in the investment contract/agreement or repay the principal.

  • Regardless of whether the investment period has reached its expiration, if the specific conditions for the redemption or repayment as agreed in investment contract/agreement are fulfilled, the investee must redeem the investment or repay the principal. The redemption of the investment or the repayment of the principal will be treated as a capital reduction.

3. An enterprise that makes hybrid investment (investor) does not have the right to control the net assets of the investee.

Where the investee must liquidate due to cessation of production and business operations, repayment of the investor’s investment as creditor’s rights can have priority status. However, the investor should not have ownership rights in the net assets of the investee in accordance with its investment percentage.

4. The investor does not have a right to vote or to stand for election.

When members of the board of directors or supervisory committee of the investee are elected, the investor cannot exercise the right to vote or be elected in accordance with the investor’s proportionate share in the investee.

5. The investor does not participate in the investee company’s daily operational activities.

If use of the investment funds is specified, the investor can supervise the use of the funds.

For hybrid instruments that meet all of the above five criteria, the CIT treatment of those investments is as follows:

Items

CIT implications

For the investor

For the investee

Interest (including minimum interest, fixed profit or fixed dividends)

Interest income will be recognized and included in taxable income for CIT purposes on the day when the interest payment becomes due.

Interest expense will be recognized on the day when the interest payment becomes due and deductible for CIT purposes.

Redemption of investments

Redemption price exceeds investment cost

The difference will be recognized as debt restructuring gain upon redemption, and included in taxable income of the current period for CIT purposes for China residents.

However, the withholding tax implications for non-China residents that derive gain from the redemption of investments are still unclear.

The difference will be recognized as debt restructuring loss upon redemption and deductible for CIT purposes.

Redemption price is less than investment cost

The difference will be recognized as debt restructuring loss upon redemption and deductible for CIT purposes.

The difference shall be recognized as debt restructuring gain upon redemption and included in taxable income of the current period for CIT purposes.

In addition, pursuant to the prevailing Business Tax (BT) regulations, interest income is subject to BT at 5%, but dividend income or income from equity transfers does not fall within the scope of BT taxable income. However, as the BT treatment of income derived from hybrid investments is still uncertain (Announcement 41 does not directly address turnover tax treatment), further clarification from the SAT is required.

For additional information with respect to this Alert, please contact the following:

Ernst & Young Tax Services Limited, Hong Kong
  • Jane Hui
    +852 2629 3836
    jane.hui@hk.ey.com
  • Becky Lai
    +852 2629 3188
    becky.lai@hk.ey.com
Ernst & Young LLP, China Desk, New York
  • David Kuo
    +1 212 773 3660
    david.kuo1@ey.com
  • Vickie Lin
    +1 212 773 6001
    vickie.lin@ey.com
  • Susan Qiu
    +1 212 773 9382
    susan.qiu@ey.com
  • Jessia Sun
    +1 212 773 5955
    jessia.sun@ey.com
Ernst & Young LLP, China Desk, San Jose
  • Diana Wu
    +1 408 947 6873
    diana.wu@ey.com
Ernst & Young LLP, Asia Pacific Business Group, New York
  • Chris Finnerty
    +1 212 773 7479
    chris.finnerty@ey.com
  • Jeff Hongo
    +1 212 773 6143
    jeff.hongo@ey.com
  • Kaz Parsch
    +1 212 773 7201
    kazuyo.parsch@ey.com
  • Bee-KhunYap
    +1 212 773 1816
    bee-khun.yap@ey.com

EYG no. CM3727