China Strengthens the Monitoring of Intercompany Loans

According to the Chinese Corporate Income Tax (“CIT”) Implementation Rule, interests paid by the non-financial enterprise to the non-financial enterprise, which does not exceed the amount of interests calculated as per the same-period and same-type loan rate granted by the financial enterprise, is allowed to be CIT deducted.

SAT Bulletin [2011] No. 34 further stipulates that the enterprises shall provide a statement of the interest rate for the same loan term and for the same loan type adopted by a financial enterprise to prove the arm’s-length nature of the interest rate adopted by the related parties upon the request of the tax authority. “Interest rate for the same loan term and for the same loan type" refers to the interest rate provided by the financial enterprise when the conditions including the loan term, loan amount, security provided for the loan, and the borrower’s corporate reputation are basically the same. Such interest rate can be either the average interest rate for the same loan term and for the same loan type published by the financial enterprise, or the actual interest rate for the same loan term and for the same loan type provided to certain enterprises by the financial enterprise.

It shall be noted that loans granted by the overseas related party in foreign currencies theoretically shall not be measured by referring to the interest rate of RMB loans granted or published by the local financial enterprise as they don’t belong to the same loan type according to the afore-listed tax regulations. However, due to the foreign exchange control in China, it is not feasible for an enterprise to obtain foreign currency loans from the local financial enterprises while there is also no such information publicly announced by the Central Bank of China. Therefore, previously majority of the tax authorities also accept the reference to the interest rate of RMB loans with other similar terms or the Loan Prime Rate (“LPR”) published by the Central Bank of China as a proof as it shows the similar interest burden the Chinese enterprise will need to bear if the financing is done locally.

However, the TP audits conducted recently show a different trend. Some Chinese tax authorities no longer deem the interest rate of the RMB loan obtained from local financial enterprises with other similar terms or the LPR published by the Central Bank of China as a reasonable benchmark. The argument is that the interest rate in Developed Countries is usually much lower than the one in China. In case no supporting documents to prove the reasonableness of the intercompany loans could be provided, it is intended to directly refer to the LPR rates of the similar loan type of the same foreign currency published by the foreign government.

In order to lower the potential TP risks in China, it is now recommended Groups which intend to provide intercompany loans to its Chinese subsidiaries considering to conduct a benchmarking study for setting the applicable interest rate, especially if no further supporting documents is available to prove the reasonableness of the interest rate set (e.g. the interest rate set is higher than the LPR rate of the similar loan type published by the foreign government and/or higher than the one the Lender paid to the financing institutions by itself).