China´s Thin Capitalization Rule

On September 19, 2008, the Ministry of Finance and the State Administration of Taxation issued the Notice Concerning Taxation Policies for the Standards for Pre-Tax Deduction of Interest Payments Made to Related Parties, Cai Shui (2008) No. 121 (the "Notice"). The Notice provides guidance for the implementation of the thin capitalization rule introduced by the new Corporate Income Tax Law, which came into effect on January 1, 2008.

Actual Interest Payments

According to the Notice, an enterprise may deduct interest actually paid to related parties within the permitted debt-to-equity ratio. It appears that the deduction should be on an actual payment basis. Accrued but unpaid related-party interest expenses are not deductible. It is not clear how this rule will interact with the withholding tax rule. According to Article 37 of the Corporate Income Tax Law, the borrower is obligated to withhold tax when interest is paid or due and payable to a nonresident enterprise.