By Susan Yang

In practice, it is common for shareholders to provide loans to the companies they invest in. However, can the interest paid by the invested company to its shareholder be fully deducted for corporate income tax purposes? There are several key considerations:

1.Deduction Standard for Interest Expenses

Article 38 of the Implementation Rules of the Corporate Income Tax Law of the People's Republic of China states that interest expenses on loans from non-financial enterprises to non-financial enterprises are deductible only up to the amount calculated using the interest rate for loans of the same type and in the same period offered by financial institutions.

2.Shareholder’s Timely and Full Contribution of Capital 

The State Taxation Administration’s Reply on the Deduction of Interest Expenses Incurred Due to Investor’s Failure to Fully Contribute Capital(State Taxation Administration Document [2009] No. 312) addresses that, according to Article 27 of the Implementation Rules of the Corporate Income Tax Law, if an investor fails to pay the required capital within the specified time, interest expenses on external loans incurred by the enterprise, corresponding to interest that should be paid for the difference between the actual paid capital and the required capital contribution within the specified period, are not considered reasonable business expenses. Therefore, these expenses should be borne by the investor and cannot be deducted when calculating the taxable income of the enterprise.

3.Debt-related to Equity-related Investments Ratio 

Article 46 of the Corporate Income Tax Law of the People’s Republic of China stipulates that interest expenses are not deductible when the ratio of debt-related to equity-related investments from related parties exceeds the prescribed limit.

The Implementation Rules of the Corporate Income Tax Law (Article 119) provide the definition of debt-related investment and equity-related investment. A debt-related investment refers to financing obtained directly or indirectly from related parties by an enterprise, which requires the repayment of principal and payment of interest, or compensation in other forms that involve the payment of interest. An equity-related investment refers to an investment received by an enterprise that does not require repayment of the principal or payment of interest, where the investor holds ownership of the enterprise’s net assets. Meanwhile, examples of indirect debt-related investments from related parties are listed:

-Debt-related investments provided by related parties through third parties;

-Debt-related investments guaranteed by related parties but provided by third parties;

-Other forms of debt-related investments with a substance of liabilities obtained indirectly from related parties.

The prescribed limit of the debt-to-equity investments ratio is not specify in Article 119, but the Ministry of Finance and the State Taxation Administration’s Notice on Tax Policies for Deduction Standards of Interest Expenses Paid to Related Parties by Enterprises (Finance and Tax [2008] No. 121) stipulates that, for non-financial enterprises, the ratio of debt-related to equity-related investments in loans from related parties must not exceed 2:1 for interest expenses to be deductible.

Regarding debt-related investments provided by a natural person, Article 1 of the 'State Taxation Administration’s Notice on the Deduction of Interest Expenses for Loans from Natural Persons to Enterprises' (State Taxation Administration Document [2009] No. 777) clearly stipulates that interest expenses on loans from shareholders or other natural persons related to the enterprise must also comply with the same standard of debt-related to equity-related investments ratio.

4.Arm's Length Principle 

According to the Ministry of Finance and the State Taxation Administration’s Notice on Tax Policies for Deduction Standards of Interest Expenses Paid to Related Parties by Enterprises (Finance and Tax [2008] No. 121), if an enterprise can provide relevant documentation to demonstrate that related party transactions meet the arm’s length principle, interest paid to domestic related parties may be deducted when calculating taxable income.

5.Actual Tax Burden of Lender and Borrower 

The Ministry of Finance and the State Taxation Administration’s Notice on Tax Policies for Deduction Standards of Interest Expenses Paid to Related Parties by Enterprises (Finance and Tax [2008] No. 121) also specifies that interest paid to domestic related parties will be deductible if the enterprise’s actual tax burden is not higher than that of the related domestic party.

In conclusion, taking all the above points into account, it is clear that the interest paid by an invested company to its shareholders may not always be fully deductible for corporate income tax purposes.