China updates guidance on hybrid mismatch arrangements and convertible bonds

International Tax Review is part of Legal Benchmarking Limited, 1-2 Paris Garden, London, SE1 8ND

Copyright © Legal Benchmarking Limited and its affiliated companies 2026

Accessibility | Terms of Use | Privacy Policy | Modern Slavery Statement

China updates guidance on hybrid mismatch arrangements and convertible bonds

Sponsored by

sponsored-firms-kpmg.png
China has relatively limited guidance on the tax classification

Lewis Lu of KPMG China looks at how the Chinese STA have sought to clarify the application of corporate income tax.

The Chinese State Taxation Administration (STA), in its ongoing efforts to improve tax certainty and the overall business environment, recently made several clarifications on corporate income tax (CIT) rule implementation (STA Announcement No. 17 [2021]), effective for filings from 2021 onwards.

Tax treatment of cross-border hybrid financial instruments

China has relatively limited guidance on the tax classification and treatment of hybrid financial instruments, i.e. those with features of both debt and equity. For example, China did not adopt the BEPS Action 2 rules [2015] to deal with hybrid mismatch tax planning.

The principal piece of guidance, STA Announcement No. 41 [2013], set out a list of criteria which must be met for the pay outs on a financial instrument to be recognised as tax deductible interest (rather than non-deductible distributions). This includes that there are periodical payments of interest at the rate agreed in the relevant contracts, that the investing enterprise does not have an ownership interest in the net assets of the investee enterprise, as well as other factors.

It was however considered that the existing rules did not adequately deal with cross-border situations, in particular the tax arbitrage possible where a foreign enterprise invests in an instrument issued by a Chinese company. Under the existing guidance it was possible for an instrument’s terms to be tailored such that the Chinese enterprise would have its payments treated as deductible interest but the foreign enterprise could, under the tax law of its jurisdiction, treat the payment as an exempt dividend.

Under the latest guidance, the STA provide that if the two enterprises are associated (i.e. 25% and above common shareholding relationship or effective control relationship) and if the investment return (capital gains or dividends) would be exempted in the hands of the foreign enterprise, then no tax deduction will be granted in China.

CIT deduction for donations-in-kind

During the COVID-19 disruption period many taxpayers made donations with their self-produced or purchased goods.

The STA has now clarified what documents can be used as support for CIT deductions, including receipts issued by government agencies and social organisations.

Tax treatment of debt converted to equity

China’s CIT law exempts dividend income from domestic enterprises but taxes interest. The STA has now clarified how convertible bonds are to be treated pre- and post-conversion.

Where an investor in convertible bonds has accrued interest, but before it is paid the bonds (plus unpaid interest) are converted to equity, the STA state that this interest will still be taxable. This is regardless of whether the interest has been recognised as revenue under the accounting rules. For the purposes of the future sale of this equity, the cost base for tax purposes is clarified to consist of the purchase price of the convertible bonds, the quantum of the unreceived interest and the associated tax.

For an issuer of convertible bonds, the interest arising from the convertible bonds can be deducted for CIT purposes. Where the issuer converts both the bonds and accrued interest payable into shares, the accrued interest payable will be deemed as having been paid and be deductible.

Tax treatment of assets where CIT determination method changes

Chinese companies without robust accounting systems are permitted to calculate their CIT on a deemed basis rather than an accounting books basis, which can lead to higher tax burdens.

With China’s ongoing economic development, many enterprises have adopted or enhanced their accounting systems and processes and have moved from the deemed basis to the accounting books basis. For companies making this transition, the STA has now clarified how to determine tax basis of purchased assets for depreciation/amortisation and capital gains tax purposes.

Separately of these STA clarifications in Announcement 17, a simplified procedure for cross-border payments has been rolled out from June 29 2021. Prior to this, the STA and the State Administration of Foreign Exchange (SAFE) sought public opinions on the draft (see previous article for more details). Compared to the draft version, no significant changes were made.

 

 

Lewis Lu

Partner, KPMG China

E: lewis.lu@kpmg.com

more across site & shared bottom lb ros

More from across our site

India also signed its first-ever bilateral APAs with France, Ireland, Indonesia and Sweden last year, the CBDT revealed
Chile’s revamped GAAR marks a shift toward structural scrutiny, pushing MNEs to strengthen tax governance, economic substance and compliance strategies
New reforms represent the most seismic shift in Canadian TP legislation since its enactment and a clear inflection point for MNEs, ITR has heard
Spain did not transpose EU VAT rules for SMEs or works of art; in other news, an increased VAT threshold came into force in South Africa
While the IBS incorporates taxable events previously covered by state and municipal taxes, its governance and operational logic represent a significant departure from the legacy model
The new office on the fourth floor of 4 More London will span 14,230 square feet, with the potential to expand to the first and second floors
MNEs now face a shift from modelling to execution as the side‑by‑side deal forces tax teams to upgrade systems, harmonise data, and prevent costly pillar two mismatches
As recent surveys suggest a disconnect between AI adoption and employee engagement, the big four risk digging themselves into a strategic hole
Almost three-quarters of surveyed tax professionals are concerned about inaccurate AI outputs; in other news, Dentons hired a partner from CMS to lead its Belgian tax team
Long-running, high-value and complex enquiries are a significant reason for HM Revenue and Customs’s increased TP yield, experts suggest
Gift this article