|Khoonming Ho||Lewis Lu|
The People's Bank of China (PBOC) issued PBOC Circular 9  on January 12 2017. This makes important changes to the regulations determining how much leverage Chinese enterprises, including foreign invested enterprises (FIEs), can take on through cross-border borrowing into China.
The changes alter the maximum debt-equity ratio achievable through cross-border borrowing. This may have the effect of making the Chinese thin capitalisation rules, and other tax rules impacting on international borrowing, potentially more relevant for a greater number of companies, going forward.
In short, prior to 2016, China required newly established FIEs to fix, as part of the pre-approval registration process, two key figures in relation to the capitalisation of the FIE. These were the total investment capital amount (TIC – the sum of total debt and equity foreseeably needed by the FIE) and the registered capital (RC) amount (i.e. equity). The debt financing ceiling for the FIE was the residual difference between the TIC and the RC, notified to the authorities. The maximum permissible debt-equity ratio (with RC standing for equity) ranged from debt-equity of:
- 1:2 for FIEs with a TIC of less than $3 million;
- 1:1 for FIEs with a TIC between $3 to $10 million;
- 1.5:1 for FIEs with a TIC from $10 to $30 million; and
- 2:1 for FIEs with a TIC exceeding $30 million.
The operation of the debt limitation, and its adjustment, was highly bureaucratic. Furthermore, the repayment of certain loans, specifically mid-term and long term debt, could potentially "exhaust" part of the debt capacity of an FIE, permanently lowering its maximum debt-equity ratio.
From May 2016, PBOC Circular 132  introduced, alongside the above-mentioned "borrowing gap" system, a more flexible approach to regulating cross-border borrowing. This is termed the macro-prudential (MP) financing management system. This applies to all enterprises in China, domestically-owned as well as FIEs, and covers financial institutions but not real estate enterprises. In relation to FIEs, these can opt, in the first year transition period, either to remain with the borrowing gap system, or they can opt into the MP financing management system. While foreign financial institutions will have to transition to the MP financing management system after one year, the government has yet to decide the final date by which all non-financial FIEs must transition.
The MP financing management system requires enterprises to monitor that their risk-weighted balance of cross-border borrowing (risk weighted balance) does not exceed a cap linked to their net assets (borrowing cap). All relevant borrowing contracts and payments, and all financial accounting information relevant to calculate the net assets of the FIE, need to be filed with the PBOC or the State Administration of Foreign Exchange (SAFE) on an ongoing basis. This is so that the latter have sufficient information to hand to ensure that the FIE is not in breach of the borrowing cap.
The borrowing cap is determined by multiplying FIE net assets by a debt-equity leverage ratio, initially set at 1:1 by Circular 132 and now changed to 2:1 by Circular 9. The calculation of the risk-weighted balance is adjusted upwards where the debts are short term (i.e. multiply by 1.5) and where the borrowings are in foreign currency (i.e. multiply by 1.5). This new system, while it does involve the additional compliance burden of dealing with increased filings with the PBOC and SAFE, may allow some FIEs, particularly those with a TIC of less than $10 million, and those borrowing cross-border in RMB, greater headroom for leverage compared with the old system.
Where an FIE finances its long term borrowing requirement with foreign currency borrowings, it can support a debt-equity ratio (taking net assets as equity) of 1.33:1. This is better than the maximum debt-equity ratios applying to FIEs with TIC of less than $10 million under current rules, and this is even before taking the difference between registered capital and net assets into account. The permissible debt-equity ratio rises to 2:1 where borrowing is in RMB. Furthermore, net assets, as the basis for the debt-equity limitation calculation, may be greater than RC for many companies, particularly where they have accumulated profits over many years – the use of net assets rather than RC in the calculation could further lift the borrowing ceiling. Consequently, depending on the level of accumulated earnings and the currency of borrowing, the new rules might also be better for some FIEs with TIC of greater than $10 million.
The new rules also resolve the earlier problem of debt capacity being "exhausted". FIEs opting into the MP financing management system can "unlock" the borrowing restrictions previously created where debt capacity was exhausted – in practice this may be one of the most significant and useful developments as many large companies had run out of quota.
Some FIEs may consequently seek to finance themselves to a greater degree from cross-border debt. Interest is generally tax deductible (subject to thin capitalisation rules) and may be subject to lower tax rates on receipt by a lending related party overseas. Withholding tax (WHT) of 10% is applied to outbound payments of interest under domestic law, but China's increasingly improved treaty network is allowing for ever lower WHT rates with treaty relief. However, it is noted that VAT at 6% (plus local charges) applies to interest payments and there is no VAT input credit for this.
China's tax thin capitalisation rules apply a 2:1 debt-equity ratio (the equity calculation arrives at a figure similar to net assets). Where an enterprise's leverage exceeds this level then interest tax deductions may be disallowed. For interest on excess debt to continue to be treated as tax deductible, transfer pricing support may be necessary. Up to now, due to the regulatory limitations on leverage, China's thin capitalisation rules have been generally less of an issue for enterprises. Going forward, with potential for greater levels of leverage for FIEs, the thin cap rules may become of greater relevance, and may require greater monitoring and compliance effort. This would particularly be the case if China loosens gearing restrictions further by additional tweaking of the adjustment factors in the MP financing management borrowing cap and risk-adjusted balance calculations. We would note that, for the moment, it does not appear that China will adopt the OECD BEPS Action 4 EBITDA-based interest deduction limitation, so tax focus will remain on debt-equity ratios.
It might be added that, beyond FIEs, the MP financing management system is also relevant for financial institutions and for domestically owned enterprises. However, it is applied in a different manner, which needs separate regulatory and tax evaluation. It might also be noted that the practical application of Chinese forex rules has recently become a problematic area. There have been reported difficulties arising in repatriating cash from China to make loan principal and interest, as well as dividend payments. Adaptation by companies to the new cross-border financing opportunities will clearly also take related concerns on-board.
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