CIT policy for perpetual bond interest Confirmed

CIT policy for perpetual bond interest Confirmed

News Flash China Tax and Business Advisory May 2019 Issue 17

In brief

Since the first renewable corporate bond was issued in 2013, China has been expanding its issuance of perpetual bonds. However, the corporate income tax ("CIT") treatment for perpetual bonds is unclear, especially the issue of whether the interest should be treated as dividend or bond interest has attracted a lot of debate in the industry. On 16 April 2019, the Ministry of Finance ("MoF") and the State Taxation Administration ("STA") jointly issued the Public Notice Regarding the Corporate Income Tax policy for Perpetual Bonds (MoF, STA Public Notice [2019] No.64, hereinafter referred to as Public Notice 64), which clarifies the CIT treatment of perpetual bond interest for the first time, and provides clear tax treatment guidelines for both issuers and investors of perpetual bonds. In this issue of China Tax and Business News Flash, we will share our main observations regarding Public Notice 64 and their impacts on issuers and investors of perpetual bonds.

In detail

Background of Public Notice 64 At the end of 2018, 1,200 perpetual bonds were issued nationwide with a total amount of RMB 1.73 trillion. On 25 January 2019, China issued the first bank perpetual bond with a total amount of RMB 40 billion. In a growing financial market today, companies and financial institutions are raising funds through different financial instruments in order to meet their own development or capital needs. Among them, perpetual bond is a new type of financial instrument which is favoured by investors because of its high coupon interest, perpetuity, additional redemption clauses and interest rate adjustment clauses. In 2013, the STA issued the Public Notice of STA on Issues Concerning the CIT Treatment for Hybrid Investment of Enterprises (STA Public Notice [2013] No. 41, hereinafter referred to as Public Notice 41), which provides the principle to determine the CIT treatment for investments which have both equity and debt features, that is, for hybrid investments which meet all of the five criteria1 stipulated under Public Notice 41, the interest income should be treated as debt interest income and debt interest expense by the investors and issuers respectively for CIT purpose. However, as the issuers of perpetual bonds are diversify, and the contract terms vary which blur the debt or equity nature of such bonds and makes it very difficult to fully apply the policy in Public Notice 41. Enterprises and the banking industry have been eagerly looking forward to regulations to clarify the CIT treatment for perpetual bonds. Public Notice 64 issued by the MoF and the STA clarifies the CIT treatment for perpetual bonds interest for the first time, and provides specified tax treatment for relevant issuers and investors.

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Definition of perpetual bond under Public Notice 64

Perpetual bond applicable to Public Notice 64 refers to a bond which is approved by the National Development and Reform Commission, People's Bank of China, China Banking and Insurance Regulatory Commission and China Securities Regulatory Commission, or registered via National Association of Financial Market Institutional Investors, and completed record filing with the Securities Self-regulatory Organisations authorised by China Securities Regulatory Commission, and issued in accordance with legal procedures, and with a redemption (renewal) option or without a clear maturity date. Perpetual bond includes renewable enterprise bonds, renewable corporate debts, perpetual debt financing instruments (including perpetual notes), and capital bonds with no fixed terms, etc.

CIT treatment under Public Notice 64

Public Notice 64 provides two options regarding the CIT treatment for interests of perpetual bonds:

Option 1: treated as dividend by both issuers and investors

Generally, perpetual bonds interest paid to investors is treated as earning from equity investments, that is, the interest paid by issuers will be treated as profits distribution by the issuer with no tax deductions available, while the perpetual bonds interest received by the investor enterprises is treated as dividend income. If both the issuer and the investor are resident enterprises, the interest earned by the investor may be applicable to the dividend exemption policy under the CIT law.

Option 2: treated as interest by both issuers and investors after meeting certain conditions

Perpetual bonds interest that meets five or more of the following nine conditions can be treated as return on debt investment and applicable to the relevant CIT policies: that is, the perpetual bonds interest paid by the issuer of perpetual bonds is eligible for CIT deduction, while the perpetual bonds interest received by the investor is subject to CIT as interest income.

1. The invested enterprise is obliged to repay the principal for this investment;

2. There are explicitly agreed interest rate and frequency of interest payment;

3. Have a defined investment period;

4. The investor does not have any ownership in the net assets of the invested company;

5. The investor does not participate in the daily operation and management activities of the invested company;

6. The invested company can redeem the perpetual bond, or can redeem after meeting certain conditions;

7. The invested company booked this investment as liability;

8. The investment does not carry the same operational risks as the shareholders of the invested company assume;

9. The settlement order of the investment is before that of the shares held by shareholders of the invested company.

Differences in taxation and accounting

From the perspective of accounting, enterprises should determine whether the perpetual bond is an equity instrument or a financial liability in accordance with Accounting Standard for Business Enterprises No. 22 - Recognition and Measurement of Financial Instruments, Accounting Standard for Business Enterprises No. 37 - Presentation of Financial Instruments and Regulations on Accounting Treatment for Perpetual Bonds ( Caikuai [2019] No. 2 ).

Public Notice 64 stipulates that in case the tax treatment adopted by the enterprise for perpetual bonds is inconsistent with the accounting method, the issuer and the investor should make corresponding adjustments for tax treatment. That is to say, the accounting treatment of the enterprise on perpetual bonds will not affect its CIT treatment of such perpetual bonds.

It should be noted that the issuer and the investor must be consistent in determining the nature of perpetual bond from the CIT perspective. Public Notice 64 requires the issuer to publicly disclose the applicable tax treatment method to investors when issuing perpetual bonds. From this point of view, the issuer is the main decision maker for the CIT treatment of the perpetual bond interest, for which, both the issuer and investor should follow the same tax treatment method for perpetual bond interest.

The takeaway

The issuance of Public Notice 64 provides a solution for the long outstanding CIT treatment issue of perpetual bonds, it is good news for both issuers and investors. Compared with Public Notice 41, which requires enterprises to meet all of the five conditions so as to treat the interest payment as interest for CIT purpose, Public Notice 64 provides a more flexible solution for issuers of perpetual bonds, which allows issuers to do so by only meeting five of the nine conditions. There are still several points which enterprises need to be aware of when on issuing or investing in perpetual bonds:

1. Effective date and retrospective application: Public Notice 64 took effect from 1 January 2019, however it is silent on retrospective tax treatment for perpetual bonds issued before 1 January 2019. It is unclear whether enterprises can

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make any tax adjustments to the existing perpetual bonds after the issuance of Public Notice 64. In addition, Public Notice 64 requires the issuer and the investor to be consistent in the CIT treatment of the perpetual bond interest, investors and issuers of existing perpetual bonds may need to check the perpetual bonds invested/issued, and proactively communicate with their in charge tax authorities to determine whether changes to the existing tax treatment are required;

2. Other tax implications: Public Notice 64 only clarifies the CIT treatment for the interest expense/income of the perpetual bonds, it is silent on the nature of income derived by the investors on the sale of perpetual bonds, that is, whether such sale should be treated as transfer of equity or debt. In particular, in the situation where the issuer treats the perpetual bonds as equity instruments for both accounting and taxation purpose, whether the investor must also treat the perpetual bonds transfer income as income from the transfer of equity investment. From the value-added tax ("VAT") perspective of the investor, is it required to follow the tax treatment method for perpetual bonds under Public Notice 64 to determine the VAT tax liability of the interest income? Further clarifications by STA are needed for these questions.

At present, there are numerous types of financial products in the market which are very complex in nature. The issuance of Public Notice 64 only clarifies the CIT treatment for perpetual bond interest, other hybrid investments should still follow the policy stipulated in Public Notice 41.

Endnote

1. The five criteria include: 1. The invested enterprise shall pay interest on a regular basis at such interest rate as agreed in the investment contract or agreement after accepting the investment (or pay minimum interest rate, fixed profit, fixed dividends on a regular basis, the same below). 2. Having explicit investment horizon or specific investment requirements, and upon the expir y of investment horizon or satisfaction of specific investment requirements, the invested enterprise shall redeem investment or repay the principal. 3. The investing enterprise does not have ownership over the net assets of the invested enterprise; 4. The investing enterprise does not have the right to vote and the right to be voted; and 5. The investing enterprise does not participate in the daily operation and management of the invested enterprise.

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Let's talk

For a deeper discussion of how this issue might affect your business, please contact:

PwC's Tax and Business Service Team

Peter Ng +86 (21) 2323 1828 peter.ng@cn.

Spencer Chong +86 (21) 2323 2580 spencer.chong@cn.

Edwin Wong +86 (10) 6533 2100 edwin.wong@cn.

Alan Yam +86 (21) 2323 2518 alan.yam@cn.

Charles Lee +86 (755) 8261 8899 charles.lee@cn.

Jeremy CM Ngai +852 2289 5616 jeremy.cm.ngai@hk.

PwC's Financial Tax and Business Services Team

South China/Hong Kong

Florence KF Yip* Tax Partner +852 2289 1833 florence.kf.yip@hk.

Central China

Matthew Wong

Tax Partner +86 (21) 2323 3052 matthew.mf.wong@cn.

Rex Ho**

Tax Partner +852 2289 3026 rex.ho@hk.

Jeremy CM Ngai

Tax Partner +852 2289 5616 jeremy.cm.ngai@hk.

North China

Oliver Kang

Tax Partner +86 (10) 6533 3012 oliver.j.kang@cn.

* China/Hong Kong Tax Leader, Financial Services, Asset & Wealth Management **China/Hong Kong Tax Leader, Banking & capital markets

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In the context of this News Flash, China, Mainland China or the PRC refers to the People's Republic of China but excludes Hong Kong Special Administrative Region, Macao Special Administrative Region and Taiwan Region. The information contained in this publication is for general guidance on matters of interest only and is not meant to be comprehensive. The application and impact of laws can vary widely based on the specific facts involved. Before taking any action, please ensure that you obtain advice specific to your circumstances from your usual PwC's client service team or your other tax advisers. The materials contained in this publication were assembled on 15 May 2019 and were based on the law enforceable and information available at that time. This China Tax and Business News Flash is issued by the PwC's National Tax Policy Services in China and Hong Kong, which consists of a team of experienced professionals dedicated to monitoring, studying and analysing the existing and evolving policies in taxation and other business regulations in China, Hong Kong and Singapore. They support the PwC's partners and staff in their provision of quality professional services to businesses and maintain thought-leadership by sharing knowledge with the relevant tax and other regulatory authorities, academies, busin ess communities, professionals and other interested parties. For more information, please contact: Matthew Mui Tel: +86 (10) 6533 3028 matthew.mui@cn. Please visit PwC's websites at (China Home) or (Hong Kong Home) for practical insights and professional solutions to current and emerging business issues.



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