Comparable Research On Thin Capitalization And Its Reference For China

The expression 'thin capitation' is commonly used to describe an approach ofinternational tax avoidances where a corporation's debt to equity ratio exceeds certainlimit, using an excessive proportion of debt capital financing in order to avoid income taxpayable. At present, thin capitalization has become one popular approach of internationaltax avoidance used by multinational corporations. The different tax treatment of interestand dividends creates an obvious incentive for the multinational corporation to applyingthin capitalization. Interest payable on debt funding used for income producing purposesis generally taxing deductible to the debtor. This treatment is to be contrasted with equityfunding. Returns on equity funding (e.g. dividends) are not tax deductible generally. Inaddition, the lender will generally be allowed a foreign tax credit for the interestwithholding tax paid under a lower tax rate than that of dividends in their homejurisdiction. With respect to the damages and impacts on the tax revenue from thincapitalization, many countries have adopted specific thin capitation rules that seek tolimit the tax recognition of debt financing of entities controlled by non-resident investors. In 1987 the Committee of Fiscal Affairs of the OECD released a report entitled'Thin Capitalization'. The report did divide the available approaches into two distinctcategories. These were referred to as the 'fixed ratio' and the 'flexible' or 'arm's length'approach. Fixed Ratio Approach/Safe Harbor Rule. As its name suggests, this method appliesan inflexible fixed ratio of debt to equity. Where this methodology is employed, a breachof a specified debt to equity ratio will trigger certain counter measures, the most commonbeing: a denial of income tax deductions for interest; or a re-classification of loans fromnon-residents as equity resulting in funds repatriated from the country of source beingtreated as dividends. The advantage of this approach is that it provides taxpayers withcertainty in the determination and ongoing treatment of financing arrangements.However difficulties with it include the denial of an otherwise commercially acceptablelevel of debt funding. Arm's Length Approach. Under this approach, investments are reviewed using a'substance over form' criterion on a case-by-case basis. The nature of the investment isreviewed in order to determine whether the transaction can be characterized as 'arm'slength', that is, whether an unrelated party would have provided funding on the same or asimilar basis. If this is considered not to be the case, then the finance provided isre-classified as equity with the subsequent treatment of any repatriation of funds as adividend for tax purposes. The disadvantage here is that the rules are somewhatsubjective and no clear guideline is provided to taxpayers. It can also be difficult toidentify normal arm's length practices in each specific circumstance. This leads to anobvious lack of certainty. This more flexible, case-by-case approach was recommendedby the OECD Report in preference to the fixed ratio approach.The 50th Annual Congress of the International Fiscal Association held in 1996recognized a number of requirements, including: Thin Capitalization Rules shall bedefinitely; thin capitalization legislation should not create an artificial source of revenuein the countries where it is applied and tax rules should be aligned with economicconditions; a high tax rate in combination with thin capitalization legislation should notserve to block foreign investment; and 'the principle of Non-discrimination' should beapplied, means that the thin capitalization rules should apply to resident taxpayers as wellas non-resident taxpayers. Although our legislature has enacted some regulations and administrations withregard to restrict the level of debt financing, there is no integrate thin capitalization rulein China. This article reviews the legislati...