The following post is not motivated by revenge or anger for Sheppard Mullin’s misuse of my material, although the infringing material is still up (I must say that the arrogance in not taking it down is rather astounding). Rather, one of my missions on this site is to point out shoddy tax analysis as I feel there are too many commercial lawyers (both domestic and foreign lawyers) in China that promote expertise in tax yet clearly dont have a sufficient understanding of this area of the law. I believe this is a function of the fact that, until very recently, basically a monkey could navigate China’s tax regime.
I have pointed out mistakes on several occasions. See the following for examples:
- One Last Post on 698;
- Branching Out of China;
I dont claim to be perfect – law is too difficult of a game to suggest that you will always be right. If I make mistakes here please point them out to me.
I make the above proviso because I dont want this to be seen as petty retaliation, although I would imagine that from an objective perspective there is a certainly some pettiness. I am not sure if I would have written this post if a quick response had been received – actually I still would have. Tax is too complex to do it part time.
This morning I had the opportunity to properly review the Sheppard series mentioned in yesterdays post. This review confirmed my initial suspiscions that it was basically all my work (not that I had any real doubts).
What was the convincing evidence? The fact that the small part which wasnt taken from me was blatantly wrong. Worse it is not just wrong, but it displays a complete lack of understanding of China’s tax laws and the source of taxing obligations in this country. Instalment 1 of the Sheppard series makes the following statement (this is only original material in the series):
The new thin capitalization rules have three immediate effects. First, they reduce the tax efficiency of debt push-downs. Second, they are likely to encourage a shift to local funding sought by foreign enterprises intending to establish an entity in China or to expand operations in China. Third, compliance to these rules will be thwarted by their lack of consistency with the Company Law of the PRC. Specifically regarding the third effect, for foreign corporations with an operating entity in China, the Company Law of the PRC stipulates debt-to-equity ratio requirements as set forth below:
| Total Investment |
Ratio of Registered Capital to Total Investment |
Registered Capital as a % of Total Investment |
| <= US$3 million |
At least 7 : 10 |
70% |
| US$3M to < $10M |
At least 1 : 2 |
Higher of 50% or US$2.1m |
| US$10M to < $30M |
At least 2 : 5 |
Higher of 40% or US$5m |
| >US$30M |
At least 1 : 3 |
Higher of 33.33% or US$12m |
Under these rules, interest payments related to inter-company loans would be tax-deductible. Under Circular 121, however, if the debt-to-equity ratio is not below 2:1 (or 5:1 for financial enterprises) the tax deductions may be violating the thin capitalization rule. Thus, foreign companies with operations in China must seek clarification of these inconsistencies.
Pardon my language but what crap. How could the Company Law, a law that does not regulate taxation, provide that certain debt amounts are deductible for tax purposes. Rather, the Company Law regulates the extent to which companies in China are allowed to fund their operations with debt (related party or otherwise) as opposed to equity – this has no relationship to deductibility for tax purposes and there is no inconsistency with the thin capitalisation rules.
How these laws interact is that whilst the Company Law may permit a company to fund their operations with a specified level of debt, if the debt is over the debt-to-equity ratio of 2:1 in the thin capitalisation rules, then the amount over the allowed ratio is not deductible (although the level of debt is still permitted for Company Law purposes). The argument of Sheppard Mullin is like saying that because Australia does not restrict (in the Corporations Act) the amount by which investments can be funded by debt, then Australia’s thin capitalisation rules in the Income Tax Assessment Act are inconsistent with the Corporations Act . Rubbish. Given how incorrect this paragraph is, there is no way the author could have written the remainder of the publication. This not only shows a fundamental musunderstanding of tax law but also the role of the Company Law.
Also, given that China’s thin capitalisation rules only apply to related party debt, why would they result in the use of local financing as opposed to overseas financing? Do they understand what they have written earlier in the post?
Until this morning, I included the following sentence at end of my original post - “It is obviously very hard to detect such things as I know from overseeing such writings from young associates at my previous firm.” In light of the above, I have now deleted that sentence.
Have I been too harsh? Perhaps but given I havent received an email or phone call I dont feel too charitable today.
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