The Guarantee of Company Financing Neutrality in Chinese Tax System: an Analysis Based on the Regime Package, Involving Thin Capitalization Rules and Other Relative Rules, Following the 2007 Reform of New Enterprise Income Tax Law

• Author: Wuyao Weng
• Position: PHD student in European Tax Law at the University of Bologna.
• Pages: 1-27

European Tax Studies 1/2010

© Copyright Seast – Al l rights reserved

1

The Guarantee of Company Financing Neutrality in Chinese Tax

System: an Analysis Based on the Regime Package, Involving

Thin Capitalization Rules and Other Relative Rules, Following

the 2007 Reform of New Enterprise Income Tax Law

Wuyao Wen g1

1. Introductio n

1.1. Tax factors affecting the decision-making of financing methods

and tax neutrality: different tax treatment on financing costs

between de bt financing an d equity financing

Speaking of capital source, there is no doubt that besides the internal

financing, the external financing is the other indispensable and crucial

approach to which the enterprises can resort. In the case of external financing,

the debt financing and the equity financing constitute two methods between

which the enterprises seeking financing should make a choice. Actually the

financing preference of company, the term used frequently in the study of

company capital structure, is exactly the result assessed in the process of

choice-making, conducted by company, with respect to financing methods

aforementioned. Herein, we f ollow closely an issue of the factors that affect

the enterprise’s decision-making with respect to financing methods and then

determine the financing preference of a company, consisting of both tax

factors and non-tax ones from the viewpoint of tax as a dividing line. And we

have to admit that the tax factors are really the considerably impactive ones in

the business operations for the com panies, not only in the decision as to how

1 The author is PHD student in Europ ean Tax Law at the Univer sity of Bologna.

European Tax Studies 1/2010

© Copyright Seast – Al l rights reserved

2

to choose the financing methods, and we can find out that in general the tax

system provides a preference for debt, given that on one hand, intere st on

debt is deductible from the tax ba se and on the contrary dividends on equity

are not, and on the other hand, the rate of withholding income tax applied to

the interests obtained by the non-resident taxpayer is usually lower than that

applied to the dividends, these two aspects combining to reach the outcome of

reducing the tax burden borne by enterprises, and accordingly, the enterprises

are usually more indicative of debt financing preference, being supported

under the pecking-order theory by Myers and Majluf (1984) which predicts

that firm s will use internal fina ncing sources first and revert to external debt

and, even more reluctantly, to new equity only after internal sources of

finance have been exhausted2. But what is worth mentioning is that the

financing preference shown by Chinese companies is different from that shown

by compa nies of western countrie s, in the other word s, currently the Chinese

companies are more of equity financing prefere nce because of the lax

restriction on capital cost of companies, the investors’ lack of investment

consciousness and the lack of withdrawing mechanism from capital market3.

And yet, does this also mean that the tax factors that undermine the tax

neutrality have only a slight impact with the result that non-tax factors prevail

over tax factors, for the enterprises to make a decision of whether to resort to

debt financing or equity financing, in Chi na? I will try to answer this q uestion

in the last but one section of this present article after exploring the Chinese

regime package with respect to deduction of financing costs.

It should be noted that whatever the financing preference shown by Chinese

companies or by companies of weste rn countries may be, from the tax factors

perspective only, to some extent, these existing factors affecting the

2 Alfons J. Weichenrieder - Tina Klautk e, Taxes and the Efficiency Costs of Capital Distortions,

CESifo Working Paper Series No. 2431.

3 頻陣X尨Д洩Д匯呑尨洩Д廓к薮些閑盲拳勲描呑尨町呼廓凩酪 11 咲匯紘 倍チ始否 馬胴J 熊崘折 滅.

(Song lin, the analysis of cap ital cost, financing cost and their impa ct on the financing

preference of Chines e company, work article)(2008 -05-03).