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Home > Company Tax > Related Party Interest Deduction Limitations: Preventing Tax Avoidance
Related Party Interest Deduction Limitations: Preventing Tax Avoidance
Businesses often engage in tax planning through transactions with related parties, using methods such as transfer pricing and, more commonly, by borrowing from related parties to replace actual capital contributions. This approach not only weakens the company's capital structure but also allows businesses to control profits by increasing interest expenses. However, such practices can raise concerns regarding tax avoidance. As a result, Article 43-2 of Taiwan's Income Tax Act has set strict regulations on the recognition of interest expenses from related party loans. The following outlines these provisions in detail.
Background: Tax Issues with Using Loans as Substitutes for Capital Contributions
In practice, businesses may reduce their capital by borrowing from related companies. For example, Company A may require NT$10 million to operate but has only a capital of NT$1 million. The remaining funds are borrowed from related Company B, with the interest expense being declared for tax purposes. From an economic perspective, this NT$9 million should be considered as capital invested by Company B into Company A, but it is treated as a loan, allowing Company A to increase interest expenses and reduce taxable income.
To prevent such scenarios, Article 43-2 of the Income Tax Act establishes the "Related Party Debt Interest Deduction Limitation" and further clarifies the operating standards through the "Regulations on the Verification of Related Party Debt Interest Expense." The regulations state that if a company's debt to related parties exceeds three times the owner's equity, the interest expense on the excess amount cannot be deducted. However, to simplify tax administration and reduce compliance costs for businesses, interest on related party loans may be exempt from this calculation if the following three conditions are met:
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The combined annual operating and non-operating revenue is NT$30 million or less.
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The declared interest expenses and related party interest expenses under Article 5 of the verification regulations are both NT$4 million or less.
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The declared taxable income before deducting interest expenses is negative, and the loss is not subject to offsetting under Article 39 of the Income Tax Act.
3:1 Debt-to-Equity Ratio and Exemption Conditions
Under the regulations, when the related party debt-to-equity ratio exceeds 3:1, the interest on the excess debt cannot be deducted as an expense. The calculation method is as follows:
Example Calculation:
A company reports NT$800,000 of related party interest expense in Year 2023. The average monthly related party debt is NT$20 million, and the average monthly owner's equity is NT$5 million. The calculation is as follows:
Interest expense adjustment = NT$700,000 × (1 − 15,000,000 / 20,000,000) = NT$700,000 × 0.25 = NT$200,000. Therefore, NT$200,000 of interest expense exceeds the limit and must be excluded from the report.
Importance of Related Party Debt Regulations
These regulations not only prevent businesses from using related party loans to avoid taxes but also emphasize the importance of economic substance, encouraging greater transparency and compliance in financial operations. Moreover, the "safe harbor principle" provides flexibility to reduce compliance pressure on small and medium-sized enterprises (SMEs) in special circumstances.
Conclusion
The implementation of related party interest deduction limitations represents strict control over related party transactions and reflects the spirit of fair taxation. Businesses should fully understand these regulations when managing their finances to avoid tax risks. By engaging in proper financial planning, businesses can ensure both tax compliance and economic benefits, enabling stable growth in an increasingly stringent tax environment.
FAQ 1: Can interest expenses on related party loans be fully deducted as an expense?
Answer: They cannot always be fully deducted. If the related party debt-to-equity ratio does not exceed 3:1 or the business meets the exemption conditions under the "safe harbor principle" (such as annual revenue not exceeding NT$30 million or interest expenses under NT$4 million), then interest expenses on related party loans can still be legally deducted. However, if the debt ratio exceeds 3:1, the interest on the excess portion must be adjusted down.