To support the operations of a subsidiary in China, it is possible to extend an intercompany loan from the parent company to the Chinese entity. However, providing loans to a Chinese subsidiary comes with several challenges. The Chinese State Administration of Foreign Exchange (SAFE) strictly controls foreign exchange in China, limiting the amount a Chinese subsidiary can borrow to the foreign debt quota. This quota is determined by one of two methods: the Financing Gap Method or the Net Asset Method. Understanding these methods is crucial as they significantly impact the total amount of funds that can be borrowed via an intercompany loan. This article delves into both methods and highlights key aspects related to intercompany loans, such as interest rates and foreign loan application procedures.

How can the maximum amount of funds borrowed under the financing gap method be calculated?

The amount of funds a Chinese subsidiary can borrow from its parent company using the Financing Gap method is based on a set of ratios determined by law. The cap on the amount of funds that can be brought into China as the following ratios define a loan:

For example, suppose the total investment of a Chinese subsidiary is 1 million USD. In that case, the total registered capital must be at least 70% of the total investment, equal to 700,000 USD. As a result, the amount of foreign debt that can be borrowed using a loan is the difference between the total investment and the registered capital. In this example, the Chinese subsidiary can borrow 300,000 USD from its shareholders. In addition, the amount of funds that can be borrowed is proportional to the capital that is contributed, meaning that if only 50% of the registered capital is contributed, the amount of funds that can be borrowed at that moment equals 50% of the financing gap.

The above example shows the importance of carefully considering the amounts of total investment and registered capital during the company incorporation phase. Although it is possible to alter the amounts of total investment and registered capital after incorporation to facilitate a shareholder loan, it is important to note that the aforementioned ratios must be maintained.

The Financing Period under the Financing Gap Method

According to the State Administration of Foreign Exchange (SAFE), a company can apply for long-term foreign or short-term foreign debt under the Financing Gap method. Generally, the term of short-term borrowing is up to 12 months, and the period for long-term borrowing is 1-3 years.

If the Chinese subsidiary chooses short-term foreign debt, it must repay the foreign debt and the corresponding interest within the stipulated time as set out by the contract. The advantage is that the amount of short-term external debt can be restored after the enterprise has repaid the principal and interest, meaning that this method can be used on multiple occasions.

Suppose a Chinese subsidiary chooses long-term foreign debt. In that case, the advantage is that the shareholder can relieve the cash position of the subsidiary and allow it to repay the external debt within a longer contractual time limit. However, the disadvantage of this method is that the amount of long-term borrowing is not reversible, as opposed to financing through short-term loans. This means this method can only be used once, and the funds borrowed will be unavailable for future long-term loan applications.

Even though the regulations specify that the length can be below 1 year or 1-3 years, from our experience, the SAFE can be more flexible. If the SAFE officer in charge can accept it, it may be possible to extend a longer loan. It is, therefore, essential to enter into a discussion with the respective SAFE department in your city/district to learn about their requirements for a company loan.

Net Asset Method

The alternative method is the macro-prudential management of the full-caliber cross-border financing quota method, better known as the Net Asset method. According to a notice from the People’s Bank of China (PBOC) on macro-prudential management of full-caliber cross-border financing (Yin fa [2017] no. 9), the maximum amount of overseas financing for an enterprise is 2 times the value of its audited net assets. The recognition of net assets must be based on the net assets in the latest annual audit report, meaning the latest audit report is used as a parameter to calculate the amount of foreign debt that can be borrowed.

The following formula is used to calculate the total permitted loan amount:

Net assets x cross-border loan leverage rate* x Macro-prudential adjustment parameter

The default value for the macro-prudential adjustment parameter is 1, but it will sometimes adjust upward or downward by the PBOC based on economic requirements. In October 2022, the PBOC adjusted the rate upwards to 1.25, and in July 2023, the rate was further increased to 1.5 (EY 2023 China Cross-Border Financing Update). The cross-border loan leverage rate can be up to 2, however, if the SAFE perceives a loan as riskier, for example due to the length of the loan period, it may apply a lower rate, for example 1.5. This would lead to a lower total loan amount that is allowed. Nevertheless, the company can argue for a higher rate or adjust the loan contract terms to ensure the leverage rate of 2 can be applied. The final rate applied is up to approval by the local SAFE.

In line with the Financing Gap method, under the Net Asset method Chinese subsidiaries can also borrow short-term (<=12 months) or long-term (1-3 years) debt. However, according to the Net Assets method, the balance of the amount of funds available for borrowing of foreign debt will be restored after the principal is repaid on time according to the contract, irrespective of the choice for short- or long-term borrowing. In other words, the subsidiary can apply for a foreign loan multiple times.

The larger the enterprise’s net assets, the larger the scale of cross-border financing will be. This will automatically increase with the increase in net assets instead of being restricted by the registered capital under the Financing Gap method.

Important to note: Foreign-invested enterprises in China may initially choose the Financing Gap or the Net Assets method to apply for a foreign loan. Once the company has selected one method, it cannot switch methods for future loan applications. Therefore, it is essential to carefully consider the choice of the process when applying for an intercompany loan.

Comparison of Intercompany Loan Quota Methods in China

Criteria	Financing Gap Method	Net Asset Method (Macro-Prudential)
Regulatory Basis	Defined by SAFE under total investment minus registered capital framework.	PBOC Notice (Yin fa [2017] No. 9) introducing macro-prudential management.
Borrowing Cap	Fixed within company’s total investment – registered capital.	Up to 2 × net assets × adjustment parameter (1.5 as of July 2023).
Flexibility	Limited; quota fixed unless total investment or capital officially amended.	More dynamic; quota expands automatically with growth in net assets.
Applicability	Used by older FIEs and companies with legacy investment structures.	Preferred for newer entities or those seeking higher financing flexibility.
Restoration of Quota	Only for short-term debt after repayment; long-term not reusable.	Quota restored automatically after timely repayment, regardless of term.
Key Advantage	Straightforward, easy to calculate during incorporation.	Greater flexibility and scalability with enterprise growth.
Key Limitation	Rigid; amendments require SAFE approval of new investment structure.	Requires regular audited net-asset updates and SAFE filings.

Foreign Loan Interest Rates

When an intercompany loan is initiated and a foreign loan agreement is prepared, the companies need to establish an interest rate based on the Loan Prime Rate (LPR). The LPR is published by the National Interbank Funding Center (NIFC), which is an institution authorized by the People’s Bank of China (PBOC). Generally, the LPR is equal to the most preferential lending rate offered by commercial banks at that period in time and the LPR is calculated by averaging the quotes provided by a panel of several banks.

The LPR is published every 20th day of each month. For example, on July 20, 2023, the 1-year LPR stood at 3.45% and the 5-year LPR stood at 4.20%. This rate is valid until the LPR of the following month is released. It should be noted that the financing period impacts the LPR and in case the term of a loan is extended this will require an alteration as well in the applied LPR.

Even though the regulations set out clear guidelines for the interest rate, which must be set based on the interbank interest rate, similar to the loan term, it may be possible to use a lower interest rate if the local SAFE can approve this. In our experience, the local SAFE officers may be more lenient with the applied interest rate, so it’s essential to discuss with the respective SAFE department in your city/district to learn about their policies for a company loan.

Interest payments are deductible for CIT purposes if the amount is reasonable and complies with the arm’s length principles . In China, like most service and royalty fee arrangements, interest payments are subject to VAT (6%), withholding tax, and surtaxes.

Application of Foreign Loan Procedures

For a Chinese subsidiary to apply for a foreign loan, generally, the following steps must be performed:

Prepare intercompany loan agreement or contract both in English and Chinese (documents must be signed/chopped by all parties);
The agreement or contract must be registered with local SAFE within 15 working days of signing;
All required supporting documents (e.g., latest annual audit report, application forms, etc.) must be submitted to local SAFE;
A special bank account to receive foreign loan (similar to a company’s Capital Bank Account) must be opened. Here it is important to review whether your local bank is permitted to handle foreign debts;
The funds in the foreign loan can be deposited on a special loan bank account.

Due to the complexity and workload required to complete the above registrations with local SAFE and local banks, many small—and medium-sized foreign-invested enterprises opt to outsource these procedures to a third-party service provider.

As stipulated in the loan agreement, the loan term should be respected. If the Chinese subsidiary is unable to repay the loan in time, it must apply for an extension with the SAFE.

Please note that these are general procedures that all companies must follow in order to receive a foreign loan. However, companies may need to submit additional documentation to the local SAFE, and the final approval of foreign loans is up to the discretion of the local authorities.

Practical Considerations for Company Loans

Based on our experience supporting our clients with company loans from the headquarters to the subsidiaries, below we highlight several practical considerations for intercompany loans:

Loan Bank Accounts

As highlighted above, a company must open a specific loan bank account to receive the loan funds. Normally, when a company sets up different loan agreements, a different bank account must be opened for each separate loan agreement. However, some banks may accept using the same bank account for the different loans. Therefore, it is essential to communicate with your local bank branch about their policies.

Multiple Loan Drawdowns

If the company can apply for a loan amount higher than what the company wants to use on short notice but would like to extend more loans in the future, splitting the loan amount into several portions is possible. This means the company can register a loan agreement for a larger principal amount and only draw down part of that loan, intending to use the rest of the balance later. The advantage is that the company will only have to draft a loan contract and register the contract with the SAFE once. When drawing down part of the loan each time, a drawdown agreement may need to be drafted for internal and bank purposes.

Intercompany lending between foreign parent and China subsidiary must meet arm’s-length interest rate standards or trigger transfer pricing adjustments and penalties. Documentation proving commercial rationale protects both parties from tax authority challenge. corporate finance specialists ensure your internal loans withstand scrutiny and remain efficient capital deployment. MSA Asia builds defensible intercompany agreements. Reach out about structuring your internal financing.