As China opens its US$500bn A-share market to foreign capital, nearly 1,200 A-shares, which were previously reserved for domestic investors, are now available to foreign investors through the qualified foreign institutional investors (QFII) scheme.
Eager to attract large, long-term foreign investors to reduce domestic market volatility while keeping international speculators at the door, new rules allow qualified foreign institutions to buy the yuan-denominated A shares traded on the Shanghai and Shenzhen stock exchanges for the first time, along with bonds listed on both exchanges.
Foreign institutions have welcomed the opening as a long-term opportunity. However, in the short term they remain concerned about corporate governance, insufficient research coverage of A-shares, the exclusion of A-shares from major international indices, the stringent foreign exchange rules and the lengthy lock-up period.
One area that is likely to be overlooked is how the income and gains derived by the QFIIs are going to be taxed. The types of income that are sourced from China would include dividends from shares and interest from bonds. The gains would be the trading gains from shares and bonds. As both these gains and income are 'China sourced', China's tax authorities will have the first right to tax them. When the amounts are then repatriated to the locality in which the QFII is tax resident, the tax authorities there could impose further tax on those amounts. Where there is double taxation, relief may be provided by local tax provisions or double tax treaty (DTT) if that locality has concluded a DTT with China. By the end of last year, China had signed 81 tax treaties and one tax arrangement with countries/ localities around the world. As all QFIIs are foreign institutions, DTT provisions between China and the place where the QFII is tax resident should be relevant.
The major China taxes that are applicable to the above income and gains include withholding income tax and business tax. Any foreign enterprise (FE) that has no establishment or place in China, but derives profit, interest and other income from within China, is subject to a withholding tax at 10 percent on such income.
An FE that derives interest income from China is also subject to business tax at 5 percent. The funding costs of the FE are not taken into consideration in that calculation. However, a circular issued in 1997 appears to exempt the business tax on interest income derived by a FE.
Dividends are not included in the taxable scope for business tax. Trading gains from the buying and selling of shares, bonds and other securities would generally attract business tax at 5 percent on the net trade gain.
The mechanism by which China levies the above taxes is to impose upon the custodian banks the duty to withhold when the custodian processes the foreign exchange remittance. There are nevertheless certain exceptions. For example, under Circular 45 an FE receiving dividends or deriving trading gains from B-shares is provisionally exempt from withholding tax. Unfortunately, a QFII would not benefit from that circular as it is only allowed to invest in A shares.
If one examines the tax treatment for a domestic investor receiving dividends or deriving trading gains from A shares, both enterprise income tax and business tax could be applicable. Therefore, if the government wants to encourage QFIIs to enter into the Ashare market, then provisions similar to Circular 45 should be made. However, if the government applies the principle of national treatment, whereby foreign investors should be treated the same as their domestic counterparts, then both withholding tax and business tax should be in place. The current position remains unclear. There are plenty of gaps in the tax treatment of investment in both stocks and bonds (see tables).
Given that foreign investors find the QFII rules restrictive, the government should provide greater clarity to the tax treatment of the various financial instruments in which the QFII could invest. Similarly, if the government is to encourage the development of long-term foreign capital in its financial markets, tax incentives should be offered to attract the foreign capital in the first instance.
The onus appears to be on the custodian bank to properly withhold the correct amount of taxes before remitting the foreign exchange out of the country. In that regard, the custodian banks should consider forming a working committee to directly liaise with the various government authorities, including the tax bureau. A case should be prepared to put forward the types of tax incentives that would encourage the development of the industry – for example, adopting Circular 45 in provisionally exempting an FE from withholding tax on dividends or trading gains.
If the government is slow in providing clarity or more prone to applying the principles of 'national treatment', then careful tax structuring of the QFII becomes paramount.
A number of countries have signed DTT with China. Some treaties provide more generous treatment in relation to withholding tax rates and the treatment of the 'alienation of shares in China'. Appropriate tax planning may increase the after-tax returns of QFIIs. However, this has to be balanced against the requirement that the QFII should be located in a place that has sound securities law and supervision system.
In this regard, it is worth noting that the double tax arrangement between Hong Kong and China does not cover dividends, interests or gains. If Hong Kong is to compete for a foothold in this new area, it should seek a dialogue with the Mainland tax authorities to update the double tax arrangement.
Written by Derek Chow, partner of the Shanghai office of PricewaterhouseCoopers.