Managing China’s wealth: Rich pickings for foreign asset managers
The steady growth of China’s middle class is increasing the demand for asset and wealth management services for domestic institutions and individuals. Henry Wong explores the commercial and tax implications of these developments.
In 1998, there were only six fund management companies in China with RMB 10 billion ($1.4 billion) of assets under management (AUM). Since then, the Chinese asset management industry has grown to more than 120 fund management companies with more than RMB 51.4 trillion of AUM. The expansion of China's middle class will drive the industry further forward in the future; it is among the most attractive parts of the Chinese financial services industry for foreign players. Foreign assets managers can bring their years of international asset management experience and global market perspective to Chinese investors, and win business on this basis.
The loosening of the foreign ownership restrictions in the sector has created a recent opportunity for foreign asset managers to operate an asset management business directly within China, rather than being limited solely to investing in China's capital markets from overseas through the QFII/RQFII/Stock Connect channels (see China capital markets open up: New opportunities bring fresh tax challenges).
Establishing an asset management company in China enables foreign fund managers to raise funds directly in RMB in China, and serve wealthy Chinese individuals directly. Since the release by the Asset Management Association of China (AMAC) of 'Answers to Relevant Questions Regarding the Registration and Filing of Private Funds (No.10)' in 2016 (FAQ 10), a total of 21 foreign-invested private fund managers (PFM) have registered with the AMAC, with 46 registered products and RMB 5.4 billion of AUM as of August 2019, according to a previous AMAC statement.
Looking ahead, foreign asset managers will need to pay attention to competition from domestic players such as securities companies, bank wealth management (WM) subsidiaries and insurance companies participating in the asset management market. In addition, domestic tech giants are progressively taking advantage of their strong distribution channels over the internet to enter the asset management scene in force. On the regulatory front, the Guiding Opinions on Regulating Asset Management Business of Financial Institutions (New AM Rules) entered effect in 2018, setting stricter requirements for asset managers. Foreign participants need to pay close attention to this.
Asset management and foreign managers
For foreign investment managers seeking to raise a securities investment fund in mainland China, there are two main options.
One of them is the joint-venture fund management company (FMC JV). Among the existing FMC JVs, most foreign investors only hold minority shares. This is because of long-standing regulatory restrictions on the percentage of shares that may be held by foreign investors in an FMC. However, in 2017 the State Council (the cabinet) announced that these restrictions would be removed within three years. Since then, the holding limit has been raised from 33% to 51%, and foreign companies have started to increase their holdings to this level. Subsequently, in October 2019, the China Securities Regulatory Commission (CSRC) made an announcement that the original deadline would be brought forward from 2021 to as early as April 2020. This means that, in principle, foreign investors will be able hold 100% of an FMC from next year.
An FMC JV facilitates the issuance of a broad range of fund products, including both publicly and privately raised funds. However, a foreign asset management firm entering the Chinese market may not necessarily want to partner with a Chinese JV partner or pay a substantial amount of premium to increase its ownership share in an existing JV. There is, therefore, another other option for entering China's asset management industry, and this is the private securities fund management company (PFM).
PFMs give foreign managers 100% control of all aspects of operations. The same sort of tax issues also present themselves for each option.
Since June 2016, foreign asset managers have been allowed to incorporate onshore wholly foreign owned enterprises (WFOE), which they can register with the AMAC as private securities fund managers. Through PFM WFOEs, fund managers can raise money from Chinese investors directly and make independent investment decisions on their behalf. AMAC-issued FAQ 10 confirms that PFM WFOEs can make investments in securities on secondary markets in mainland China. In August 2019, the AMAC further announced that foreign PFMs could apply to conduct retail mutual fund businesses. Prior to this, PFMs could only raise private fund products and sell to high-net-worth individuals or institutions through private offering.
The PFM WFOE registration rules require that its foreign shareholder (and ultimate foreign controller) must be a financial institution licensed by the financial regulatory authorities in its home jurisdiction. The securities regulatory authorities of that jurisdiction must have signed a memorandum of understanding on securities regulation cooperation with the CSRC, or other institutions recognised by the CSRC. Furthermore, the PFM and its foreign shareholder (ultimate controller) must have not been subject to any material penalty by a regulatory or judicial department in the past three years.
China asset management operations – tax perspective
From a tax perspective, the most relevant issue for both FMC JVs and PFMs is the VAT on asset management products. The relevant guidance provides that the manager of asset management products will be treated as the VAT payer, to the extent that the latter falls within the VAT charge. The applicable VAT rate is 3%, charged under the simplified method; namely, without the ability to claim any input credit. The relevant guidance is provided in Circular Caishui  No. 140, Circular Caishui  No. 2 and Circular Caishui  No. 56.
It is notable that China decided to impose the VAT filing and payment obligations for asset management products on the fund/asset manager, instead of imposing it on the issuance vehicle of the products itself. The main reason is that most, if not all, asset management products existing in China are structured as contractual funds and not as legal entities or partnerships. Contractual asset management funds cannot be registered as taxpayers under the existing tax administration system and therefore cannot directly pay the VAT.
As VAT rules for asset management products deem the fund/asset manager to be the taxpayer, complicated VAT filing and calculation issues arise when that manager is managing multiple products at the same time. For example, the trading of financial commodities like listed securities, foreign exchange, and derivatives is subject to VAT, with the ability to offset gains and losses within a VAT reportable year. However, what if asset management product 'A' realises net gains on trading of financial commodities, while asset management product 'B' realises a net loss? In such a case, the manager will need to decide how to allocate the net VAT liabilities to each product – the manager must aggregate all the VATable activities together and pay the VAT on behalf of all of the products under its management.
So far, there is still no clear guidance on how to deal with the allocation of VAT cost across different products. It is therefore at the manager's discretion to decide what is the most acceptable method for the investors from a business standpoint.
Another issue is how to deal with the trading gains obtained by different types of securities funds, if the same PFM is raising both private and public securities investment funds – assuming the PFM upgrades its licence to include a public mutual fund business. Currently, there is a VAT exemption available for public securities investment funds on gains derived from trading of shares and bonds. As this tax preference policy cannot be applied to private securities funds, PFMs will need to be careful in selecting IT systems capable of conducting sophisticated VAT calculations. This will have to be able to manage the different applications of VAT for different financial instruments, different income types, and different types of fund registration (for instance, public vs private products).
According to Circular 140, gains from redemption, where assets are held to maturity, are not within the scope of VAT. However, according to Circular 36, any transfer of the ownership of financial commodities will be subject to VAT. This leaves a question over whether a fund unit redemption should be subject to VAT or not. In particular, it is quite common for a public fund product to be issued without any fixed maturity date, so there is never a concept of 'held to maturity'. On the other hand, one would argue that the fund unit will not exist after the redemption directly with the fund manager, meaning that there is no transfer per se. This differentiates the situation from trading, which involves buying and selling of a fund unit with another third party in the market. It remains uncertain whether fund redemption is subject to VAT or not.
Another issue for PFMs is that China now implements the common reporting standard (CRS) on tax information exchange with other jurisdictions. The key guidance here was set out in May 2017 in Administrative Measures on Due Diligence Checks on Tax-related Information of Non-residents' Financial Accounts. Foreign investors operating PFMs in China must fulfil the obligations set out in this guidance, including:
a) Due diligence on financial account: designing and implementing a due diligence process to identify reportable accounts (for example, non-resident account).
b) Information collection and reporting: collecting reportable information, such as the tax residency country of the account holder, completing the CRS filing in a timely manner and submitting a written annual report.
c) Continuous compliance: establishing an ongoing monitoring mechanism, following up with the implementation of the CRS compliance obligations and replying to the examinations of regulatory authorities.
Failure to fulfil CRS compliance obligations may lead to punishment by the regulatory authorities, including impaired assessment of taxpayer creditworthiness, operations suspension, revocation of business permits, and cancelation of the accountable senior management personnel's appointment qualifications.
Given the opening up of the retail mutual-fund business to foreign PFM WFOEs, a series of issues need to be carefully considered. These include, the capability of the IT systems to monitor the valuation, bookkeeping, VAT determination on the increased numbers of fund products being raised by the PFM, and meet compliance requirements cyber-security and data privacy rules, operational risk and regulatory rules, and human resource arrangements.
China's new asset management rules
Regulatory efforts have recently been made to unify the oversight of the asset and wealth management sectors in China and ensure that they do not stray too far from their core social purpose.
These new measures are intended to remove the perception among Chinese investors that asset management products issued by banks provide 'implicit guarantees' on their returns and principal amounts. Chinese financial regulators have expressed increasing concern that many fund products raised in the market are investing in non-standard assets (such as credit and lending) that lack transparency and could have liquidity problems, or involve arbitrage that further promotes shadow banking activities. In this regard, since April 2018, the China Banking and Insurance Regulatory Commission (CBIRC) and People's Bank of China (PBOC) have issued several regulations.
These include the New AM Rules, Measures on Supervision and Administration of Wealth Management Business of Commercial Banks (WMB Measures) and Administrative Measures on Wealth Management Subsidiaries of Commercial Banks (Subsidiaries Measures).
These rules will impact all asset management institutions in China, including domestic, foreign-invested and JV institutions. The New AM Rules emphasise that asset management business activities should stick to "managing the assets entrusted by others". Asset managers should not branch out from this to raise asset management products that could be seen as involving cash pooling, provision of guaranteed payments or redemptions, or use multi-level structures that disguise underlying lending activities (for instance, products that compound shadow lending imbalances in the financial system).
Requirements are set out in the New AM Rules to limit the promotion of products that provide principal or redemption guarantees. Investor education by financial institutions must draw their attention to investment risks, and wean investors away from the belief that investment products will always provide principal or redemption guarantees.
From the tax perspective, VAT rules stipulate that returns on investments that provide "fixed, guaranteed or principal-protected" returns, should be treated as interest on a loan, and subject to VAT. However, in practice, there are still many ambiguities on the meaning of "fixed, guaranteed or principal-protected" returns. It is not clear whether a substance-over-form approach needs to be applied, or whether the 'form' set out in the explicit terms of contracts or contract equivalent documents should be followed. As the New AM Rules no longer allow asset managers to provide guaranteed redemption on its products, theoretically speaking, all asset management products governed by the New AM Rules would not provide "fixed, guaranteed or principal-protected" returns. However, if the Chinese tax authorities eventually take a substance-over-form approach to determine whether a financial or investment product is principal-protected or not, investors will need to pay close attention to the specific nature of the investment. In particular, they will need to pay attention to any special arrangements in new product contracts based on the existence of credit or income enhancement arrangements. These could be seen, in substance, as providing guaranteed or principal-protected returns, such that VAT is due on the income received.
Regarding valuation approaches for asset management products, the New AM Rules encourage application of the fair market value recognition method by asset managers. This may result in changes to the existing valuation methods used for asset management products. In order to reflect the asset value fairly, potential VAT and related surcharges on unrealised investments will also need to be considered for accrual. This will add further complexity to VAT calculation work, raising requirements for IT system upgrades.
Foreign asset managers that are planning to establish their first PFM WFOE, or to update their existing one to tap into the public mutual fund market, should pay close attention to all these regulatory developments.
As can be seen, there are increasing opportunities for foreign institutions to participate in asset management business in China. At the same time, the issuance of a series of new asset management rules have set higher requirements for asset managers. Many uncertainties and ambiguities persist in the tax space, with further clarity hoped for in the coming years as the market matures.
The author would like to thank Aileen Zhou, KPMG China senior manager, and Wendy Ding and Hans Hu, KPMG managers, for their contributions to this article.
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Henry Wong is a tax partner based in Shanghai with KPMG China. He has specialised in tax advisory and M&A services for more than 18 years with a particular focus in the asset management and private equity sector. He has extensive international and China tax experience and serves clients across different industries on direct and indirect tax advisory projects, due diligence work, merger and acquisition advisory, cross-border tax compliance and tax planning, as well as day to day corporate tax compliance engagements.
Henry serves many financial sector clients including asset and fund managers, banks, insurance companies, securities and brokerage, as well as leasing companies and investors in non-performing loans (NPL). He works extensively with various investment fund clients including private equity firms, mutual fund companies, QFII, QDII, QFLP, QDLP, hedge funds, REITs, etc.
Recently, Henry also advised financial services clients on China VAT reform, US FATCA and the common reporting standard (CRS).
Prior to joining KPMG China, Henry worked with KPMG Canada in Toronto on international and Canadian tax matters for financial services and assets management clients.