Ever-tighter regulation of Chinese private funds: Time to re-visit tax planning
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Ever-tighter regulation of Chinese private funds: Time to re-visit tax planning

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Henry Wong of KPMG China considers the changes announced through Announcement 71, and explores how foreign asset management firms can seize the new opportunities for establishing private funds in China.

In 2020, the China Securities Regulatory Commission (CSRC) officially released the first regulatory document specifically addressing the supervision of the Chinese private fund industry and private fund managers – ‘CSRC Announcement [2020] No. 71 – Provisions on Strengthening the Supervision of Private Investment Funds (Announcement 71)’.

The main purpose of Announcement 71 is to reinforce the supervision of private funds and crack down on various forms of non-compliance, thereby protecting the legal rights and interests of private fund investors and promoting the healthy and disciplined growth of the industry. This includes, inter alia, measures to address illegal approaches to capital raising, failure of funds to ensure qualified investor requirements, and failure to perform registration and filing obligations.

Announcement 71, as a formal ministerial-level regulation, has a stronger enforcement status than the existing industry self-monitoring notices, issued through the Asset Management Association of China (AMAC), which over time have become more difficult to enforce in practice.

A more regulated private fund sector will likely lead to higher compliance costs for private fund managers and may warrant a re-think on the optimal approach to structuring private funds from tax standpoint. This article will highlight the changes in Announcement 71, and the tax matters for a foreign asset management firm to consider in order to make the most of the new opportunities for establishing private funds in China.

Fund manager registration in specific localities to access incentives

In recent years, there has been a trend for private fund manager legal entities to be registered in certain cities or provinces offering local financial subsidies and preferential tax policies. For example, Hainan province offers companies a 15% corporate income tax (CIT) rate vs the normal rate of 25%, and individuals can access a 15% individual income tax (IIT) rate vs the normal rate that can go as high as 45%.

This being said, the fund managers would, in practice, operate their business in 1st tier cities like Shanghai, Beijing or Shenzhen. In order to better regulate the private fund managers, the CSRC proposed, in their earlier draft consultation, rules that would have specifically disallowed such practices. However, following industry lobbying, the requirement was removed from the final version. At the same time, Announcement 71 made stipulations on the registered names, which must be used by private funds, which could impact on their access to preferential treatments.

Specifically, the new rules require that the private fund manager must register the corporate name of the fund manager entity with words like ‘private fund’, ‘private fund management’ or ‘venture investment’. In addition, the business license scope of the fund manager should specifically include the terms ‘private investment fund management’, ‘private securities investment fund management’, ‘private equity investment fund management’ or ‘venture investment fund management’.

Local governments will take these designations into account when determining whether a newly established enterprise falls within the one of the ‘encouraged’ sectors, listed in national and local catalogues of encouraged sectors, and thereby entitled to preferential tax rates. As it stands, financial services like asset and fund management are not explicitly included in these catalogues, and so the new Announcement 71 obligations for private funds to explicitly state the nature of their activities in their name registration and business licence may complicate local authorities granting them local incentives.

Despite this, fund managers should still conduct a detailed location study, and in particular contact the local commerce or investment promotion departments and officials responsible for attracting foreign investment to see if locally offered financial subsidies are available. For example, in some instances a certain percentage of tax revenue contributed locally may be fully returned as a financial subsidy.

In other cases, rental subsidies, talent subsidies, or even one-time subsidy support may be offered by the local government. The level of financial subsidies offered can vary depending on the size of the operation, and the number of employees hired and working at the location of the fund manager entity. As such, advance planning should be undertaken before paying a visit to the local officials.

Restrictions on private fund lending activities

Announcement 71 clarifies that private funds are not allowed to engage in investment activities such as borrowing and lending, provision of guarantees or engaging in ‘disguised’ debt arrangements.

At the same time, there is exemption from these restrictions where the loans and guarantees are made alongside equity investments in the same target company. This is so long as (i) such loan or guarantee is made with a term of one year or less; (ii) the maturity date of the loan or guarantee is not be later than the exit date from the equity investment; and (iii) the balance of the loan or guarantee shall not exceed 20% of the paid-in capital of the private fund.

Apparently, this rule is intended to deal with the existing non-compliance of certain ‘so-called’ equity investment funds which are actually providing financing or making debt investments in a disguised form. While this might appear to restrict private funds in China to focus on equity-type investments, but CSRC can provide for exceptions. Market players expect that private funds registered as credit funds or non-performing loan investment funds may be able to access the exception, as this would align to the government’s goal of opening up China’s non-performing loan market to foreign investors.

To set up a private fund focused on non-performing loans in China, a possible option is the Qualified Foreign-limited Partnership (QFLP) regime. This is an onshore Chinese limited partnership which facilitates foreign investment, through the partnership, by limited partners. Use of the QFLP fund structure raises the question of the tax treatment of future fund distribution to non-resident limited partners.

Currently, the relevant Chinese tax rules are very limited, simply stating that a Chinese partnership should be taxed as on a ‘flow-through’ basis and that only the partners are subject to income tax. However, the rules are ambiguous on the tax characterisation of income received through a partnership.

It is not clear whether the fund distributions received by a non-resident institutional partner would be treated as passible investment income, and subject to 10% withholding tax (WHT), or whether the income would be viewed as arising from an active business and taxed at 25% CIT. In connection with the latter, in practice many local tax officials assert that the onshore QFLP, in combination with the onshore private fund manager/general partner entity, should be viewed as giving rise to a ‘permanent establishment’ (PE) for the non-resident partners in China, providing a basis for the 25% tax imposition.

This cannot be considered as a reasonable position, given that the limited partner is not responsible for the operation of the onshore QFLP, nor are they legally permitted to intervene in its management. If, in the alternative, a non-resident partner decided to invest in the same Chinese target directly as a foreign shareholder, the income received would normally be subject to Chinese WHT at 10%. This means that investing through a QFLP could lead to tax inefficiency and uncertainty.

Over recent years, local tax officials have become more aware of this tax anomaly and are becoming more open to negotiation. Therefore, foreign asset managers are suggested to conduct an advanced consultation with the local tax authority. They could even seek assistance from the local investment promotion officials as part of the market-entry location study.

Raising capital from ‘qualified investors’ including QFII/RQFII

Announcement 71 designates the ‘qualified investors’ for Chinese private funds as belonging to three new categories. These are (i) asset management products issued by institutions under the supervision of the State Council’s financial supervision and administration department, (ii) Qualified Foreign Institutional Investor (QFII) and (iii) Renminbi Qualified Foreign Institutional Investor (RQFII).

Announcement 71 also excludes any requirement to ‘look through’ these ‘qualified investors’ to verify the identity of the ultimate investors. These provisions help to resolve certain issues for private fund managers:

  • Access to funding from QFIIs and RQFIIs (permitted under September 2020-issued rules from CSRC, People’s Bank of China, and State Administration of Foreign Exchange) means private fund managers no longer need to rely solely on domestic financial institutions or the private banking arms of foreign banks to raise money; and

  • The lack of a requirement to ‘look through’ qualified investors means that private funds are less likely to fall foul of the rules imposing a maximum number of ultimate investors, while also reducing compliance and due diligence burdens.

While this is all very helpful, the VAT treatment for QFIIs and RQFIIs trading securities through private securities investment funds is not entirely clear. According to the relevant regulations, gains derived by QFII/RQFII from the direct trading of financial instruments are VAT exempt; for example, direct trading of A-shares and bonds through a QFII’s custodian bank. However, it is not clear whether this exemption holds for trading via a private investment fund given that the trading gains arising to funds and asset management products on financial instruments are subject to a special 3% VAT levy. Discussions with the tax authorities on this matter remain inconclusive to-date.

Key takeaways

China’s continued opening of the financial services market to foreign investors, together with its tighter regulation of non-compliant players is, generally speaking, good news for foreign asset managers who are traditionally more compliance and risk-management focused. However, tax ambiguities will need to be further clarified in order to let foreign asset managers take full advantage of these opportunities, and getting professional tax advice is encouraged to avoid unwelcome surprises.

The author acknowledges the contribution by Conrad Turley (tax partner) and Grace Zhao (senior tax manager) of KPMG China in writing this article.

Henry Wong



KPMG China

T: + 86 21 2212 3380

E: henry.wong@kpmg.com

Henry Wong is a tax partner based in Shanghai with KPMG China. He has specialised in tax advisory and mergers and acquisitions (M&A) services for more than 20 years with a particular focus in the asset management and private equity (AMPE) 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, M&A 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 and REITs. Recently, he has 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.

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