China's capital markets have grown exponentially in recent decades and are now steadily opening up to foreign investors.
Notable recent developments include the China A-shares market, which has been progressively added to many leading international stock indexes such as MSCI, S&P Dow Jones and FTSE Russell. Its weight in these stock indexes is continuously increased.
The domestic Chinese bonds market was also added to the Bloomberg Barclays Index Aggregate in April 2019. Meanwhile, in June 2019, the Shanghai-London Stock Connect was officially launched, covering both the primary and secondary markets. This complements the earlier Stock Connect schemes between Hong Kong SAR and Shanghai/Shenzhen. The Shanghai-London Stock Connect allows Chinese companies to list on the London Stock Exchange (LSE) – an arrangement not facilitated by the Shanghai-Hong Kong Stock Connect scheme.
The Shanghai Stock Exchange Science and Technology Innovation Board (STAR Market) was opened in July 2019. It mainly attracts tech start-ups and is an attempt to replicate the successes of the US NASDAQ stock market. Then more recently in September 2019, the Chinese government announced that the quota limitation on the qualified foreign institutional investor (QFII) and RMB qualified foreign institutional investor (RQFII) programmes is now completely abolished. As such, qualified foreign asset managers are free to choose between the QFII/RQFII or Stock Connect channels to invest in China's capital markets directly without quota limitation.
Finally, in parallel with these developments, the steady growth of China's economy and increase in the middle-class population has meant that the demand for asset and wealth management services for domestic institutions and individuals is also growing significantly. The commercial and tax implications of these developments are explored further in Managing China's wealth: Rich pickings for foreign asset managers.
On the tax front, China has progressively rolled out a series of tax exemption policies to encourage the development of the capital markets. However, the Chinese financial service sector's unique tax environment still presents significant challenges and tax uncertainties for investors and industry players. In this article, we consider the major business and tax challenges presented for the leading types of investment channels into China, to enable foreign asset managers to be better prepared when investing into China.
Investing into China's capital markets
Without any establishment in mainland China, foreign asset management institutions can still directly participate in China's capital markets via different channels, mainly the QFII/RQFII (just announced to be fully opened up to all qualified investors), CIBM Direct (China Interbank Bond Market), Stock Connect and Bond Connect, among others. Set out in Table 1 and below is a snapshot of the eligible investors, regulatory institutions, eligible investments and investment currencies of different channels.
|Investment channels||Eligible investors||Regulatory bodies||Eligible investments||nvestment currency|
|Stock Connect (Shanghai-Hong Kong, Shenzhen-Hong Kong)||All foreign investors including individuals (but only institutional professional investors for SZSE ChiNext shares)||People's Bank of China (PBOC), China Securities Regulatory Commission (CSRC), Hong Kong Securities and Futures Commission (HKSFC)||– Approximately 1,260 stocks as of September 6 2019:|
– 578 Shanghai Stock Exchange (SSE) shares: Constituents of SSE 180 Index and 380 Index and dual SSE-Hong Kong Exchanges and Clearing (HKEX) listed shares
– 680 Shenzhen Stock Exchange (SZSE) shares: Constituents of SZSE Component Index and SZSE Small/Mid Cap Innovation Index and dual SZSE-HKEX listed shares
|Offshore RMB, HKD and USD|
|Bond Connect||Foreign financial institutions (commercial banks, insurance companies, securities companies, FMCs and other asset management institutions) and investment products issued by them, other medium- and long-term institutional investors (like pension funds, charitable foundations etc.) as approved by PBOC||PBOC, Hong Kong Monetary Authority (HKMA), China Government Securities Depository Trust & Clearing Co, China Securities Depository and Clearing Company.||All bonds traded in the CIBM||Onshore RMB, offshore RMB|
|China Interbank Bond Market (CIBM) Direct||PBOC, Ministry of Finance (MOF), State Administration of Foreign Exchange (SAFE)||All cash bonds and other products permitted by the PBOC.|
Foreign institutions can also invest in repos, bond borrowing and lending, bond forwards, IRS, FRA, etc.
|Onshore RMB, offshore RMB|
|QFII||Foreign institutions meeting the following requirements:|
– Commercial banks: ≥ 10 years operation, ≥ $5 billion AUM, ≥ $300 million Tier 1 capital
– Securities companies: ≥ 5 years operation, ≥ $5 billion AUM, ≥ $500 million capital
– Asset management institutions, insurance companies and others: ≥ 2 years’ experience, ≥ $500 million AUM
|CSRC, PBOC, SAFE||– All securities listed on SSE/SZSE|
– Cash bonds in interbank market
– Securities investment funds, including close-ended, open-ended and ETFs
– Index futures
– FX derivatives (for hedging purposes only)
– Other products approved by CSRC
|USD or other FX (convert to RMB onshore)|
|RQFII||Foreign institutions in (including asset management institutions, securities companies, commercial banks, insurance companies and overseas subsidiaries of China FMCs)||CSRC, PBOC, SAFE||Offshore RMB|
The Stock Connect programme was first launched in 2014 between the Shanghai and Hong Kong SAR exchanges, and was extended in 2016 to encompass a link between the Hong Kong SAR and the Shenzhen market. It allows mainland Chinese investors to purchase Hong Kong SAR and Chinese companies listed in Hong Kong SAR. At the same time, it allows foreign investors to buy listed China A shares, without having to apply for a licence to invest through QFII/RQFII channels.
Stock Connect covers both individual and institutional investors and is the easiest way for foreign investors to invest in the China A share market, with no need to open a bank account in mainland China. Instead, investments can be made via Hong Kong SAR stock brokers. This being said, foreign investors are limited on their selection of investable securities. As of September 2019, only 578 securities listed on the SSE and 680 securities listed on the SZSE are eligible for trading under Stock Connect.
In the most recent development, Shanghai-London Stock Connect was officially launched in June 2019, and it covers both primary and secondary markets. Investors can trade depositary receipts in the secondary market. For 'westbound' listings, Shanghai Stock Exchange-listed companies can use newly issued shares to issue global depositary receipts (GDRs) and to achieve primary market security issuance on the LSE. This differs from the existing Shanghai-Hong Kong Stock Connect, which is only a secondary market trading mechanism.
Preferential Chinese tax treatments have been provided to attract foreign investment through Stock Connect. Foreign investors are temporarily exempt from corporate income tax (CIT) and VAT on trading gains arising on transfer of A-shares. However, dividends from A-shares, paid to foreign investors, are subject to 10% withholding tax (WHT). While treaty relief can be available to certain investors such as sovereign wealth funds (SWFs), the tax treaty relief application and tax reclaim processes remain inefficient, and industry groups continue to lobby for a streamlined approach.
While investors can technically apply for WHT refunds to the in-charge tax bureau of the listed company which paid the dividend, in practice the application procedure is cumbersome and time-consuming. There is inconsistency between the WHT refund documentation requirements of different local tax authorities; foreign investors consequently need to liaise closely with each listed company and their specific in-charge tax authorities to secure refunds.
We also observe that most tax authorities require the official seal of the listed company on the application documents and that listed companies may take different approaches to providing their official seal to investors. For example, listed banks generally require that the share certificate, usually held by the offshore custodian bank of the foreign investor, be notarised by an authorised public notary and certified by the Chinese embassy in the country of incorporation. This is very onerous and takes a of lot time; investments in multiple listed companies result in a heavy workload for WHT refund applications.
Similar to Stock Connect, Bond Connect is a mutual market access scheme that allows eligible investors from mainland China and overseas (through Hong Kong SAR) to trade in each other's bond markets. Through Bond Connect, launched in 2017, foreign investors can trade in the secondary market and subscribe for CIBM bonds in the primary market through Bond Connect, meaning they can trade all CIBM bonds. At the end of 2018, the China Foreign Exchange Trade System (CFETS) and Bloomberg together launched access channels to China's interbank bond market. This allows foreign investors to obtain bids and quotes data, as well as trade onshore Chinese bonds via the Bloomberg terminals, making investment activity more efficient. Similar to Stock Connect, Bond Connect may now be the most convenient channel for foreign investors who are otherwise not qualified to use CIBM Direct access (discussed further below), to participate in China's bond market.
As regards to the Chinese tax treatment, Caishui  No. 108 (Circular 108) provides for a three-year exemption from CIT and VAT for interest income derived by foreign institutional investors investing in Chinese bonds; this runs from November 7 2018 to November 6 2021. However, there still remains a number of tax ambiguities. Three in particular stand out:
- Do asset backed securities (ABS) qualify as 'bonds'? There are various types of tradable debt instruments available to foreign investors in the Chinese bond market, including ABS, asset-backed notes (ABN) and interbank certificates of deposit (CD). However, Circular 108 does not provide a clear definition of 'bonds'. There is some uncertainty as to whether the VAT and CIT exemptions for bond interest can be applied to income from special debt instruments, for example ABS, ABN and CD, or whether it is limited to plain-vanilla bonds, such as government bonds, government-supported institution bonds or corporate bonds. While ABS and ABN can be traded in the interbank bond market and are considered 'bonds' by many financial institutions, they differ in terms of issuance and trading mechanisms. The originator will first transfer the underlying assets to a special-purpose vehicle (SPV) set up for issuance of a specific asset management product. The manager of the SPV will oversee the ABS and issue securities to investors.
- Do ABS returns qualify as 'interest'? Circular 108 provides a CIT exemption for 'interest income' with the definition cross-referencing the CIT Law. The CIT Law defines 'interest income' as being derived by an enterprise from the provision of funds for use by others, where this does not constitute equity investment – it specifically lists (non-exclusively) deposit interest, loan interest, bond interest, and arrears interest. It is unclear whether the income derived from holding ABS should be treated as interest income and therefore qualify for the Circular 108 exemption. A tax administrative point to note is that, at present, an asset management product cannot be registered by the manager or the sponsor with the tax bureau. Consequently, the manager or the sponsor cannot act as the withholding agent for foreign investors, in the same way as corporate bond issuing companies would. Therefore, 'interest' arising on ABS investments, while not yet subject to Chinese withholding tax as an administrative matter, may not necessarily be entirely free of liability to Chinese tax as a legal matter. As such, this creates an additional tax exposure for foreign investors who wish to invest in these investment products.
- Is there VAT on returns from asset management products? An asset management product is regarded as a 'financial product' from a Chinese VAT perspective. Income from a financial product may be subject to VAT if it is regarded as a principal-protected product. However, VAT regulations are unclear on the meaning of principal-protected product and different tax bureaus take varied and inconsistent positions on the matter.
CIBM Direct Access
Before the launch of the Bond Connect scheme in 2017, certain foreign institutional investors were able to invest in China's interbank bond market through an application to be eligible investors with CIBM.
Tracing the history of this investment channel, in 2010 the PBOC launched a pilot scheme allowing foreign central banks or monetary authorities, RMB settlement banks in Hong Kong SAR and Macau SAR, and cross-border RMB settlement participating banks in Hong Kong SAR and Macau SAR, to trade and settle bonds in the CIBM. In December 2011, QFIIs and RQFIIs were allowed to apply for approval and quota to invest in the CIBM via a bond settlement agent. The PBOC from July 2015 allowed foreign central banks, monetary authorities, international financial organisations and SWFs to invest in the CIBM without approval requirements and quota limits. From 2016 onwards, more types of foreign institutional investors were allowed to invest in the CIBM, including commercial banks, insurance companies, securities firms, fund management companies and other asset management institutions, as well as their investment product vehicles. This was in addition to pension funds, charity funds, endowment funds and other mid-term or long-term institution investors recognised by the PBOC.
CIBM Direct has higher qualification requirements than Bond Connect for investors to be eligible, but it also provides a wider scope of investment opportunities. This includes repos, bond borrowing and lending, bond forwards, interest rate swaps (IRS), and forward rate agreements (FRA), among others, for hedging purposes, which brings certain advantages in terms of risk management.
In respect of the bond investment, the tax issues that foreign investors face under CIBM Direct Access are similar to those faced for investments via Bond Connect. However, given the wider range of investment types accessible, there are even more tax uncertainties that arise. For example, take the tax treatment of derivative transactions. Technically speaking, according to relevant VAT regulations, gains derived from derivative transactions are subject to VAT. However, in practice, the Chinese transaction counterparty will generally not withhold VAT arising in relation to foreign investors because of the lack of a relevant withholding mechanism.
A QFII is a foreign institutional investor that meets certain qualification criteria and is approved by the CSRC. It can invest in a range of securities products, and was in the past subject to an investment quota approved by the State Administration of Foreign Exchange (SAFE). As of August 2019, the total quota of 292 foreign institutions stood at $111.38 billion.
The RQFII programme is a modified version of QFII that facilitates foreign investment in mainland China via offshore RMB accounts. It was also similarly subject, in the past, to an investment quota approved by the SAFE. As of 2018 year-end, the total RQFII quota amounted to RMB 1.940 trillion.
With the opening up of China's capital markets and financial services sector underway, it was recognised that the existing rules of the QFII and RQFII schemes would no longer meet the demands of the new market environment. In response, in early 2019 the CSRC issued the 'Notice on Public Consultation for the Measures for the Administration of Domestic Securities and Futures Investment by QFII and RQFII and the Provisions on Issues Concerning the Implementation of the Measures for the Administration of Domestic Securities and Futures Investment by QFII and RQFII' (the CSRC consultation papers).
The QFII/RQFII programmes already have a more comprehensive investment scope than Stock Connect or Bond Connect. The scope will now be further expanded by the CSRC consultation papers to cover private fund investments, and will also be permitted to invest in stocks listed on the New Third Board (the National Equities Exchange and Quotations System Co), financial and commodity futures, and bond repos.
In parallel with the release of the CSRC's consultation papers, the SAFE firstly abolished investment quota restrictions for QFII/RQFII in September 2019 and secondly, simplified FX settlement rules. The latter changes provide that: 1) the 20% annual limit on the repatriation of principal and profit by the QFII is now removed; 2) the three-month lock up period on repatriation of principal for QFII/RQFII is now removed; and 3) QFII/RQFII is now allowed to hedge exchange rate risk through entering into FX derivative transactions.
While these changes facilitate remittances for QFII/RQFIIs, a requirement for tax clearance remains. QFII/RQFIIs needs to perform a record filing with the local tax bureau and submit tax record filing forms, with the local tax bureau's stamp, to the remitting bank before net income and net trading gain proceeds can be repatriated from China. This makes profit repatriation less convenient compared with other channels. The tax record filing takes time and effort, and uncertainties exist in relation to the application procedure requirements (in the absence of any relevant nationwide guidance), and local tax authority practices. In particular, many tax authorities only accept an application on a yearly basis. This means that profits realised by a QFII/RQFII at the beginning of the year can be repatriated no earlier than the middle of the following year subsequent to the submission of application documents.
Furthermore, where there are sub-accounts set up under QFII/RQFII master accounts, there can be challenges in separately repatriating profits from these sub-accounts. In practice, the tax authority may only accept a repatriation application at the whole QFII/RQFII account level. This means that a foreign asset manager that uses a sub-account structure should plan in advance on profit repatriation.
Preferential tax policies for QFII/RQFII provide temporary CIT and VAT exemptions for gains on trading of equity investment assets, including shares. However, tax uncertainties exist, and will increase with the scope expansion of the QFII/RQFII programme:
- VAT treatment of corporate bond interest: Bond interest is subject to VAT since the May 2016 implementation of VAT reform, meaning that QFII/RQFII licence holders must conduct VAT filing and settlement for profit repatriation. While Circular 108 provided a tax exemption for bond interest, it is not clear how to treat interest arising before the circular became effective on November 7 2018. Uncertainty exists in particular for corporate bonds in the absence of an effective VAT withholding mechanism. There is also uncertainty on the treatment of bond interest arising before the May 2016 VAT reform rules entered into effect (namely, the application of previously existing business tax). The practice adopted by local tax authorities is also inconsistent.
- Tax treatment of fund distributions. According to Caishui  No. 1, distributions from security investment funds are exempt from CIT. However, it is not clear if this applies to non-resident taxpayers such as QFII/RQFII, and the practices adopted by local tax authorities are inconsistent. On the other hand, VAT rules stipulate that for investments that provide returns that are "fixed, guaranteed or principal-protected", the returns should be treated as "interest on a loan", and be subject to VAT. However, in practice, there are still many ambiguities on the meaning of fixed, guaranteed or principal-protected investment returns. Distributions from funds that invest in bonds are treated, in practice, as bond interest by some local tax authorities and subject to VAT.
- VAT treatment of FX gain/loss of QFII principal. According to the relevant FX regulations, a QFII must provide principal for investment in foreign currency and then convert it into RMB for investment. If a QFII wants to remit funds out of China (including both profit and principal), it has to convert its RMB into foreign currency. It is unclear whether the FX gains derived from these conversions of the principal should be subject to VAT. Technically speaking, realised gains from FX trading are subject to VAT. However, the QFII is not 'actively' engaging in FX trading and the conversions are made pursuant to a regulatory requirement. FX gain/loss is only realised during the currency conversion at the time of repatriation. In practice, some local tax authorities may impose VAT on the above-mentioned realised FX gain of the principal.
Making the most of the opportunities
With all these exciting new developments opening up China's capital markets, tremendous opportunities are now available to foreign investors, and these are expected to proliferate in the near future. However, as with other industries and sectors in China, as regulatory rules are relaxed and new opportunities present themselves, tax rules necessarily have to do some catch-up. This is crucial so that the new policies are, in practice, effective at encouraging fresh foreign investment into China, and are not stymied by tax uncertainties.
We certainly hope that the Chinese tax authorities will continue to clarify rules on the taxation of foreign investment into the Chinese capital markets. In the meantime, investors are recommended to seek appropriate advice from tax professionals, keep a close watch on tax rules development, and fully understand market practices and local tax authority interpretations. In addition, active participation in asset management industry associations is crucial for raising suggestions for improvement to the relevant China regulatory bodies.
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.
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.
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