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Historically, procedural and technical guidance for determination and remittance of capital gains tax (“CGT”) by foreign institutional investors in China has been undefined. The condition originated in 2009, when the State Administration of Taxation (“SAT”) clarified the applicability of withholding taxes on interest and dividends but was silent on the topic of CGT. In light of the resulting uncertainties, foreign institutional investors that obtained the necessary regulatory licenses for investment in China’s “A” share market needed to determine their CGT accrual position individually with the assistance of their appointed tax advisors. Recently, prompted by the launch of the Hong Kong-Shanghai Stock Connect (“Stock Connect”) late in 2014, the SAT issued guidance concerning the applicability of CGT to Qualified Foreign Institutional Investor (“QFII”) and Renminbi Qualified Foreign Institutional Investor (“RQFII”) Schemes, and most recently have requested that outstanding unpaid taxes be remitted to the Chinese government. This article examines historical problems faced by QFII/RQFII with respect to Chinese CGT determination, and highlights current open issues that must be evaluated by impacted investors in order to comply with the government’s mandate to remit the tax.
Nonresident portfolio investors have been investing in China A shares through the QFII Scheme since 2002, and through the RQFII Scheme since 2011. Historically, QFIIs have been exempt from Chinese Business Tax with respect to gains derived from trading Chinese securities but pursuant to Guoshuihan  47 (“Notice 47”), QFIIs are subject to withholding tax on dividends and interest received from Chinese securities at the rate of 10 percent. Notice 47, however, did not specifically clarify the tax treatment of capital gains derived by QFIIs from trading of A shares. Lack of clarity with respect to the applicability of the 10 percent withholding tax to QFIIs' gains related to A shares has been a source of uncertainty in the market.
On November 15, 2014, the Stock Connect was launched, which provides an alternative platform for global investors to access China’s “A” share market, and for Mainland China investors to access the Hong Kong stock market. Until the launch of Stock Connect, direct entry into China from an equity investment perspective was permitted only through the QFII and RQFII Schemes. Mainland China investors were permitted to invest globally, but only through the Qualified Domestic Institutional Investor (QDII) Scheme. Prompted by the launch of the Stock Connect, the SAT and China Securities Regulatory Commission (“CSRC”) jointly issued Caishui  79 (“Circular 79”). Circular 79 clarified that QFII and RQFII are temporarily exempt from withholding tax with respect to capital gains derived from the trading of equity investments, including shares in mainland China enterprises on or after November 17, 2014. Circular 79 did not provide an expiration date for the temporary exemption, but did provide for applicability of the 10 percent withholding tax to dividends paid by “A” shares traded on Stock Connect; thus aligning the withholding tax treatment on dividend income for QFII/RQFIIs investing in Chinese securities in the local market with investments via Stock Connect. As in the local market, tax relief pursuant to a tax treaty with China requires a prior approval by the SAT. With respect to capital gains derived by QFII/RQFIIs prior to November 17, 2014, the Circular 79 provided for applicability of withholding tax according to current applicable law. The applicable law has not, however, historically provided for an assessment mechanism for CGT, nor has it provided guidelines for the determination, calculation or remittance of any taxes that may arise with respect to gains derived by QFII/RQFII prior to November 17, 2014. The ambiguity surrounding the procedural aspects of the governing law continued to perpetuate the existing uncertainty with respect to potential tax liability.
Chinese Tax Authorities Notified Historical Capital Gains Taxes Must Be Remitted
On January 19, 2015 the SAT notified local custodian banks that pursuant to Circular 79, withholding taxes on gains derived by QFII/RQFII prior to November 17, 2014 (“Pre-November 2014 Gains”) should be remitted to the SAT by the end of 2015. The SAT determined to pursue the collection of outstanding CGT through local tax bureaus that oversee local custodian banks. Through the notification that CGT should be paid, the SAT answered an important question that QFII/RQFII and their investors had been asking over the years, but the SAT did not address remaining critical issues surrounding the procedural aspects of compliance with the CGT determination and remittance requirements. Specifically, the SAT did not clarify the tax filing requirements or remittance procedures for meeting QFII/RQFIIs’ tax compliance obligation. As local custodian banks do not support CGT determination and remittance process as a matter of market practice, impacted investors have no choice but to turn to their appointed tax advisors for assessment of the impact of Circular 79 on their operations in China, identification of tax compliance requirements under the Circular 79 and determination of any applicable tax treaty relief.
Namely, in order to comply with the SAT requirement that taxes on Pre-November 2014 Gains should be paid, impacted QFII/RQFII are tasked to evaluate exposure to Chinese CGT on transactions in Chinese securities prior to November 17, 2014, and any assumptions made on prior CGT accruals and positions taken on tax provisions, as communicated to the QFII/RQFII’s fund accountant. An analysis of transactions and CGT calculation would need to be performed for each year. Furthermore, investors may need to determine whether protection from Chinese CGT is available under an applicable tax treaty and, if so, what documentation, in addition to certification of tax residency, should be provided in order to prove entitlement.
Following the January 19th announcement, the Shanghai Tax Bureau (“STB”) held a meeting with the local industry group that represents local custodian banks, where the STB provided some clarification of their requirements but many aspects of compliance remain outstanding. Among them are the tax return filing parameters and procedure for claiming tax treaty protection. While the STB did not set a specific deadline for the filing of tax returns and remittance of taxes, QFII/RQFIIs are requested to accomplish these requirements as soon as possible. It is understood that the SAT intends to collect the outstanding taxes by the end of 2015.
The local market participants understand that realized gain should be calculated on a first-in-first-out (“FIFO”), security-by-security, or weighted average method. Each sale order of securities is treated as selling each and every security transferred, and taxed accordingly. The STB clarified that the tax calculation should be done on gross basis, and netting of gains and losses is not permitted. QFII/RQFIIs that instructed their fund accountants concerning their accrual position should evaluate assumptions made on prior CGT accruals and positions taken on tax provisions, and communicate any changes to their fund accountant and their appointed tax advisor.
The determination of the applicable statute of limitations (“SOL") also remains unclear. The SAT and the STB are currently in the process of determining whether the SOL should be 3, 5 or potentially unlimited years. In the meeting with local custodian banks, the STB informed that further confirmation with the SAT and alignment with the impacted tax bureaus is necessary in order to conclude on the length of the applicable SOLs. This issue remains outstanding until resolved by the tax bureaus and the SAT. Clarification of the applicable SOLs is expected to be communicated by the local custodian banks as soon as it is notified. Further, local custodian banks urged the STB to refrain from imposing late payment interest on the retroactive CGT and the STB is considering the proposal.
Although the STB advised that QFII/RQFII can determine independently whether the Chinese securities held by the investor constitute land-rich companies based on the methodology of their choice, the determination of the applicable methodology by the QFII/RQFII is left entirely up to the investor. Subject to the SAT’s right to audit the chosen methodology, a QFII/RQFII may report to the tax bureau their chosen methodology for determination that a security is a land-rich company at the time tax payment is remitted to the tax bureau. Such determination may impact the QFII/RQFII’s ability to claim tax treaty protection against Chinese CGT on gains from securities that are determined to constitute land-rich companies.
To the extent that the issuer of a “Red Chip” company shares is considered a Chinese resident enterprise, gains from such securities may also need to be included by QFII/RQFII in the scope of CGT. A “Red Chip” security is issued by a Chinese company that is incorporated outside of China, but is listed on the Hong Kong Stock Exchange. QFII/RQFII would need to engage with their appointed tax advisor to review their holdings and conduct the necessary investigation into the status of the issuers of any “Red Chip” holdings to determine whether gains from any “Red Chip” securities should be included for the purpose of determining the total CGT liability.
The Chinese tax authorities’ notification to the local custodian banks that QFII/RQFIIs must remit historical CGT illuminated the SAT’s position that the 10 percent withholding tax applies to nonresident investors, but did not provide impacted investors sufficient clarity with respect to the procedural requirements to achieve compliance. Impacted QFII/RQFII clients must turn to their appointed tax advisors for assistance with determining their CGT liability and meeting their tax compliance obligation on historical gains from Chinese securities. Global Custodians are in a position to assist impacted clients with ensuring that accurate transaction data is communicated by the local custodian banks and prior accrual instructions are communicated to the QFII/RQFII’s appointed tax advisor. The local custodian banks should ensure that the relevant tax bureau that is charged with facilitating the remittance of the unpaid taxes is properly informed of impacted foreign investors’ positions. Clients should take necessary steps to evaluate their tax position and discuss the impact with their client service teams and appointed tax advisors.
For more information, please contact your BBH Relationship Manager or Global Tax Services Group:
Europe and Americas:
Stephen Vescio (Global Head) tel: 617.772.6818 email: firstname.lastname@example.org
Maria Gurevich tel: 617.772.6787 email: email@example.com
Mark Walata tel: 617.772.2303 email: firstname.lastname@example.org
Fred Chin (Asia Head) tel: 852.3756.1765 email: email@example.com
Naoko Tani tel: 813.6361.6472 email: firstname.lastname@example.org