Time for QFIIs and RQFIIs to pay their taxes

It is difficult to imagine that a cross-border investment programme could run for over ten years without a clear tax regime. The Qualified Foreign Institutional Investor (QFII) scheme was launched in 2002 and allows selected overseas institutional investors to convert their foreign currency to invest in China's capital markets. The Renminbi Qualified Foreign Institutional Investor (RQFII) is a similar scheme that was launched in 2011 and allows approved investors to use offshore renminbi to invest in China's capital markets.

A QFII or RQFII should entrust a domestic commercial bank as custodian and a domestic securities company as broker. Through hundreds of approved QFII/RQFIIs, foreign investors were able to invest in Chinese equity, bonds and other financial instruments such as exchange-traded funds (ETFs), warrants and mutual funds.

As of November 28 2014, the cumulative approved quota of QFIIs was US$65.748 billion and Rmb298.4 billion for RQFIIs. Regulators have only recently shed light on the tax obligations for these schemes.

Clarified tax regimes

Business tax

In 2005, the Ministry of Finance (MOF) and the State Administration of Taxation (SAT) issued Caishui [2005] No 155 to exempt QFIIs from business tax.

Income tax

The income tax regime for QFIIs and RQFIIs has been dogged by uncertainty since the schemes were launched. The current corporate income tax laws and regulations have not specifically stated that QFIIs and RQFIIs are subject to taxes in China with respect to gains on the sale of investments. In general, Chinese income taxes for foreign investors are imposed on a source-withholding basis, as stated in Article 3 of the PRC Enterprise Income Tax Law, which stipulates "If a non-tax-resident Enterprise does not have an establishment in China, or if it has an establishment in China but its income is not actually connected with such establishment, it shall pay Enterprise income tax on that of its income sourced in China." QFIIs and RQIIs therefore appear to be liable for a 10% China withholding income tax on gains derived from the sale of A-shares or other equity assets. Most practitioners argue against this interpretation, as the nature of trading portfolio investments is completely different from typical passive income (such as dividends and capital gains) that are subject to withholding tax. Chinese tax authorities have not, however, proactively collected this income tax in the past decade. The MOF and SAT have only recently clarified whether and how to impose the income tax, which holds both advantages and disadvantages for QFIIs.

The good news is that QFIIs and RQFIIs, along with those investing in A-shares through the Shanghai-Hong Kong Stock Connect, will be temporarily exempted from income taxes on gains from the sale of A-shares from November 17 2014, the day the Stock Connect was launched. The bad news is that the MOF and SAT have stated that any gains achieved by QFIIs and RQFIIs prior to November 17 2014 are subject to PRC income tax pursuant to the relevant tax laws.

The Shanghai-Hong Kong Stock Connect is a pilot programme that links the stock markets in the two cities. Under the programme, investors in Hong Kong and mainland China can trade and settle certain shares listed on the other market through the exchange and clearing house in their home market.

Regulators have taken the position that providing the A-shares tax exemption is necessary in order to ensure the success of the Stock Connect. On October 31 2014, the MOF, SAT and China Securities Regulatory Commission (CSRC) issued the Circular on the Issue of Provisionally Exempting the Proceeds Derived in China by QFIIs and RQFIIs from the Transfer of Stocks and Other Such Equity Investment Assets from Enterprise Income Tax (Caishui [2014] No 81), exempting investors from business tax and income tax for gains derived from the trading of A-shares through the Stock Connect. On the same day, the MOF, SAT and CSRC issued the Circular on Tax Policies Relevant to the Pilot Project for the Mechanisms to Provide Mutual Trading Access Between the Shanghai and Hong Kong Stock Markets, or Caishui [2014] No 79 (Circular 79), exempting QFIIs and RQFIIs from income taxes for gains derived from trading of A-share or other equity assets starting from November 17 2014. QFIIs and RQFIIs are afforded a free ride with the Stock Connect in terms of income taxes, as the central government aims to "create fair tax treatment for investors under the Stock Connect and QFII/RQFII schemes".

The trade-off requiring exposure to income taxes for the period before November 17, however, is expensive, potentially costing taxpayers billions of renminbi. Circular 79 stipulates that QFIIs and RQFIIs must pay PRC income taxes for gains achieved before November 17 2014.

Checking tax status: a priority

Most QFIIs and RQFIIs have not paid income taxes during the past ten years. The liquidated Lehman Brothers QFII account appears to be the only QFII to have paid PRC income tax. Conservative QFIIs and RQFIIs had provisioned for income taxes of approximately 10% of profits in case taxes were eventually levied. Aggressive funds have taken other approaches, such as preparing to rely on income tax treaty protections.

QFIIs and RQFIIs with tax provisions need to approach the tax authorities to verify the calculation method and coordinate the payment of taxes. QFIIs and RQFIIs without provisions will need to revisit their tax status as China continues to restrict the granting of tax treaty benefits. Shell companies may be denied benefits even when a tax treaty protection is claimed.

For QFIIs and RQFIIs, Circular 79 ends over ten years of ambiguous tax policy. For other taxpayers, it serves as an important lesson: many uncertain tax positions represent merely a matter of when, not if, taxes will be due.


Kevin Wang and Pingting Ren, AllBright Law Offices, Beijing


More from CLP:
Circular on the Issue of Provisionally Exempting the Proceeds Derived in China by QFIIs and RQFIIs from the Transfer of Stocks and Other Such Equity Investment Assets from Enterprise Income Tax
Circular on Tax Policies Relevant to the Pilot Project for the Mechanisms to Provide Mutual Trading Access Between the Shanghai and Hong Kong Stock Markets
PRC Enterprise Income Tax Law