At a compliance seminar held last month, officials from the Asset Management Association of China (AMAC) and the State Administration of Taxation (SAT) informed industry executives that Chinese regulators are planning to retrospectively implement a 10% capital gains tax (CGT) on equity investments made under the Qualified Foreign Institutional Investors (QFII) and Renminbi Foreign Qualified Institutional Investors (RQFII) programs for the period 17 November 2009 to 16 November 2014. When made official, it is expected that this decision will have serious implications for offshore funds that invested in the People's Republic of China (PRC) through the QFII and RQFII programs during that period.

Background

There has been much uncertainty over the issue of the CGT since the inception of QFII and RQFII programs in 2002 and 2011, respectively. While PRC laws have suggested that foreign investors were subject to CGT on equity investments, CGT was never collected. This led to confusion amongst foreign investors as to whether CGT is payable and due, and has led to some investors making provisions for the CGT liability while others have been anticipating that it will not be implemented.

On 15 November 2014, the PRC Ministry of Finance, the SAT and the China Securities Regulatory Commission (CSRC), issued a circular (Caishui [2014] 79) clarifying the PRC's CGT policy in respect of QFIIs and RQFIIs. In that circular, QFIIs and RQFIIs (provided that they do not have an establishment or place of business in the PRC) would be exempt from CGT from 17 November 2014 onwards. However, investment gains by QFIIs and RQFIIs before 17 November 2014 would be subject to CGT. No details were given in the circular as to the method and basis upon which such CGT would be levied.

In February 2015, further information about aspects of the CGT were provided at a compliance seminar organised by AMAC in Beijing. According to the participants, CGT would be levied at the rate of 10% on all investment gains (including dividends, interests and capital gains from transactions) involving equity investments in PRC for the period from 17 November 2009 to 16 November 2014. Equity investments would, for this purpose, include A-shares, B-shares, mutual funds, warrants and index futures. Investment gains derived from transactions involving pure debt investments are not covered by the scope of this implementation.

It has been reported, unofficially from the compliance seminar, that the CGT would be based on gains in relation to each separate transaction and that profits and losses from multiple transactions cannot be offset. Similarly, it also has been reported that a penalty would be levied on overdue CGT on dividends and interests, but not for overdue CGT from transactions involving equity investments.

Collection of CGT

The Shanghai and Shenzhen branches of the SAT will be jointly responsible for the collection of the CGT.
QFIIs and RQFIIs will be required to submit related documentation (including detailed records of each transaction during the period 17 November 2009 to 16 November 2014) to the relevant branch of the SAT before 31 July 2015. QFIIs and RQFIIs wishing to apply for exemptions under international tax treaties will be able to submit related documentation for further approval. Full payment of the CGT will have to be made by September 2015.

Impact on Foreign Funds

Although details of the CGT have not yet been officially announced by the PRC authorities, the decision to implement the CGT could potentially have a serious impact on foreign funds that invest through the QFII and RQFII programs.

Implications for QFIIs and RQFIIs

Under PRC law, the responsibility for the CGT payment rests on the relevant QFII/RQFII, regardless of whether the QFII/RQFII is investing for itself or others. QFIIs and RQFIIs that invest in PRC for Foreign Funds, would typically have a right in their contracts to withhold 10% for purpose of CGT and/or indemnity/reimbursement provisions relating to PRC tax (including CGT). We expect that in most cases, a sufficient amount has been withheld by the relevant QFII/RQFII, and this will not be an issue. However, in cases where no amount is withheld, or where the amount withheld falls short of the actual CGT levied (which could be the case since CGT would be levied on net gains of each transaction rather than net gains on multiple transactions), a QFII/RQFII would have to rely on the indemnity/reimbursement provisions under its contract with the Foreign Fund. In the absence of any indemnity/reimbursement provisions, a QFII/RQFII would most likely have to bear the CGT shortfall without recourse to the Foreign Fund.

Implications on Foreign Funds

Where the CGT amount is not withheld (or sufficiently withheld) and the Foreign Fund has agreed to indemnify or reimburse the QFII/RQFII holder, there would be issues for the Foreign Fund in meeting this contractual obligation. A Foreign Fund would most likely have two options available:

1. Recovering the amount from those investors that invest with it during the period 17 November 2009 to 16 November 2014. 
2. Liquidating assets currently in its portfolio (if there are assets).

There are issues with both options. In pursuing the first option, the Foreign Fund would have to ensure that it has, in its fund documentation, an indemnity/reimbursement provision which is drafted broadly to allow it to recover the CGT amount from its investors and, more importantly, from investors that had already exited the Foreign Fund. If there is such a provision, the Foreign Fund would need to deal with other practical issues, for example, whether these investors still exist (they may be wound up or deceased) or if they can be successfully located.

If the first option is not possible, or the amount cannot be otherwise recovered in full under the first option, a Foreign Fund would most likely have to pursue the second option, by liquidating its current assets to fund its CGT obligation. While this would not be a problem if all investors in the Foreign Fund are the same during the period 17 November 2009 to 16 November 2014, there will be issues where the investors are different, particularly the potential disputes with existing investors of the Foreign Fund in using their assets to fund its CGT obligation that should have been payable by the exited investors.

In any event, all Foreign Funds may want to review, in detail, their fund documentation with investors, and arrangements with the QFII/RQFII, to better understand and assess the options available to them in dealing with their CGT obligations.

Looking Forward

We are still awaiting official announcements from the relevant PRC authorities, including the PRC Ministry of Finance, the SAT and the CSRC in relation to the CGT issue. We will publish further alerts on this topic as and when additional information is available.