Tax clarification from China could yield funds windfall

There remain a number of obstacles before the new Shanghai-Hong Kong Stock Connect in finalised. An answer to one, the question of capital gains tax, could have the ancillary benefit of resolving a long outstanding issue for QFII funds.

 There are a number of obstacles to the new Shanghai-Hong Kong Stock Connect. Whilst each could hamper the success of the new project, an answer to one of them, the question of capital gains tax, could have the ancillary benefit of resolving a long outstanding issue that have affected funds trading Chinese equities.

Numerous funds that have been previously operating in China using a Qualified Foreign Institutional Investor Scheme (QFII), have been deprived of clarification of their capital gains tax status, and pending that decision from the taxman, a portion of their profits have been withheld.

The same question arises for the Stock Connect. Is capital gains tax payable or not? It appears as though levying the tax for the Stock Connect is just not feasible.

 “Capital gains tax liability for a firm with a QFII can be calculated because counterparties have all the trading records. In the case of the Stock Connect they cannot, as customers might use several brokers and accounts can be moved,” said Nick Ronalds, managing director, equities, at the Asia Securities Industry and Financial Markets Association (ASIFMA). “It would be impossible for brokers to calculate a tax liability if the State Administration for Taxes asked them for it. Could tax authorities then say that the brokers themselves are liable for retroactive taxes? In the absence of a rule saying that they would never do that, even the possibility of it happening would be off-putting and untenable to brokers.”

Charles Li, the CEO of Hong Kong Exchanges and Clearing (HKEx) has said that the matter of capital gains tax clarity is close to resolution for the Stock Connect, but if resolved for the Stock Connect, then as a by-product it also has to be resolved for QFII. If the tax has to be waived for Stock Connect, then the precedent is set for QFII, and that will be good news for China A share funds as their withheld money could be returned.

Another matter that has to be resolved for the Stock Connect is the question of beneficial ownership. HKEx’s clearing entity CCASS will in effect be a clearing member of the Shanghai Stock Exchange’s clearing house, ChinaClear. Shares that are held by CCASS on behalf of counterparties and clients will be in ChinaClear and subject to Chinese law.

The legal term ‘security of ownership interest’ considers how the investor can be certain that shares are really his. In most developed countries there is the concept of nominee structures, such as a trust bank, where assets are held by an institution but are recognised as not owned by the bank. Therefore, creditors of the bank would not attach those assets in a liquidation.

“In the case of CCASS there is a remote possibility they could go bankrupt –  so the question is whether a creditor could then attach shares held at ChinaClear,” said Ronalds. “Some clarification would dispel questions. Currently, it is not explicitly addressed – neither Hong Kong or China have issued their final rules, so the logical way for it to be addressed is for the final rules to state that shares are held on a nominee basis.”

Another issue that is a hindrance to participants is that of pre-delivery of shares. It would be a surprise if that was fully resolved by day one.  

“Pre-delivery means that institutions on the buy-side have to transfer their shares to brokers on virtually a daily basis,” said Ronalds. “They don’t necessarily know in advance what shares they are going to buy and sell. Plus it is not the way buy-side systems are set up. It is also not the way traders think about their strategies. It’s a significant problem especially for traditional buy-side institutions.”

There are other matters that are impeding the Stock Connect.  A daily and aggregate quota for traders creates execution uncertainty for traders.  Based on comments made by exchanges and other parties, the quota will be expanded and may be done away with in future. But until then there is uncertainty.

In addition, payment for mainland shares has to be done in RMB, but in the CNH offshore version of RMB which is subject to its own supply and demand. There has to be certainty that there is sufficient liquidity therefore at certain times of day, in order to fund transactions.

Currently, several issues may potentially put off a trader from using the Stock Connect.

“There are still much to do before the launch of Shanghai-Hong Kong Stock Connect,” said Michael Karbouris, the head of Asia Pacific business development at NASDAQ OMX. “All outstanding regulatory approvals must be granted, trading and clearing rules need to be finalised, and systems will need to be fully developed, configured and tested before they can go live. Unresolved issues include beneficial and foreign ownership rights as well as tax treatment. These will require concrete, defined rulings by regulators and exchanges.”

For all Stock Connect loose-ends for matters to be fixed by the scheduled start date of 13 October 2014 may be too ambitious, and amendments in that case will have to be made when it is up and running.