Tax conundrum may explain Stock Connect delay

With the Shanghai-Hong Kong Stock Connect having failed to arrive on time, the thorny issue of capital gains tax may be the cause.

For the Shanghai-Hong Kong Stock Connect, 27 October 2014 had been the start date that had been anticipated by many in the industry.  Despite the authorities having trumpeted its introduction for six months and systems testing having been completed, October has come and will now pass without the Stock Connect having gone live.

As the anticipated start date approached, pronouncements from officials diminished to the point of almost complete silence. Over the weekend, Hong Kong Exchanges and Clearing (HKEx) said it had not received the relevant approval for the launch of Stock Connect, and there was no firm date for its implementation.

Capital gains tax could be the reason for the delay. Capital gains tax does exist in China and the question about whether foreigners should pay any sort of capital gains tax on Chinese shares has been an issue tabled for many years at the China Securities Regulatory Commission (CSRC) and the State Administration for Taxation (SAT).

There are other bodies in China equally interested in the situation, including the Ministry of Finance (MOF) and the currency regulator, the State Administration for Foreign Exchange, (SAFE).

The CSRC would like there to be no taxation, because it is in their interests to have lower taxation in China’s stock markset. The SAT’s job is made easier if they do not have to collect tax. The MOF is the recipient of the tax, so it would be in their interests to get the money.

“As foreigners have traded in the markets for ten years via Qualified Foreign Institutional Investor (QFII) scheme, they have accumulated a potential tax liability, which at some future point, China may collect,” says Aaron Boesky, the CEO of Marco Polo Pure Asset Management in Hong Kong. “There was a similar occurrence in Taiwan, where foreigners were charged back taxes. Also in China, in 2010, the SAT announced they would collect a dividends tax on QFII’s and collect that back to 2008. So there exists a local precedent that they may go back a year or two. They still collect this tax today.”

With QFII quotas held by not only the world’s biggest institutions, but by governments like Kuwait and Singapore, there is pressure on China to provide clarity on the capital gains tax situation

The results of any QFII taxation decision impact on what applies to Stock Connect – and vice-versa.

If China has one rule for Stock Connect – in which they are not taxed and one rule for QFII  – in which they are taxed, then Boesky feels that QFII would inevitably close, as everyone would exit in order to take advantage of the preferential conditions in the other scheme.

“It is possible Stock Connect investors will have to withhold some of their gains in the form of a contingent liability in the event that they get collected on later,” he said. “Your contingent withheld liability would stay with the broker. If you move brokers, the inheriting brokers would receive the records of how much you paid for shares and they would withhold the contingent tax. It is logistically possible to apply capital gains tax to all these programmes.

He understands from his sources that the start of the Stock Connect programme needs to trigger an announcement that finally clarifies taxation for foreigners in China. However those discussions that have taken place in China have revolved around both extremities, namely, that there will be a waiver, or, alternatively that there will be a tax applied. At this point clarity is still needed, although there seems little sense of urgency.