China Asset Management has become the first mainland fund house to gain an exemption in Hong Kong from a 10% capital gains tax (CGT) on an RQFII fund.

As a result it will not set aside money to cover the potential levy for the product in question. This sets a precedent that other firms are likely to follow.

The firm received a Hong Kong Tax Resident Certificate for the Rmb8.4 billion ($1.39 billion) ChinaAMC CSI300 Index ETF in late October, paving the way for it to use the Hong Kong-China tax treaty allowing for tax exemptions on trading A-shares.

The offshore arms of Chinese fund houses have typically set money aside to cover some or all of the 10% CGT on funds under the renminbi qualified foreign institutional investor (RQFII) scheme, on the advice of Hong Kong’s Securities and Futures Commission.

The exemption has cleared up some – but not all – of the uncertainty around the issue. China’s State Administration of Taxation (SAT) has yet to make a similar decision on whether or how much to tax foreign investors trading in mainland markets.

Other firms plan to pursue a similar course, including China Universal Asset Management. The firm aims to drop its RQFII tax charge, but declined to comment on the time-frame.

Yang Jian, head of index and quantitative investment, congratulated ChinaAMC. The move will benefit all market participants in respect of ETFs under the RQFII scheme, particularly investors, notes Yang.

Freddy Chen, managing director and head of sales at China Asset Management (HK), says the firm had been working with a tax adviser to find a way to obtain the exemption, talking to mainland and Hong Kong authorities to see whether it is workable. “Obviously, the first mover always takes time,” he tells AsianInvestor.

Under the double taxation avoidance treaty signed by China and Hong Kong, tax residents based in the latter would be exempt from capital gains when trading A-shares. However, 10% CGT will still apply if an investment is made into a land-rich firm – defined as a company where 50% or more of its assets are in immovable property.

Chen says 43 of the 300 constituent stocks in ChinaAMC’s ETF are considered land-rich companies; almost all of them are property firms.

While Hong Kong’s IRD has said the fund may enjoy the tax exemption, Chen says it has not been able to gain clearance from China’s SAT.

“The SAT has never stated very clearly on the withholding treatment on tax, so what we are trying to do is more of a defensive move. In cases where SAT tries to impose some tax on capital gains, we may source some relief from the HK-China treaty for the avoidance of taxable profit.”

Based on an estimation made on January 24, ChinaAMC calculates that ploughing back the tax into the fund will result in a boost of 1.75% to its net asset value. “1.75% should be considered significant considering this is a passive index tracking product,” he says.

“We have been running the ETF for more than one and-a-half-years, and we notice that one of the major sources of tracking error is actually the tax provision policy,” Chen says. “This is something we can’t control so we expect the tracking error can be further reduced after we lift most of the tax withholding provisions.”

The tax exemption removes a major obstacle for institutions investing into China, he adds.