The securities regulators and stock exchanges of Hong Kong and Shanghai have released further details on the mechanics of their Stock Connect programme, although questions remain over taxation.

The regulators announced their own draft regulations for the landmark scheme, which links the two bourses and allows institutions and wealthy people to trade cross border. The initiative was unveiled by Chinese premier Li Keqiang on April 10, as reported.

It has been confirmed that quota will be granted at the exchange level, freeing participants and brokerages from the headache of dealing with quota directly, notes Shanghai-based consultancy Z-Ben Advisors.

The programme will not allow short-selling or margin trading, and brokerages will be restricted from block trading and dark-pool trading. The latter will keep programme flows within exchange, where they can be monitored effectively, Z-Ben states.

The overall quota cap for daily trading held at the exchanges has already been revealed, at Rmb13 billion for northbound investment and Rmb10 billion for southbound.

Updates confirm these amounts are net of the daily ownership total within the programme, which means there could be a self-correcting mechanism for additional demand, notes Z-Ben. As more participants enter, greater volume could push daily totals traded over the stipulated amounts, although flows are capped by quota limits.

“A new stipulation on price fluctuations was also most likely implemented to allay fears of very rapid outflows or decreases in price in any individual stock,” observes Z-Ben in a report.

It stresses that large institutions with multiple avenues of holding A-shares – the QFII, RQFII and now Stock Connect programmes – will need to monitor their daily activity closely, given the total foreign ownership limit of 30% appears to remain in place.

But both Z-Ben and consultancy KPMG point to outstanding questions regarding tax, including the implementation of double tax relief under the Hong Kong and China double tax treaty.

The only additional tax guidance in this week’s update came in the form of a 10% withholding tax for dividends and bonus shares. But there was no mention of capital gains tax.

KPMG notes that in the 11 years that the QFII initiative and more recent RQFII scheme have been operating, there have been uncertainties over China tax consequences of such investments, with operational discrepancies for foreign investors.

On the Stock Connect scheme, KPMG outlines additional questions. If treaty protection is available for withholding tax on dividends and capital gains, it asks, how does a taxpayer claim this and what are the prerequisites for making a claim?

Further, it asks who would be liable for the collection and payment of withholding tax? How are capital gains calculated? What trade-related expenses can be deducted from the gain? And what about carry forward or back of trading losses?

Nevertheless, Z-Ben expresses confidence that China’s State Administration of Taxation will act soon to clarify taxation issues prior to the scheme’s launch, which could be as soon as this October.

Similarly it expects more details on how trades can be placed, which at present appears to be purely on a first-come, first-served basis.

It suggests northbound interest will outstrip southbound flows, given there is already a potentially ready market built into the Greater China fund management space.

Z-Ben sees the Stock Connect programme appealing to smaller institutions and hedge funds, which have faced challenges accessing QFII, while other asset managers could substitute some of the synthetic holdings for physical A-shares as a cheaper option.

This scheme is forecast to complement – rather than replace – the existing QFII, RQFII and QDII initiatives, at least for the foreseeable future. But ultimately it provides a means for these other cross-border schemes to be wound down, while increasing flexibility in cross-border investment in the near term, notes Z-Ben.

“A decade from now, institutions that would have once utilised QFII alone may be able to make the bulk of their A-share purchases through Hong Kong,” Z-Ben says.

It notes that near-term expansion of the programme to include the Shenzhen Exchange could increase its attractiveness. While Z-Ben does not expect major flows overnight, “the infrastructure for a transition to a more open investment account for Greater China now appears to be coming into place.”