Uncertainty over whether China will charge a 10% capital gains tax on QFII and RQFII funds is becoming an increasingly big issue as these programmes expand. And sources say there’s no indication of when the situation might be clarified.

While the 10% levy has not yet been enforced by China’s State Authority of Taxation (SAT), some fund houses have been setting aside provisional reserves in anticipation of the tax charge.

These provisional amounts vary from firm to firm, especially in respect of qualified foreign institutional investor (QFII) fund managers, notes Jeremy Ngai, a partner in the China tax and business advisory services at consultancy PwC.

For example, some may set aside 5% of capital gains, half the figure set by SAT. This is because firms’ assessment varies as to the likelihood of SAT actually collecting the levy, he says.

Some QFII holders, meanwhile, argue that as they should be exempt from capital gains tax (CGT), due to double-taxation treaties between China and certain countries. As such, these QFII holders are not making tax provisions, Ngai adds.

RQFII fund managers, on the other hand, have been more consistent in setting aside 10% of capital gains. Many existing RQFII funds are domiciled in Hong Kong, and as such, fall under Hong Kong regulations.

One source close to discussions with China’s SAT tells  AsianInvestor that the tax authorities had considered granting full exemption to QFII capital gains, mirroring other countries’ tax treatments on QFII such as the US.

The China Securities Regulatory Commission has in the past weighed in on the debate, stating that collecting the tax and enforcing the rules would be difficult, adds the source.

However, the proposal has been rejected by some Chinese financial authorities, which say such capital tax exemptions would be a disadvantage to domestic investors, who are already subject to a 25% tax for trading mainland stocks.

Hong Kong’s Securities and Futures Commission has already had discussions about this issue with the Hong Kong arms of mainland asset managers, and has been encouraging fund firms to set aside 10% of capital gains. 

However, setting aside the money in anticipation that China’s SAT will start charging CGT is burdensome, especially for RQFII ETFs, says an executive at the Hong Kong unit of a mainland fund house. He argues that the decision to withhold 10% of CGT could increase the tracking error among such products.

The higher the return, the larger the amount of cash that may be taxed, says the fund executive. “This is bad for ETFs, because supposedly you should have the lowest cash levels possible. An ETF is supposed to invest all gains – at least 99% of cash levels should be tracking the underlying stocks. Once you have high levels of [non-invested] cash reserves, you start to deviate away from the index.”

And then there’s the uncertain role of Hong Kong brokers. Mainland brokers are technically responsible for collecting levies from Chinese fund houses, and so presumably Hong Kong prime brokers will be responsible for collecting taxes from the Hong Kong subsidiaries.

But the lack of action from SAT has kept them on the sidelines and left the decision about whether to withhold tax down to the fund manager and their trustees.

“We can’t predict what will happen, so we just take a conservative approach,” says the fund executive. “If you leave it as reserve and if the SAT decides to tax the fund, at least it won’t affect the NAV and current unit holders won’t face a loss.

“By contrast, if the tax authorities don’t take the reserve, the money can be used to invest in stocks to increase the NAV for the benefit of the investors.”

Neither the CSRC nor the SAT responded to requests for comment.