China Tax Limbo Has Investors Guessing Before Bourse Link

When is a tax not a tax? When you’re investing in Chinese stocks.

While the nation’s laws suggest foreign equity investors are subject to a 10 percent levy on capital gains, the government has never collected the tax, according to PricewaterhouseCoopers. Confusion over the policy since China’s quota system for foreigners began more than a decade ago has led to a mishmash of compliance, with some setting aside cash for the liability and others anticipating it won’t be implemented, according to HSBC Jintrust Fund Management.

Pressure is increasing on China to spell out its stance as the country moves closer to starting an exchange link with Hong Kong that will give foreigners unprecedented access to the $3.5 trillion stock market and boost the yuan’s role in global financial transactions. MSCI Inc., which kept mainland shares out of its global indexes in June, says the lack of clarity on tax policy is one of investors’ biggest concerns.

“All this creates uncertainty, and international investors don’t like uncertainty,” Sebastien Lieblich, an executive director at MSCI Index Research, said by phone from Geneva. “They don’t want to be left in limbo.”

China is counting on demand from foreign money managers to boost equity valuations from near record lows and turn Shanghai into a global financial center. Tax policy was one of several market-structure shortcomings, including capital controls and rules against same-day trading, cited by investors when MSCI gathered views on mainland shares for its June index decision.

Cross-Border Trading

“I want them to decide soon about the tax,” said Ryosuke Kawahata, a Tokyo-based money manager at Mizuho Asset Management Co., which oversees about $39 billion, including mainland shares through China’s Qualified Foreign Institutional Investor program. “I’d like to know if we should be investing on expectations we will give up 10 percent, if we need to set aside some cash.”

Hong Kong’s bourse is working with mainland authorities to clarify how the law will be implemented before the exchange connect begins, it said in an e-mailed response to questions this month. The China Securities Regulatory Commission and the State Administration of Taxation didn’t respond to faxed requests for comment.

Authorities said in April the link would start in about six months. The exchanges agreed to allow as much as 23.5 billion yuan ($3.8 billion) of daily cross-border trading, opening up the mainland market further to foreigners while giving wealthy Chinese investors a route to buy Hong Kong stocks.

Market Support

While MSCI’s Lieblich says it’s unclear when China will clarify the tax rules or what policy makers’ decision will be, the fund tracker Howbuy predicts authorities will delay enforcing a capital gains tax until they’re confident shares can weather such an announcement.

“Like elsewhere in the world, the regulators actually care very much about market performance,” Zeng Linghua, the Shanghai-based head of research at Howbuy, said in a phone interview. “Only when the market has grown big and strong enough to be capable of withstanding the repercussions, will the government start to tackle the issue.”

For investors based in the mainland, the nation’s personal-income laws stipulate a 20 percent tax, though authorities have exempted them from the levy since 1994 to promote development of the stock market.

Valuation Gap

Confusion over tax policy hasn’t kept foreigners from increasing their holdings of yuan-denominated mainland equities, known as A shares, through the QFII program. China approved about $57.9 billion of the quotas as of July 30, up from about $45 billion a year earlier, according to the State Administration of Foreign Exchange.

The Shanghai Composite Index has climbed 9.4 percent from its low on March 20 amid speculation government stimulus will boost economic growth and that the exchange link will lure arbitragers to mainland shares trading at a lower prices than their Hong Kong-listed counterparts.

Companies with dual listings are valued at a discount of about 8 percent on the mainland versus Hong Kong, according to the Hang Seng China AH Premium Index.

Money managers who want to avoid China’s tax regime can get exposure to the country by purchasing shares of mainland companies in Hong Kong, which has no capital gains tax. The Hang Seng China Enterprises Index has climbed 21 percent since March 20, twice as much as the Shanghai Composite.

The mainland index rose 0.9 percent today, while the Hang Seng China index added 0.1 percent.

“This is potentially a big deterrent for investors and the connect is very important to regulators,” said Jesse Lazarus, an analyst at Shanghai-based Z-Ben Advisors Ltd., an investment-management consulting firm. “We expect they are going to finally release what that tax rate is.”

— With assistance by Kana Nishizawa, Shidong Zhang, and Allen Wan

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