Outbound investments from China

Outbound investments from China

For Chinese individuals making outbound investments, overcoming the obstacles from the aspects of regulatory and foreign exchange control becomes a priority.

As China is now the second largest economy in the world and produces millionaires and billionaires faster than any other country every year, going abroad and investing overseas has become increasingly attractive for Chinese individuals.

While many Chinese high net worth individuals are emigrating from China to other countries such as the US, Canada, the UK, Australia, and Singapore every year, and while the Chinese tourists are now the biggest customer group of luxury goods in Europe, investing overseas by Chinese individuals is still a mission impossible. For example, a Chinese individual cannot remit out cash of more than USD 50,000 a year even for buying a home. In addition to the difficulty in moving money offshore, investing overseas by Chinese individuals requires strict government approval, for which amazingly no clear rules have been issued so far.

Regulatory Approval Requirement for Outbound Investments

From a legal perspective, investment overseas by Chinese individuals mainly involves two big issues – the regulatory approval requirement and the foreign exchange control restriction.

In 2004, the National Development and Reform Commission (the “NDRC”) issued the “Interim Measures for the Administration of Verification and Approval of Overseas Investment Projects” (the “Measures”). The Measures primarily apply to Chinese enterprises. However, Article 26 of the Measures states that “with regard to the verification and approval of a project carried out by an individual or other organization, these Measures shall apply as the reference”.

With that, it seems that the examination and approval procedures for overseas investments by individuals shall be the same as that applicable to Chinese enterprises. However, in practice, this has not been tested so far and we are not aware of any case where a Chinese individual has successfully gone through such approval procedures.

Furthermore, after getting the NDRC approval, an investor needs to get one more round of approval from the Ministry of Commerce (the “MOC”). However, the “Measures for the Administration of Overseas Investment” issued in 2009 by the MOC only set out the specific approval procedures for Chinese enterprises, without any specific references to offshore investments by Chinese individuals. Following the common legal practice in China, no rules usually means not allowed. As a result, the MOC will simply not accept an application for approval for overseas investments by Chinese individuals.

Foreign Exchange Control

The foreign currency used for overseas investments by Chinese individuals is deemed as for capital use, which is currently under strict control. Although the existing foreign exchange control rules seem to allow that overall, there are no operating rules setting out whether and how individuals can apply to the relevant authorities for remitting out cash of more than USD 50,000 every year.

In practice, the foreign exchange authorities will simply use this as a reason for turning down such a request. The annual quota of USD 50,000 is stipulated in the “Administrative Measures for Personal Foreign Exchange”. As such, Chinese individuals often find it impossible to obtain the foreign exchange approval for overseas investments.

How to Get around Those Obstacles

Among many creative ways for getting around the legal obstacles mentioned above, the more straightforward way is for a Chinese individual to use a Chinese company as the investment vehicle. This is allowed although various government approval and registration procedures have to be followed. This structure may have a tradeoff from a Chinese tax perspective though, because it adds one more layer of Chinese tax.

For example, if an individual directly invests in a HK company and sells the HK company later on, the capital gains will be subject to a 20% Chinese individual income tax. If the individual invests in HK company through a Chinese company, the same capital gains will be first taxed at 25% at the Chinese company level and further taxed at 20% at the individual shareholder level (i.e. at an effective tax rate of 40%).

Another way is for a Chinese individual to form an offshore company in one of the traditional offshore financial centers such as the BVI, the Cayman Island and HK and use transfer pricing techniques to move cash from China to that offshore company. For example, the individual may arrange for a Chinese company he or she owns to export products to a HK related company at a relatively low price, which will then sell such products to a third party at a high price. This obviously creates a tax issue as transfer pricing between two related parties is always subject to scrutiny. However, many Chinese individuals tend to ignore such a risk.

A third way is to use a bank product that is called “security onshore and lending offshore” to get a loan overseas. A simple description of that product is that a Chinese individual will arrange for a Chinese company that he or she owns to place a security with a bank in China, which will then instruct an overseas branch to grant a loan to an overseas related party of the Chinese company. Technically speaking, the Chinese company must own the overseas company. In practice, this requirement is not always followed by banks.

Other than those ways of moving cash offshore, which are technically legal, there are other alternatives. But most of those alternatives are within the grey area and some even directly violate the Chinese foreign exchange rules. One example is to move cash offshore by using an underground fund remittance agency. https://www.zhonglun.com/

Why Chinese HNWIs wishing to establish offshore trusts should act now?

Why Chinese HNWIs wishing to establish offshore trusts should act now?

Chinese HNWIs should act now as China may introduce a tax reform with the new estate tax, exit tax on emigration and adopt new rules to tax the contribution of appreciated assets into an offshore trust.

Chinese high net worth individuals (“HNWIs”) are very interested in using offshore trust for wealth planning because of the unique benefits offshore trusts offer and also due to the fact that Chinese domestic trusts are not suitable for wealth planning.  As to the timing, we think Chinese HNWIs should act now so that they could avoid the adverse consequences caused by the next wave of Chinese tax reform.

China may introduce estate tax soon

Estate tax has suddenly become a very hot topic in China recently.  There has been a lot of media coverage on this over the past few months.  In 2004 the Ministry of Finance issued a draft of the Provisional Regulations on Chinese Estate Tax for public comments.  Although the draft was revised again in 2010, it had never become law.

The introduction of estate tax was then repeatedly mentioned as a medium term goal in several important resolutions on reform adopted by the central government over the past few years.  There were even rumors earlier this year that Shenzhen would become the first city to introduce estate tax on a pilot basis, which caused widespread panic among local residents, but those rumors turned out to be a false alarm.

Why estate tax has suddenly become a media focus is the natural result of the widespread frustration and anxiety among Chinese people about the increasing income disparity between the rich and the poor. The people who are in favor of estate tax argue that estate tax can significantly help to solve this income disparity issue.

However, the opponents take the view that it is simply too early to introduce such tax in China because China doesn’t even have the required basic infrastructure for collecting and administrating such tax (e.g. a nationwide asset registration system and a reliable asset valuation system), let alone certain key technical issues that would need great wisdom to figure out the answers for, such as the exemption amount, the tax rate, etc..

Despite of those hurdles such as the infrastructure and the difficulties in working out those technical issues, in my personal view, because generating additional tax revenue from estate tax is not a top goal for China (at least not yet), the timing for the introduction of estate tax in China would mainly depend on whether and how quickly China can have good control over the income disparity issue.  If China fails to do so, estate tax may arrive much earlier than people would anticipate.

Needless to say, if China introduces estate tax, it will automatically introduce gift tax.  So for those who think they could get around with the estate tax by giving wealth to their children or other family members as gift should think again.

China may also introduce exit tax on emigration

Many countries impose an exit tax on persons who cease to be tax residents in those countries.  This often takes the form of a capital gains tax against unrealized gain attributable to the period in which the taxpayer was a tax resident of the country in question.  Exit tax can be assessed upon change of domicile, habitual residence or citizenship.

China also taxes its tax residents on worldwide income, but nonresidents are taxed only on China sourced income. So if a Chinese individual becomes a nonresident from a resident, under current Chinese tax rules, the person will no longer need to pay Chinese tax on non-China sourced income, even if the income represents the unrealized capital gains attributable to the period when the person was still a Chinese tax resident.  The change of such tax residency often takes place when the person emigrates from China to another country.

We may see a change to such rules soon if the current emigration wave continues to rise.  Although there is no official study confirming this, China is now the largest emigrant source country in the world.  While the emigration is generally not Chinese tax-driven, it will be just a matter of time before the Chinese tax authorities realize the resulting permanent tax revenue loss.  At that time, the introduction of exit tax would likely be inevitable.

China may adopt new rules to tax the contribution of appreciated assets into offshore trusts

China currently doesn’t have any specific tax rules on trust.  As a result, in the case of offshore trust, when a Chinese settlor contributes appreciated assets (e.g. company shares) into a trust, people generally would take a position that the contribution should not give rise to any Chinese tax.  If such appreciated assets are offshore assets, when they are disposed of by the trustee, no Chinese tax would apply because the trustee is not a Chinese tax resident.

If the trustee distributes such income to the beneficiary or beneficiaries, under current Chinese individual income tax rules, another position could be generally taken that the distribution should be considered gift and thus not taxable in China.   In other words, the use of offshore trust could minimize the Chinese tax that the settlor should have paid if he or she disposed of such assets directly.  The current capital gains tax rate for individuals is 20%.

China will soon reform its individual income tax law. The trust taxation rules will certainly be part of the reform and it won’t be too difficult for the Chinese tax authorities to detect the loophole mentioned above.  Or they may fix it earlier simply by introducing a deemed sale rule or a general anti-avoidance rule. https://www.zhonglun.com/en/