77ti0349 zhao turley by Conrad Turley

Volume 77, Number 4

by Abe Zhao and Conrad Turley Reprinted from Tax Notes Intâ&#x20AC;&#x2122;l, January 26, 2015, p. 349

Foreign Investment in Chinese Public Securities Markets â&#x20AC;&#x201D; Remaining Tax Issues

January 26, 2015

by Abe Zhao and Conrad Turley

Abe Zhao is a tax partner based in KPMG’s Beijing office, and Conrad Turley is an international tax senior manager based in KPMG’s Beijing office. This article examines the current state of portfolio investment routes into Chinese public markets for listed securities and their anticipated development into the future; the manner in which historic arrangements for investing from overseas into Chinese public markets for listed securities gave rise to potential tax exposures, and the stance of foreign investors regarding these exposures; and the impact of the latest tax authority policies on both the prospects for foreign investors from now on, and for their legacy tax exposures in the past.

he launch on November 17, 2014, of the highly anticipated Shanghai-Hong Kong Stock Connect program, the latest move in the integration of Chinese and global public markets for listed securities, was accompanied by a number of key announcements by the tax authorities directed at settling some long-running areas of tax uncertainty for foreign investors into China. Specifically, a temporary exemption from Chinese corporate income tax (CIT) on capital gains from ‘‘A’’ shares traded through the new Stock Connect program, and through the existing investment arrangements for qualified foreign institutional investors (QFIIs) and Renminbi QFIIs (RQFIIs), has been put in place, while tax settlement notices regarding the legacy

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tax liabilities under the QFII/RQFII arrangements are expected to be sent to QFII/RQFII license holders soon.

I. The Regulatory Environment The creation of the existing channels for portfolio investment in Chinese public markets for listed securities is a complex story, but must be considered to understand that: • portfolio investment into China to date has necessarily been indirect, via QFIIs/RQFIIs, and this is a major cause of the existing tax complexities; and • the existing level of foreign investment in Chinese listed securities, built up over more than a decade, is a miniscule fraction of what is to come, as the three key obstacles to expanded foreign portfolio investment in China — quota allocations, capital mobility, and taxation of capital gains — are resolved. Since the early 1990s, the ‘‘B’’ share markets in Shanghai and Shenzhen allowed for Chinese enterprises to raise equity from, in U.S. dollars and Hong Kong dollars respectively, and gave China portfolio investment access to foreign investors. The red-chip and ‘‘H’’ share listings of many Chinese enterprises on the Hong Kong Stock Exchange, and of further listings of Chinese enterprises on the U.S. and other countries’ exchanges, provided further avenues to foreign portfolio investors to invest in foreign-currency-denominated equity in Chinese enterprises. However, it was only with the inauguration of the QFII program in 2002

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Foreign Investment in Chinese Public Securities Markets — Remaining Tax Issues

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The QFII program was, however, quite restrictive. Only the largest global fund houses and banks were permitted to apply for licenses, and were granted only limited quotas for conversion of foreign currency to renminbi for purchasing A shares, under the tight foreign exchange control regime for capital accounts in China. Further, until recently QFII license holders were not able to establish separate, segregated securities accounts2 for the clients whose monies they invested. As such, most foreign portfolio investors, not being able to obtain QFII licenses in their own right, needed to use indirect investment arrangements into China facilitated by these QFII license holders, under which the latter would be the registered owner of the invested securities. Popular in this regard were so-called access products, derivatives sold by QFII license holders under which economic exposure to certain underlying A share investments was granted to product purchasers while, at the same time, the QFII license holder retained legal and beneficial ownership in the A shares required to hedge the access products and booked the dividends and gains from the A shares to its own accounts. Structuring these arrangements was quite lucrative for QFII license holders. So-called agency products were also frequently offered, under which the QFII license holders invested in A shares for the account of their clients, and the contracting for which recognized the QFII license holder as holding the A shares solely as nominee for the client. As noted, however, the QFII was necessarily the registered owner of the shares with the exchange. In particular, QFII license holders often lent their quota to institutional investors such as hedge funds. International mutual fund managers used both of these products in constructing their China-focused mutual fund portfolios, though given liquidity concerns most funds tended to invest the overwhelming majority of funds in Hong Kong and U.S.-listed Chinese enter-

This article covers foreign portfolio investment into the Chinese listed shares in the secondary market. Foreign strategic investment into the Chinese A shares in the primary market is governed by a separate program and is not within the scope of this article. 2 Until 2012, solely QFII proprietary accounts or omnibus nominee accounts could be set up. As a consequence, the QFII license holder would be the registered owner of all A shares, and the holding of QFII proprietary and client assets would be commingled. Even when an omnibus nominee account was used, the related assets might not be treated as separate from the assets of the QFII/custodial bank, leading to advisor custody, account segregation, and asset protection concerns.

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prise shares. From a fund manager perspective, quota limitations could make it difficult for managers to fully replicate the A share index. Enhancements to the QFII rules in 2012 significantly relaxed the restrictions. These new measures: • allowed for separate securities accounts to be set up for the assets of each client, alleviating custody and asset segregation concerns; • provided for an expansion of the asset classes into which investment could be made;3 and • allowed for a relaxation of the QFII license application requirements4 and significant increases to QFII quotas,5 thus making mutual fund managers more likely to obtain their own QFII licenses for investing on behalf of their funds. At the same time a ‘‘sister initiative’’ of QFII, RQFII,6 allowed for investment of renminbi obtained in the offshore market into Chinese listed markets and quickly became popular in the structuring of exchange traded funds (ETFs) for investing in both A shares and Chinese bonds.

3 In 2012 QFII investment scope expanded from A shares, exchange-traded bonds, and open/closed-end funds to include stock index futures, SME bonds, and the interbank bond market (which account for 97 percent of total cash bond turnover in China). The Chinese bond market capitalization was the third largest in the world at $5.5 trillion in September 2014, behind the United States and Japan. ‘‘A Changing Bond Landscape in China,’’ S&P Dow Jones Indices, Nov. 2014. 4 A whole array of smaller asset management companies, private equity funds, securities companies, and pension funds, with much smaller assets under management, could now obtain QFII licenses. 5 The total available QFII quota, out of which investment quotas for individual QFII license holders can be approved, has increased in stages from $10 billion (2002 to 2007), to $30 billion (2007 to 2012), to $80 billion (2012), and to $150 billion (from 2013); $66 billion of this has been allocated for investment. ‘‘China outstanding QFII quota rises to $65.7 bln at end-Nov,’’ Reuters, Dec. 9, 2014. 6 Under the RQFII scheme quota, CNY 70 billion ($11 billion) was made available in 2012. Initially limited to Hong Kong subsidiaries of Chinese companies, from March 2013 it was widened to include international banks and asset managers with a Hong Kong presence (total CNY 270 billion) and later the RQFII quota was granted for allocation to institutions in Australia (CNY 50 billion), Canada (CNY 50 billion), France (CNY 80 billion), Germany (CNY 80 billion), Qatar (CNY 30 billion), Singapore (CNY 50 billion), South Korea (CNY 80 billion), Taiwan (CNY 100 billion), and the U.K. (CNY 80 billion), for a total current quota available of CNY 870 billion ($139 billion). CNY 300 billion ($48 billion) of this quota has already been allocated to 94 institutions (80 in Hong Kong and 14 outside). ‘‘China outstanding QFII quota rises to $65.7 bln at end-Nov,’’ Reuters, Dec. 9, 2014.

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that foreign portfolio investment in the renminbidenominated A share markets in Shanghai and Shenzhen, formerly restricted to Chinese domestic investors, became possible.1

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Nonetheless, even with all of these improvements, more than a decade after the inauguration of the QFII program, foreign investors still account for just over 2 percent of Chinese A share market capitalization ($114 billion out of $4.48 trillion). The renminbi assets freely available for investment from international investors total $340 billion, which is 0.2 percent of the global market.8 Foreign investment in domestic securities makes up 86 percent of GDP in the United States and a mere 4 percent of GDP in China.9 Consideration of the current situation makes clear the extent of the adjustment set to take place as the Chinese capital markets fully open up, and the extent of the investment opportunities on the horizon. The low level of foreign portfolio investment penetration is only in part a function of the QFII quota limitations. The restrictions on capital mobility (lock-up periods, repatriation restrictions) have meant that A shares have been excluded from the leading global benchmark indices, such as those compiled by MSCI (Morgan Stanley Capital International) and the Financial Times,10 on liquidity grounds. Given that China’s domestic securities markets are now the sec-

The RQFII version of the open-ended China fund is currently preferred to the QFII version, because it: • provides a longer period in which to place quota monies (standard QFII rules expire the quota if not used in six months) and allows for recycling of funds (disposal of securities and repatriation of proceeds leads to exhaustion of quota under standard rules); • provides for daily liquidity (repatriation from China) as against monthly limited repatriation under the standard rules; • removes lock-up periods (up to one year lock-up following initial investment is standard) and requirements on investment composition; • makes quota increase procedures more flexible; and • allows for transfers of quotas between funds of the same manager. 8 For comparison, assets denominated in other leading currencies and freely available to international investors were, in U.S. dollars, $55 trillion of U.S. dollar assets, $29 trillion of euro assets, $17 trillion of yen assets, and $9 trillion of pound sterling assets. The renminbi assets freely available to international investors were, by contrast, on par with the Philippine peso assets. See ‘‘China’s historic stock opening to recast global investing,’’ Financial Times, Sept. 25, 2014. 9 See ‘‘A new era dawns in Chinese outward portfolio investment,’’ Financial Times, Sept. 1, 2014. 10 The exclusion of A shares from global indices leads to a significant contrast with other developing markets in the portfolio market penetration of foreign institutional investors; the emerging-market average share of total market capitalization for foreign institutional investors is 25 percent vs. 2 percent in China

ond largest11 globally, this is a highly unusual situation, and the Financial Times12 has stated that if the domestic securities markets were completely opened up, China’s weighting in its emerging market index would be increased to 37 percent (from 19 percent), in its Asia Pacific index to 21 percent (from 9 percent), and in its global index to 5 percent (from 2 percent). Three main obstacles to this major alteration to the global investing landscape have been the quota allocations, the capital mobility issue, and the ambiguity on the taxation of capital gains. The launch of Shanghai-Hong Kong Stock Connect boosts the existing available quota by CNY 300 billion ($48 billion), roughly an additional 20 percent on top of the currently available quota under the QFII/RQFII programs. Commentators expect further increases of the quota to CNY 1 trillion ($160 billion) once the initial quota is exhausted,13 as well as an expansion of the program to cover Shenzhen’s stock exchange and other assets, beyond A shares, such as commodities, bonds, and derivatives.14 In addition to the quota increases, Stock Connect addresses the capital mobility issue with no lengthy lock-in periods. Considering this alongside the increasing capital mobility afforded under the RQFII regime for open-ended China funds, the barriers to including A shares and other Chinese listed securities on global indices are rapidly lifting. Given the progress on the quota and capital mobility fronts, the remaining piece of the puzzle is the tax on capital gains. Hence, the significance of the State Administration of Taxation’s (SAT) November 14 announcement on temporary exemption for Stock Connect and QFII/RQFII investors into China, and the importance of resolving legacy QFII/RQFII tax issues, is the focus of the remainder of this article.

(though with the recent increases in quotas foreign portfolio, investors can purchase up to 4.5 percent of the China market capitalization). ‘‘A new era dawns in Chinese outward portfolio investment,’’ Financial Times, Sept. 1, 2014; and ‘‘Through Train to Connect China A-shares with MSCI,’’ Deutsche Bank Markets Research, Nov. 17, 2014. 11 By November 2014, the capitalization of China’s stock markets stood at $4.48 trillion (including Chinese companies listed in Hong Kong), having surpassed Japan at $4.46 trillion, but still behind the United States with its $24.4 trillion market. 12 At present, the existing China weighting is based on investment in H shares. FTSE White Paper, ‘‘China A-shares and Global Indices — Adapting China Equity Benchmarks for Tomorrow’s Needs,’’ FTSE International, Feb. 19, 2014. 13 A daily northbound Hong Kong to Shanghai quota of $2.1 billion applies. 14 Currently, Stock Connect falls short of RQFII and QFII due to the limited range of investments, being solely a selection of A shares. See ‘‘China’s historic stock opening to recast global investing,’’ Financial Times, Sept. 25, 2014.

(Footnote continued in next column.)

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Further, new regulations in 2012 provided much greater capital mobility for QFII/RQFII license holders investing in open-ended China funds, reducing the lock-up periods and allowing for more regular capital remittance out of China.7

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II. Chinese Taxation

There was no such ambiguity in relation to the business tax; Cai Shui [2005] No. 155 provided that any gains derived by a QFII from the sale of A share listed companies would be specifically exempt.

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As QFIIs had not historically sought to repatriate, the tax issue had remained dormant. The Lehman Brothers estate, however, in seeking to liquidate all its remaining QFII holdings and repatriate them from their custodian bank in China, found itself in a dispute with the Beijing tax authorities, who sought to collect the capital gains withholding tax at 10 percent. The enforcement action was a wake-up call for QFIIs. Market intelligence in summer 2011 suggested that the SAT, along with other government branches, was studying the imposition of capital gains withholding tax on historic gains of QFIIs, taking into account various implementation issues (that is, the calculation basis for gains, the possibility of netting gains and losses, the retroactive time frame for the application of tax, the imposition of penalties, and the manner in which tax treaty relief might be obtained). The study culminated in the release of Circular 79, discussed below. Nevertheless, the implementation issues remain under consideration and have not been clarified with the public yet.

B. Complexities of Treaty Relief If capital gains withholding tax arises, QFII license holders (and the investors using them to invest in A shares and other China securities) had to consider the validity of tax treaty relief claims for their historic capital gains tax exposures. QFII license holders and the RQFII license holders also needed to consider the application of tax treaty relief in the future in their tax provisioning. Three key technical questions arise in applying treaty capital gains tax relief in a QFII context, when the treaty between the QFII/RQFII’s country of residence and China provides for tax relief, namely that the satisfaction of the treaty eligibility criteria that the QFII/RQFIIs are: • ‘‘persons’’; • tax residents of the treaty jurisdiction; and • to be regarded as the alienators of the disposed A shares. China’s treaties show some variation in the level of relief they provide from capital gains withholding tax on shares. Until recently, the U.K. and Dutch treaties in effect allowed China to tax gains on minority shareholdings (providing no relief), while the Irish treaty excludes all non-land-rich share gains from Chinese

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A. Capital Gains Tax for QFIIs The above outline of the development of the regulatory framework for foreign portfolio investment into China sets the backdrop to understand the equally complex development of the accompanying tax framework. As China is clearly on the verge of experiencing a surge in the proportion of its public securities markets invested in by foreigners, it is crucial that the historic tax issues be understood and resolved. Investments by foreigners in H shares and B shares were, from the beginning, exempt from tax. Guoshuifa [1993] No. 45 (Circular 45) specifically exempted dividends from H shares and B shares, as well as capital gains realized by foreign enterprises on the disposal of H shares and B shares, from the foreign enterprise income tax, predecessor to the CIT Law introduced in 2008. With the commencement of the QFII program in 2002, QFII license holders were faced with an absence of any specific QFII tax rules, and so generally made inferences based on the tax circulars for H shares and B shares and from the conduct of the tax authorities. QFII license holders received dividends on their A share investments without the tax authorities pursuing them or the dividend paying companies for dividend withholding tax, though some QFII license holders (and parties investing through them) did make accounting provisions for tax potentially being sought retroactively by the tax authorities at a later date. However, there was universal consensus among QFIIs that capital gains withholding tax should not be applied, despite the absence of any specific exemption in this regard, and accounting tax provisions were not generally made.15 Following the introduction of the new CIT Law on January 2, 2008, Guoshuihan [2009] No. 47 (Circular 47) abolished the Circular 45 dividend and capital gains withholding tax exemptions for H shares and B shares. Dividend withholding tax at 10 percent was consequently duly enforced from that time onward and was withheld from payments to A share investors, as well as from dividend payments to H share and B share investors. However, there was no attempt to enforce (and still to this date there has not been any attempt to enforce) capital gains withholding tax against disposals of H shares and B shares. Many QFIIs investing in A shares continued to take the position that capital gains withholding tax would not and should not be enforced and continued to make no accounting tax provisions.

However, a sea change in approach was prompted by a 2010 enforcement action against the QFII holdings of the Lehman Brothers estate. Historically, QFIIs had generally recycled their renminbi on the sale of A shares; they did not seek to remit disposal proceeds but instead reinvested them in more A shares, not wanting to have part of their quota deemed exhausted. While withholding tax technically applies to capital gains from the time that gains are realized, in practice the tax authorities do not seek to collect it until the time of repatriation of sales proceeds out of China.

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To the extent that the current rules did not allow holdings in any Chinese company greater than 10 percent through any given QFII/RQFII,16 and as long as the company was not land rich, QFII license holders considered that they should have some basis for treaty relief. However, while QFII/RQFII license holders were confident they would satisfy the person criterion (since they generally are organized as corporate persons) and the residence criteria (being subject to the local corporate income tax in the treaty counterparty countries either on the basis of their local incorporation or on the basis that their place of central management is located in the treaty counterparty country), there was some concern with the alienator criterion. While the QFII/RQFII license holder, as registered holder of A shares in historic cases,17 would be the party subject to tax on disposal gains under Chinese domestic tax law, when an ‘‘agency trade’’ was in point, the QFII license holder would be acting purely for the account of its client, and would not record the holding on its own balance sheet and would not be taxed as an alienator in its home state, since the gains arising did not arise to the QFII license holder itself as income. Chinese tax law and practice is unclear on the circumstances in which the tax authorities must look through a foreign transacting entity to an underlying principal in applying tax treaties. While SAT Circular 30 (2012) and Announcement 24 (2014) provide for look-through of foreign entities with China-sourced income for the purposes of treaty application in some instances, this is solely regarding applying treaty relief for dividends, interest, and royalties.18 The SAT, at various times, has indicated differing preferences for either the look-through approach or for treating the QFII license holder as the appropriate claimant of treaty relief. Use of the look-through principle could result in significant complexity in the case of funds investing through QFII arrangements, as look-

16 The sum of separate QFII/RQFII holdings in a Chinese company must be less than 30 percent of total share capital. 17 As noted, with the introduction of new segregated account arrangements for clients of open-ended China funds since 2012, more recent agency trades would have the underlying investor, rather than the QFII, as the registered owner of the A shares. 18 While SAT Circular 30 (2012) covers dividends, interest, and royalties, SAT Announcement 24 (2014) deals with dividends and interest only.

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ing further through these funds would generate perhaps impossible administrative complexity in tracing and determining the treaty applicability to individual underlying investors. Most recently, it is understood that the SAT is tending toward treatment of the QFII license holder as the appropriate treaty relief claimant as the most workable solution. This would allow all QFII trades, agency, access, and proprietary for which the QFII is the registered owner of the A shares to be treated the same way.19

C. New Tax Guidance In the lead-up to the November 17 launch of the Shanghai-Hong Kong Stock Connect platform, concerns remained that the capital gains tax issues that had cast uncertainty over QFII/RQFII investment arrangements could undermine the effectiveness of this landmark step in the ongoing liberalization of China’s capital markets and in the internationalization of the renminbi. Thus, the temporary CIT and business tax exemptions for investors in China A shares using Stock Connect, as issued in Circular 8120 on November 14, 2014, and effective for gains derived from November 17 onward, met with universal welcome. The provision of temporary CIT exemption for QFIIs/RQFIIs for gains from the transfer of shares (and other equity investments) on the same terms in Circular 7921 was taken as generous and sensible, given the potential for administrative complexity from handling treaty relief claims on a prospective basis. This would also cover unrealized gains arising up to November 17; the effect of this exemption was for most QFII license holders, and funds investing through them, to announce shortly after the issuance of Circular 79 that they would release accounting tax provisions regarding the unrealized gains. However, Circular 79 noted that China-sourced gains derived by QFIIs and RQFIIs from the transfer of shares before November 17 would be subject to CIT in accordance with the CIT Law. In line with this, in late November, the SAT instructed relevant local tax authorities (that is, those in Shanghai, Beijing, and Shenzhen, where the major QFII onshore custodians are located) to begin issuing formal tax settlement notices to QFIIs over the coming months. Under these

19 For proprietary and access trades, there should be no question of the QFII license holder being the alienator of the shares for treaty relief purposes. 20 Caishui [2014] No. 81 (Circular 81), issued jointly by the Ministry of Finance, the SAT, and the China Securities Regulatory Commission (CSRC), applies to both individuals as well as corporations, and provides exemption from the IIT as well as the CIT, in addition to a business tax exemption. 21 Caishui [2014] No. 79 (Circular 79), jointly issued on October 31, 2014, by the MOF, SAT, and CSRC; QFIIs and RQFIIs are temporarily exempt from CIT regarding China-sourced gains derived from the transfer of shares (and other equity investments) on or after November 17, 2014.

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withholding tax. However, most Chinese treaties exempt non-land-rich share gains as long as the shares held by the nonresident in the Chinese company have been less than 25 percent of the total issued equity interests of the Chinese company (held directly or indirectly) during the 12-month period preceding the sale date.

PRACTITIONERS’ CORNER or average tax basis, with or without tax treaty relief, and so forth), to facilitate tax authority negotiations;

Each QFII/RQFII license holder will have to prepare a special purpose audit report verifying the amount of gross gains on a transaction-by-transaction basis for the period from the inception of the fund until November 17, and submit it to the local tax authority of the relevant custodian bank.

• evaluating the extent to which tax treaty relief will be available where the QFII/RQFII license holder is taken as the appropriate treaty relief claimant, ensuring that the detailed treaty qualification requirements are met, and that the requisite forms and supporting documentation are prepared;

As noted above, the SAT has to date left open a number of implementation questions central to determining the final liability in settling legacy QFII/RQFII capital gains tax exposures. Notable among these issues are: • The tax basis for computing the A share gains (weightedaverage or FIFO method). This issue arises when a QFII/RQFII acquired its inventory of A shares on different dates at different prices, and it is impossible to trace the shares being sold to a particular batch of shares bought previously. • Gross versus net basis. When a QFII/RQFII realizes gains from the disposal of some shares but incurs losses from the sales of other shares, the question is whether it would be allowed to offset the gains with the losses in computing the taxable amount (the latest indications are that this would not be permissible and that gross basis determination will apply). • The retroactive time frame for the application of legacy tax. While a look-back to 2002 is technically possible, the stronger indications are that 2008 would be taken by tax authorities as the year from which legacy tax obligations are to be calculated. • The imposition of late payment interest. While technically late payment interest could be applied, the understanding is that some mitigation of penalties may be made on the grounds that the tax law and practice relevant to QFIIs have historically been unclear and that there was no historical enforcement of the tax by relevant local tax authorities. Administrative penalty is unlikely. • Treaty relief. As noted, most recently it is understood that the SAT is tending toward treatment of the QFII license holder as the appropriate treaty relief claimant as the most workable solution. Given that tax settlement notices will be received by all QFII/RQFII license holders by the end of January, efforts will need to be undertaken in: • agreeing with the relevant in-charge tax authority the required level of disclosure, format, and contents of the special purpose audit report; • extracting and compiling details of disposal transactions over the required time frame, and conducting tax calculations, for several different scenarios (for example, gross or net gains with loss offset, how many years to go back in assessment, FIFO,

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• considering whether the relevant tax authorities would be willing to entertain a treaty relief claim based on looking through the QFII/RQFII license holder to underlying investors and negotiate with the authorities accordingly, to the extent that treaty relief is not available under the treaty between the QFII/RQFII license holder jurisdiction and China; • negotiating with the tax authorities to ensure that late payment interest is not levied or mitigated; and • allocating end tax liabilities to QFII clients. The settlement of these legacy exposures will clean the slate for QFIIs/RQFIIs and provide a sound basis for future operations and expansion. Nevertheless, a number of challenges remain for the future, and it is worth reflecting on these next.

D. Challenges for the Future Circulars 79 and 81 provide for temporary exemptions without stating the precise duration. Further, there is no specific guidance provided elsewhere in China’s tax law on the time frame to be ascribed to a temporary exemption when it is not otherwise specified. However, such temporary exemptions are a regular feature of Chinese tax law policymaking and can, in practice, be of long duration.22 The term ‘‘temporary’’ may be taken to mean ‘‘indefinitely, until such time as revoked by the State Council.’’23 To the extent that the temporary exemption for QFIIs is later revoked, the application of CIT to A share gains arising would be a function of the availability of tax treaty relief.

22 As an illustration, a temporary exemption for foreign invested enterprises from city construction and maintenance tax, as well as educational surcharges, was put in place in 1994. Since no further circulars were issued in the interim, the temporary exemption remained in effect until 2010, when it was finally abolished. 23 Note also that even when the temporary exemptions are given an initial defined time frame, these are also frequently rolled over repeatedly so as to become a standing exemption. For example, the IIT exemption for A share capital gains for Chinese individuals was introduced as a temporary exemption in 1994 for only two years, and then continually renewed; it is still in effect.

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notices, QFIIs will have to report and settle, in one single lump sum, all capital gains withholding tax on securities disposed before November 17 (legacy tax).

PRACTITIONERS’ CORNER COMING ATTRACTIONS

Loss restriction events in Canada (Tax Notes International) Jack Bernstein reviews the technical rules regarding provisions in the Income Tax Act (Canada) that restrict the use of tax losses following an acquisition of control. German guidance on partnerships under treaty law (Tax Notes International) Rolf Eicke discusses new guidance released by the German Ministry of Finance regarding the treatment of cross-border partnership activities under treaty law. State and local tax matters (State Tax Notes) We will feature a new SALT column by Jaye A. Calhoun of McGlinchey Stafford. Kay Miller Hobart and Ray N. Stevens, partners with Parker Poe Adams & Bernstein LLP, will resume their SALT Solutions column. Strategies used by private equity firms to minimize their taxes (Tax Notes) Gregg D. Polsky explains how carried interest rules and management fee waivers allow managers to pay preferential rates on their risky and non-risky pay. The Obama administration’s framework for business tax reform (Tax Notes) Calvin H. Johnson criticizes the administration’s support for easing limits on small business depreciation and increasing the research credit.

III. Looking Ahead As noted above, foreign investment in domestic securities makes up 86 percent of GDP in the United States and a mere 4 percent of GDP in China. There is considerable room for growth of foreign participation in China’s stock market. Through the regulatory reform since 2012 as well as the recent clarifications of tax policies, China has gone a long way toward resolving the three key obstacles to expanded foreign portfolio investment in China: • quota allocations; • capital mobility; and • taxation of capital gains. Some final adjustments will complete the required framework and facilitate the promise of complete integration of the Chinese and global capital markets and the internationalization of the renminbi. ◆

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It is anticipated, based on the experience with earlier revocations of temporary tax exemptions, that the cessation of the Circular 79 exemption would result in the application of tax on a prospective, rather than a retroactive, basis. Nonetheless, to support the further integration of the Chinese and foreign capital markets and the internationalization of the renminbi (as the overall objectives of the Stock Connect and QFII/ RQFII programs), the SAT at some point should confirm the exemption as being permanent. Furthermore, to the extent that increasing interest in the Chinese bond market, already the third largest in the world with a capitalization of $5.5 trillion, is driving much of the expansion in China-focused ETFs, a clarification that the Circular 79 exemption applies also to bonds would be welcome. While there has not, to date, been reports of active enforcement of withholding tax by the Chinese tax authorities regarding the sale of bonds by foreign investors, either for government or for corporate bonds, given the technical ambiguities surrounding the taxability of bonds and the interest in bond investment for overseas, a clarification would be positive. Further, to the extent that QFII/RQFIIs invest in listed Chinese mutual funds, it would be helpful for these to be explicitly exempted. As a matter of practice, since there is a specific income tax exemption available for distributions to domestic Chinese investors from listed investment funds, domestic fund managers do not generally supply details to investors of specific securities underlying their units in the investment fund. As a QFII/RQFII would consequently lack information to support a Circular 79 exemption on the basis that the mutual fund holds certain A shares, it would be best for the gains on sale of mutual fund units to be explicitly exempted.