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China has set up a number of obstacles to hinder investment into and out of its growing economy. By Guy Coltman
Things are changing in the People’s Republic of China - not quickly and, arguably, not as much as many investors might like, but they are changing, and the vast country is tipped to become the biggest economy in the world sometime between 2030 and 2050.
China’s GDP has climbed to staggering levels. The economy has grown more than 10 times in the past 30 years, reaching a nominal $4.99tr (£3.05tr) in 2009. China’s foreign direct investment (FDI) rose to $58.35bn in the first seven months of 2010 after reaching $95bn in 2009.
FDI has hitherto usually been structured through holding companies incorporated in the Cayman Islands and the British Virgin Islands (BVI), but many other jurisdictions are now seeking a significant piece of the Chinese pie. Jersey Finance has opened an office in Hong Kong and Guernsey Finance has launched in Shanghai, which are both keen to show their capabilities as offshore locations.
However, the Chinese government is nervous about the prospect of wealth flowing out of China and has put up several barriers to try to make it difficult for foreign investors to enter the market; and, indeed, for wealthy Chinese to invest outside China.
For example, the government appears to be shutting down avenues for foreign investment through Circular 10, while the country’s commerce ministry has ordered local authorities to halt the approval of some foreign property investments and speculative purchases.
Circular 10 is designed to tighten up on so-called ’round-trip investments’, whereby Chinese domestic companies are reorganised into an offshore holding company structure and ownership is moved offshore. Circular 10 requires Chinese nationals and residents to obtain both national and local government approval before transferring assets into offshore vehicles. Such approval can be difficult to obtain.
A number of international investors have established deal structures that are compliant with the asset transfer regulations, including maintaining assets within the ownership of a Chinese entity. The entity contracts to provide the economic benefit of those assets to an offshore vehicle owned jointly by the foreign investors and China residents. There is always the risk that the government will decide these structures no longer comply, but for now it represents an opportunity despite the apparent tightening of the rules.
China also has extremely strict requirements that non-residents must meet in order to qualify for tax benefits. The StateAdministration of Taxation (SAT) scrutinises every structure to ensure that it has both commercial and economic substance. The SAT has issued Circular 698 to discourage transactions with the objective of avoiding China’s capital gains tax through an indirect transfer of shares.
The SAT, using the ’substance over form’ principle, can disregard the existence of an intermediary holding company if it lacks a reasonable business purpose and was established for the purpose of avoiding tax. Foreign investors are consequently subject to Chinese withholding tax on capital gains derived from the transfer. If the offshore holding company can show substance the structure should be acceptable.
There are also strict rules for China’s growing high-net-worth investors looking to invest outside the country, but there does appear to be some easing. According to the China Daily newspaper, the government of the eastern city of Wenzhou has launched a pilot programme to allow residents to invest directly overseas, with a cap of $200m a year. The invested amount cannot exceed $3m in any single project and investment in overseas property or equities markets is not allowed. It is a small step, but it indicates some motivation towards the liberalisation of the investment rules.
The Qualified Domestic Institutional Investor (QDII) scheme also allows Chinese outbound investment. The scheme lets investors invest in foreign securities markets via certain fund management institutions, insurance companies, securities companies and other asset management institutions that have been approved by the China Securities Regulatory Commission (CSRC). It allows Chinese institutions and residents to entrust Chinese commercial banks to invest in financial products overseas.
Numerous requirements need to be fulfilled under the QDII scheme, but one that has the Crown dependencies (Guernsey, the Isle of Man and Jersey) currently out in the cold is that investments must be connected to an approved jurisdiction that has signed a memorandum of understanding with the CSRC. The Crown dependencies have yet to do this.
The biggest issue for offshore jurisdictions remains how to attract investors over the commonly used Cayman and BVI. Certainly, China is relatively unfamiliar with the Channel Islands.
However, now that Jersey companies can, and have, listed on the Hong Kong Stock Exchange and more than a quarter of Chinese businesses listed on AIM use a Jersey holding company, China’s familiarity with Jersey is growing.
As China becomes more accessible to the rest of the world - and in particular to investors from the US and Europe -
matters such as a jurisdiction’s reputation, regulatory framework and the quality of its professional services will start to count for more than cost and familiarity.
Guy Coltman is a partner at Carey Olsen