Escaping Panda’s Claws

The People’s Republic of China is requiring Qualified Foreign Institutional Investors (QFIIs) and Renminbi Qualified Foreign Institutional Investors (RQFIIs) to pay, by September, tax on the gains from trading of A-Shares realized from 2009 through November 16, 2014. Circular 79 has temporarily waived tax on the gains from trading of A-Shares realized after November 16, 2014 that are not connected to any permanent establishment in China.

A-Shares are the class of shares in Chinese companies traded on Chinese stock exchanges restricted to foreign investors other than QFIIs or RQFIIs. The estimated $1 billion to $4 billion tax would mostly be due from mutual funds and brokerage firms.

Likewise, over the past few years, investments made by U.S. venture capital and private equity funds in Chinese companies have exploded. For those successful investments, the funds have had to deal with potential Chinese withholding tax on capital gains, either as reserves for financial reporting purposes or actual cash tax liabilities.

China generally imposes a 10% withholding tax on capital gains realized on the disposition (directly or indirectly) of stock or equity interests in Chinese companies, with certain exceptions (e.g., an indirect disposition of an interest in a Chinese company where the offshore holding company has sufficient substance and is not a Chinese tax resident enterprise).

The tax rate may be reduced or eliminated under the U.S. – China Income Tax Treaty (Treaty), where a less-than-25% interest in a Chinese company is disposed of or sold. The Treaty doesn’t address how this withholding tax would apply to an investment partnership. The Chinese tax authorities have, in some cases, applied the Treaty at the partnership level and, in other cases, looked through the partnership and applied the Treaty at the partner level. But in all cases, the partnership must be organized in the U.S. in order for the Treaty to apply.

If Chinese withholding tax is assessed despite the application of the Treaty (e.g., when a 25%-or-more interest in a Chinese company is disposed of or sold), it may qualify for a foreign tax credit that reduces the U.S. tax liabilities of U.S. partners.

A foreign tax qualifies as creditable if the tax is compulsory and levied on income.  A foreign tax credit can reduce U.S. tax liabilities if there is net positive foreign source income. Chinese withholding tax on capital gains is clearly compulsory and levied on income. Capital gains are generally sourced to the residence of the seller (determined at the partner level), making it U.S. source for U.S. partners. However, an election under Sec. 865(h) of the Internal Revenue Code may be made to treat the gain as foreign source, provided that is allowed under an applicable treaty. Indeed, the Treaty contains such a re-sourcing rule where Chinese income tax is imposed.

In summary, while there is uncertainty in the application of the Treaty, in many cases it is more advantageous to invest in Chinese companies through a U.S. fund than an offshore fund. Where Chinese withholding tax is imposed on capital gains, an election under Sec. 865(h) should be considered to treat the gains as foreign source.