In the opening session of the Asia Financial Forum in Hong Kong held in January 2013, Guo Shuqing, the previous Chairman of the China Securities Regulatory Commission (CSRC), noted that China could increase the level of its QFII and RQFII investment quotas by 10 times. His comments sparked wide spread media observations that the Mainland Government intended to continue opening up the Mainland’s capital markets to foreign investment.
Background – a brief introduction of the QFII and RQFII schemes
The Qualified Foreign Institutional Investor (QFII) scheme enables specified types of foreigners to use their offshore foreign currency for investment in the Mainland’s securities market. The Renminbi Qualified Foreign Institutional Investor (RQFII) scheme is a modified version of the QFII scheme which facilitates the use of Renminbi held outside the Mainland for investment in the Mainland’s securities market.
Key milestones of the QFII and RQFII schemes
Click here to view table.
The QFII scheme was established in 2002 to attract long-term foreign institutional investors to China’s domestic A-share market.
By the end of May 2012, a total of 172 QFIIs were approved, but QFIIs accounted for only 1.1% of the total market capitalisation of China’s A-shares. In order to “further introduce long-term capital from abroad, strengthen domestic market confidence and promote stable growth in China’s capital markets and their opening-up to foreign investors”1, CSRC and the State Administration of Foreign Exchange (SAFE) substantially revised the QFII rules (2012 Revised QFII Rules) in late 2012. The aggregate QFII investment quota increased from USD30 billion in 2007 to USD80 billion in 2012.
In February 2013 alone, SAFE granted an aggregate of USD850 million in investment quotas to nine foreign investors. As of the end of April 2013, SAFE had issued a total of USD41.882 billion in investment quotas to 198 QFIIs.
See Box 1 for highlights of the main changes implemented by the 2012 Revised QFII Rules.
Box 1 – Key changes under the 2012 Revised QFII Rules
- CSRC lowered the qualification threshold for a QFII licence.
- QFIIs are permitted to invest in the fixed income products traded on the inter-bank bond market. This has been endorsed by PBOC, the regulator of the inter-bank bond market, in a notice issued in March 2013.
- QFIIs may engage more than one securities dealer to trade securities in each stock exchange.
- The Renminbi account structure has been modified so that a QFII may open a maximum of six Renminbi deposit accounts designated for securities trading for different clients.
- SAFE approval for repatriation of realised profit is no longer required provided that the total monthly repatriation (including capital and profit) does not exceed 20% of its total investment in China at the end of the previous year.
An initial investment quota of RMB20 billion was granted under the RQFII scheme to the Hong Kong subsidiaries of PRC fund management companies and securities companies in 2011.
The investment quota increased to RMB70 billion in April 2012, in connection with the launch of RQFII A-share Exchange Traded Funds. In late 2012, Guo Shuqing, the previous Chairman of CSRC, announced plans for an RMB200 billion expansion in investment quota of the scheme.
In view of the popularity of the RQFII products, the growing use of Renminbi in Hong Kong and in order to promote Hong Kong as the leading offshore Renminbi centre, CSRC, SAFE and the People’s Bank of China (PBOC) relaxed the RQFII rules in March 2013 (the revised RQFII rules and the implementing rules are collectively referred to as “Revised RQFII Rules”). As of the end of April 2013, SAFE had issued a total of RMB76.3 billion in investment quotas to 26 RQFIIs.
See Box 2 for a summary of the key changes introduced under the Revised RQFII Rules.
The RQFII scheme is also expected to be expanded to include Taiwan.2 Many Taiwanese institutional investors are already active investors in Hong Kong-launched Renminbi products. According to CSRC’s announcement in January 2013, CSRC will accept Taiwan’s request for a separate RQFII investment quota of RMB100 billion.
Box 2 – Key changes under the Revised RQFII Rules in 2013
The scope of eligible applicants was expanded to include:
- Hong Kong subsidiaries of Chinese commercial banks and insurance companies
- financial institutions which are registered in Hong Kong and with principal places of business in Hong Kong. RQFIIs are no longer subject to the “20% equities/80% bonds” restriction on asset allocation.
- The scope of permitted investment was expanded to include stock index futures and fixed income products traded on the inter-bank bond market.
- SAFE has imposed stringent requirements on RQFIIs other than open-ended funds (e.g. investment deadline, recycle of investment quota, lock-up period, repatriation/ remittance restrictions) (see table under the sub-heading “Harmonisation of the two schemes” below).
- RQFIIs are required to set up separate designated accounts with onshore custodian banks for trading in domestic stock exchanges and the inter-bank bond market, and for trading of stock index futures.
What do the recent developments mean for foreign investors?
Harmonisation of the two schemes
The recent changes to the QFII and RQFII rules harmonise the two schemes to a large extent.
The following table summarises the key features of the two schemes based on the current regulatory framework:
Click here to view table.
While the recent reforms to the QFII and RQFII schemes further increase the investment quotas and facilitate a more streamlined process for the repatriation of profit, market participants continue to seek clarification on a number of key issues.
The current Mainland tax position for QFIIs is as follows:
- QFIIs are exempt from business tax on income derived from the securities traded through approved securities brokers
- China-sourced dividends (from holding A-shares or B-shares) and interest (from holding PRC fixed income products) paid to QFIIs are subject to a 10% withholding tax
- if a QFII is eligible for a reduced withholding tax rate under any applicable tax treaty or other arrangement, the QFII can apply to the relevant tax bureau for the lower rate to apply.
The State Administration of Taxation (SAT) has not issued any specific notice in relation to tax arrangements for RQFIIs. However, given the similarity in the policies underlying the two schemes, it is reasonable to suppose that the same tax treatment applies to RQFIIs.
What is far from clear is the treatment of capital gains. Under the general tax provisions of China’s income tax laws, a 10% withholding tax is imposed on capital gains derived by non-resident enterprises without a permanent establishment in the PRC. SAT has yet to publish any specific tax regulations relating to the taxation of capital gains derived by QFIIs or RQFIIs. It was reported in 2012 that China’s regulators were reviewing draft regulations to introduce capital gains tax on foreign institutional investors’ earnings from onshore equity transactions. We await the publication of those regulations.
In practice, we see increasing numbers of QFIIs including special tax provisions for PRC capital gains withholding tax in their investment documents, in anticipation of such a tax to be imposed in the future.
If China imposes a withholding tax on capital gains derived by QFIIs or RQFIIs, RQFIIs may be eligible to tax treaty benefits under the PRC-Hong Kong Avoidance of Double Taxation Arrangement because RQFIIs are all Hong Kong incorporated or registered entities under the current scheme.
Eligible institutions for RQFII status
Following the expansion of the range of eligible applicants under the Revised RQFII Rules, all entities holding a Type 9 regulated activity licence issued by the Securities and Futures Commission (SFC) in Hong Kong are eligible to apply for an RQFII licence. There are currently over 900 Type 9 licence holders in Hong Kong. The market expects that China’s regulators are likely to give priority in the near term to applicants with an existing PRC connection.
Under the Revised RQFII Rules, financial institutions registered in Hong Kong and with their principal places of business in Hong Kong are now also eligible to apply for an RQFII licence. There has been discussion among Hong Kong entities as to how to determine whether a financial institution is “registered in Hong Kong”. The discussion also centres on whether the place of incorporation of the applicant entity is relevant, or whether wider analysis at the group level is required to determine that an applicant entity has its “principal place of business in Hong Kong” for the purpose of an RQFII application.
In addition, CSRC requires an applicant to not only have obtained the Type 9 licence from SFC but also to have started its asset management business prior to application. It is not clear whether an entity which has launched its asset management business overseas before obtaining the Type 9 licence will be considered as satisfying this requirement.
Offshore segregated account mandate structures
Offshore segregated account structures have been used under the QFII scheme to enable offshore investors to have access to the China’s securities market without offshore investors needing to hold QFII licences. Following the relaxation of the types of permissible products under the Revised RQFII Rules, we expect to see similar segregated account mandates adopted under the RQFII scheme.
The chart shows a basic segregated account mandate structure under the QFII scheme:
Click here to view chart.
While a segregated account mandate structure is cost effective for offshore investors, an offshore investor is exposed to risk on the QFII licence holder in relation to the ownership of the PRC securities held in the onshore custodian account. We commonly see one of the following onshore custodian account arrangements for QFIIs:
- Segregated Custodian Client Account – The onshore custodian account is categorised as a segregated client account designated for an offshore investor. Currently, a segregated client account is only available for offshore open-ended fund clients. The offshore investor’s ownership in the PRC securities is recognised under PRC law.
- Nostro Custodian Client Account – The onshore custodian account is categorised as a nostro client account, with no segregated sub-accounts for individual offshore clients.
A nostro custodian client account carries the risk that upon the insolvency of the onshore custodian or the QFII licence holder, the offshore investor is unable to recover its securities, although the risk is generally perceived to be low because the onshore custodian account is in the nature of a client account.
- Proprietary Custodian Account – The onshore custodian account is categorised as a proprietary account of the QFII licence holder under PRC law, without any reference to the offshore investor.
PRC law does not recognise an offshore investor’s ownership in the PRC securities under a “proprietary custodian account” structure. The offshore investor is therefore at risk that upon the insolvency of the onshore custodian or the QFII licence holder, the offshore investor is unable to recover its securities held in the onshore custodian account because its assets are held to be owned by the onshore custodian under PRC law.
In structuring the onshore custodian arrangement, it is important for an offshore investor to understand the type of the onshore custodian account being used and to consider whether it has a direct claim against, or right of subrogation to, the PRC securities held in the onshore custodian account.
We expect to see a steady increase in the QFII investment quota granted by China’s regulators as China continues to relax its capital controls on foreign currency movements. Notwithstanding the limited pool of Renminbi outside China, the RQFII scheme is expected to be further expanded in order to meet the increasing demand for offshore Renminbi products. Taking advantage of their unique RQFII status, the trend for PRC financial institutions (including large PRC insurance companies) tapping Hong Kong’s capital markets will continue at full speed.