China's New Tax May Hit Hedge Funds More Than Investment Rivals

(Bloomberg) -- Hedge funds may be the biggest losers from a new 3 percent tax on some investment returns in China.

The new value-added levy, which will take effect on Jan. 1, is part of a broader shift in how companies pay tax in the world’s second-biggest economy. While there are still uncertainties around how the tariff will be implemented, what’s known about the type of activities to be taxed suggests that hedge funds may be the asset managers hit the hardest, said Natalie Yu, a Beijing-based partner with Deloitte LLP.

“The whole industry will be affected, but hedge funds may face a bigger impact,” said Yu. The strategies that hedge funds use mean it’s likely more of their returns will be taxable under the new rules compared to other asset-management vehicles, she said. Further, rival products such as mutual funds are partly exempt from the new charge.

It would add to the pressure on China’s hedge fund industry, which has also been coming under increasing regulatory scrutiny. The China Securities Regulatory Commission said earlier this month that it’s investigating 10 cases of alleged wrongdoing in the industry and is seeing a “trend of rising legal violations.” In November, China unveiled a proposal to overhaul regulation of asset-management products that would mark the “beginning of a new era” in Chinese financial supervision from 2019.

Dai Ming, a fund manager at Hengsheng Asset Management Co. in Shanghai, said the changes may be an attempt to eliminate smaller funds by increasing their costs. “There are many hedge funds in the market right now, even after 10,000 of them are gone there are still 10,000 left,” he said.

The tax comes from mainland China shifting company tariffs to value-added levies, changes that have seen many industries end up paying less. The new regime was extended to the finance industry in May 2016, with the more specific rule on the asset management sector released at the end of last year. That regulation was delayed twice and amended several times before its January start date was announced by the Ministry of Finance on June 30.

“It’s a problem how to tell my clients about the three percent tax, which came with no obvious reasons,” said Dai. “We need to figure out who should pay for it or how to split it, and the process by which we pay it.”

More Details

Financial institutions are still waiting for more detailed rules to specify benefits, costs, and accounting practices, according to industry officials.

Different types of firms are preparing for the new tax based on their own interpretation, said Jane Xue, China asset and wealth management leader at PricewaterhouseCoopers LLP, and there are uncertainties on how the rules will operate in practice.

The Ministry of Finance gave some more clarity on Dec. 25th. When calculating taxable income from bond and stock trading, managers can use either the actual purchase price of the securities or their value on the last trading day of 2017, according to a document on the ministry’s website. That reduces the potential for a wave of selling from people ditching profit-making holdings to avoid tax before buying the securities back in 2018, according to a TF Securities Co. research note.

Uncertainties remain even after MOF’s statement, China International Capital Corp. said in a report, adding that it expects the authorities to release further details after the tax goes into effect.

Kenneth Leung, Ernst & Young LLP’s leader of indirect tax for Greater China, said China is the first country to introduce a value-added tax on interest income from loan services or fixed-income from financial investments. 

“There are still uncertainties around the tax,” he said. “Managers should proactively consult with tax authorities for clarity to avoid risks.”

To contact Bloomberg News staff for this story: Gary Gao in Shanghai at cgao58@bloomberg.net, Amy Li in Shanghai at yli677@bloomberg.net.

To contact the editors responsible for this story: Sam Mamudi at smamudi@bloomberg.net, Jessica Zhou at jzhou75@bloomberg.net, Paul Panckhurst

©2017 Bloomberg L.P.

With assistance from Gary Gao, Amy Li