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[SHANGHAI/HONG KONG] China will temporarily exempt taxes on profits made from a landmark scheme linking the Shanghai and Hong Kong stock exchanges, the finance ministry said on Friday, removing a potential stumbling block for global investors eager to directly buy Chinese stocks for the first time.
Market players cheered the announcement, though Chinese regulators left themselves wiggle room to apply a tax to foreign investors at a later date.
The Shanghai-Hong Kong stock connect, to be launched on Nov 17, will let international investors trade Shanghai-listed shares via the Hong Kong stock exchange, and mainland investors to trade in Hong Kong shares via the Shanghai Stock Exchange.
While the programme will be constrained by quotas initially, analysts say it has the potential to create the world's third-largest stock market if the two boards are fully integrated.
But there have been major concerns over implementation, the impact of pro-democracy protests in Hong Kong, and tax policy for the scheme.
Clarity on tax policy had been anxiously awaited, especially as the programme is set to launch on Monday.
Individuals and companies in Hong Kong buying shares in Shanghai will be temporarily exempted from paying income tax on gains for an unspecified period.
China's exemption of capital gains taxes "removes a huge concern for investors and brokers," said Nick Ronalds, head of equities for the Asia Securities Industry & Financial Markets Association in Hong Kong.
"Launching the scheme with tax uncertainty looming would have been a major obstacle for investors and removes a big source of risk and uncertainty," he said.
Beijing's statement said that mainland individuals buying shares in Hong Kong through the programme would be exempt from income tax for three years, but will be liable for tax on dividends.
The statement also said that business tax on Qualified Foreign Institutional Investor (QFII) and Renminbi Qualified Foreign Institutional Investor (RQFII) schemes - the two main avenues currently available for foreigners to invest in Chinese stocks - will also be temporarily exempted.
Mainland companies will be taxed on profits and dividends earned through the scheme, based on China's Enterprise Income Tax law, according to a Q&A that the Finance Ministry issued along with its announcement.
However, tax experts say that this law doesn't directly apply a separate tax to profits from share sales.
Investors on both sides will be liable for stamp duties, and Hong Kong investors will be taxed 10 per cent on dividends earned from mainland investments, according to the announcement.
In the Q&A, the ministry said that the goal of the tax policy was to support development of the connect scheme, promote liberalisation of the capital account and create fair tax treatment for investors under the connector and the QFII/RQFII schemes. "I have to say, this is not bad," said Brian Ingram, chief investment officer at Ping An Russell Investments in Shanghai, in reaction to the announcement.
He pointed out that the MOF's mention of the risk of "unfair tax policy" suggested regulators want to give QFII and RQFII formal equal treatment with participants in the stock connect programme. "This can definitely be a positive boost for participation in the A-share market," Mr Ingram said.
Some industry executives said the lack of a firm timeline for foreign investor tax exemptions worried them. "Clearly, it is not a permanent change and we have seen China revoke exemptions on tax in the past," said James Badenach, partner in the financial services tax division at EY in Hong Kong. But he added that the announcement was a step in the right direction.
Nor did the announcement say what would be done with profits earned previously under the QFII and RQFII schemes; industry insiders say that most institutional investors have escrowed between 10-15 percent of profits in case a tax is announced.
"For long-established QFII investors, this announcement may be a bit frustrating: there is still no clarity on what should be done with the US$400m-1.2 billion that QFII asset managers have withheld for previous years," said Stephen Baron of Z-Ben Advisors, a fund consultancy focused on the China market.
It's unclear how much of a boost the tax incentive will give to mainland investment in Hong Kong.
Mainland investors have been hesitant to invest in overseas stocks through the current Qualified Domestic Institutional Investor (QDII) scheme, which allows Chinese stock punters to buy shares overseas through mutual funds.
Analysts believe they will be similarly wary of investing in Hong Kong shares in the first phase of programme launch, leading to concerns about the impact of one-way flows on the pool of offshore yuan in Hong Kong.