At long last, the Qualified Domestic Limited Partnership (QDLP) program in Shanghai has been implemented. The first batch of six hedge fund managers has been approved to participate into the program. They have started setting up the wholly foreign-owned fund management companies (“Onshore FMC”), as well as beginning RMB fund raising.
The QDLP allows qualified domestic private RMB funds, established in Shanghai, to invest into offshore securities markets. A typical investment and operational structure for the QDLP program is depicted in the diagram below.
The QDLP program is an important step forward for international asset managers entering the Chinese market. Although the foreign exchange quote granted to each approved asset manager is only US$50 million at this stage, being symbolic rather than material, QDLP reflects China’s long-term commitment to opening the capital account and internationalising the RMB, as well as Shanghai’s ambition of becoming an international financial centre.
Due to the regulatory restrictions (including foreign exchange restrictions), Chinese investors are usually not able to invest in offshore securities markets other than via the Qualified Domestic Institutional Investors (QDII) program. But the QDII investment funds are issued to the general public and are not tailored to the needs of specific investors. The QDLP program now provides a new channel for Chinese domestic capital to be invested in offshore securities markets and this should be greatly welcomed by Chinese institutional investors and high net-worth individuals.
While the QDLP program provides a new window of opportunity for both overseas hedge funds and Chinese domestic investors, asset managers need to manage a number of issues. They need to consider the marketing strategy for promoting QDLP products to Chinese investors, looking into routes to market such as having a Chinese partner or engaging with distribution channels such as trust institutions, wealth management institutions, etc. Moreover, asset managers need to be alert that Chinese investors have less experience of hedge funds than investors in more developed markets like the US and UK, and so may have more questions. Asset managers should also consider how to deploy manpower in this new market, taking account of employing local Chinese residents, sending people to oversee this new market, or even using the employees of existing regional offices like entities in Hong Kong through travelling to China on frequent basis, etc.
Chinese investors, especially individuals, would require asset managers to set up the best structure for them to invest into the QDLP fund. Tax would be one key consideration in designing the structure to maximise the after-tax investment return. In this regard, asset managers might explore collective investment schemes, allowable under the Chinese regulatory regime, as an intermediary for collecting individuals’ investments. But asset managers will need to make sure that such structures minimise Chinese tax implications for their investors.
The QDLP program is designed so that the offshore fund manager of the master fund can collect the management and performance fees under the “master-feeder” structure. Nevertheless, asset managers need to design a structure for compensating the Onshore FMC that takes into account Chinese tax and transfer pricing issues. The structure should mitigate both the Chinese tax cost at the Onshore FMC level and the possible PRC tax authority’s challenges as well. While asset managers have particular management fee and performance fee arrangements with investors, a tailored tax structure for compensating the Onshore FMC should be designed in order to make the structure tax efficient. In some situations, exploratory discussions with the tax authorities prove a useful way of minimising the risk of challenges at a later date.
China is implementing a program to move from business tax (BT) to value added tax (VAT) across all industries. Currently, the program has been rolled out nationwide for some industries, including the so-called modern service industry. In this context, the Onshore FMC may be subject to the VAT at 6% on its income, instead of being subject to BT at 5%.
Although the VAT is creditable, the Onshore FMC may be subject to higher overall tax cost as a result of the increased VAT rate versus the BT. What’s more, input VAT credits are very limited.
Often, regional offices send their employees to support the Onshore FMC’s operations. But asset managers should be careful how they arrange the relationship between these regional office employees and the Onshore FMC. They need to look into putting these people under dual employment of the two entities or under a secondment arrangement. Such an arrangement would not only help to alleviate Chinese income tax for these people, but would also manage the risk of inadvertently giving the regional office a taxable presence in China. If a regional office were judged to have a taxable presence, its income attributed to these persons would be exposed to Chinese corporate income tax of 25%.
Selecting the best location for registering the Onshore FMC and QDLP fund is a key issue for asset managers seeking to participate in the QDLP program. Shanghai’s recent establishment of the Shanghai Pilot Free Trade Zone, which created a new business landscape, has made this particularly relevant. What’s more, there are some districts in Shanghai that are aggressively promoting the hedge fund industry by providing highly favourable policies. Usually asset managers need to explore the level of local financial subsidies and available support from local government – including support in marketing to investors – when selecting a specific location for registering the fund and fund managers.
It is foreseeable that the QDLP program will expand further with more and more asset managers participating in the program. Looking to the future, the total volume , as well as the individual volume for each QDLP fund, will be increased. The QDLP program definitely provides good business opportunities for international asset managers. That being said, various issues must be addressed beforehand if asset managers are to make the most of their opportunity. We suggest that asset managers take a proactive approach and talk to the Shanghai financial service authority in advance, as well as seeking assistance from advisors.
This article was first published in the AIMA Journal, Q4, 2013 and is reproduced with the kind permission of AIMA.