出海经纬 | Diversified Financing Approach: Pearl Bonds

According to the "Overall Plan for the China (Shanghai) Pilot Free Trade Zone", the Shanghai FTZ implements an innovative regulatory model of "first-line opening, second-line control", which promotes the free flow of goods, services and other elements within the zone and encourages enterprises to fully utilise both domestic and foreign resources and markets to achieve cross-border financial liberalisation. Pearl bonds are offshore bonds within the "domestic but outside the customs territory" of the FTZ, and their cross-border fund flows must follow the principle of "first-line opening, second-line control". Although the principal and interest earned from investing in Pearl bonds can be freely remitted overseas, funds returning to China must still comply with the regulations of the State Administration of Foreign Exchange.

In practice, some regional foreign exchange administrations consider that companies issuing Pearl bonds do not need to register external debt if all investors are local or domestic. Currently, there are few cases of Pearl bonds with foreign investors, and whether external debt registration is required still depends on the foreign exchange administration's determination of whether Pearl bonds are considered foreign bonds. As most of the Pearl bonds issued involve cross-border funds, companies generally register external debt for Pearl bonds.

In view of the fact that free trade bonds tend to be recognised as foreign debts, in addition to filing and registering with the NDRC in advance and submitting the issue information to the NDRC after issuance, according to Article 9 of the Measures for the Administration of Foreign Debt Registration, "If the debtor is a domestic debtor other than a financial department or a bank, it should go to the local foreign exchange bureau one by one and register or file the foreign debt contract in due time: "If the debtor is a domestic debtor other than a finance department or a bank, it should go to the local foreign exchange bureau to register or file the foreign debt contract one by one within the prescribed time". After registering the foreign debt contract, the issuer should go to the bank to open the foreign debt contract of domestic institutions with the form issued by the foreign exchange bureau.

If the provisions of Circular 34 are not applicable to the investment in Pearl bonds by foreign institutions, the foreign investors shall be taxed in accordance with their subscription to the foreign bonds issued by domestic entities. In view of the fact that China has formulated relevant tax incentives for QFII/RQFII, the application of tax policies should be discussed in the following cases:

① Interest income

Pursuant to the Notice of the Ministry of Finance and the State Administration of Taxation on Comprehensively Launching the Pilot Project of Changing Business Tax to Value-added Tax ("Document No. 36"), Annex 1, Article 1, Paragraph (5), Item 1, provides as follows: "1. Loan services. Lending refers to the business activity of obtaining interest income by lending funds to others for their use. All kinds of income obtained from occupying and lending funds, including income from interest (capital preservation gains, remuneration, capital occupancy fees, compensation, etc.) during the period of holding (including maturity) of financial commodities ......"; and Article 15 of Document No. 36 stipulates that: "Value-added tax rate: (a) Taxpayers incurring taxable acts, ...... tax rate is 6% ......".

Accordingly, the act of a bondholder subscribing to and receiving interest on foreign bonds issued in local currency by a domestic entity may be recognised as a loan service and the foreign bondholder is liable for VAT.

However, Article 13 of Document No. 36 stipulates that the sale of services by an overseas entity or individual to a domestic entity that takes place entirely outside the territory is not a sale of services within the territory and is not subject to VAT. In the case of Pearl bonds, if the bond is issued on an offshore stock exchange and settled through the CIBD and the Shanghai Clearing House, the settlement behaviour may be deemed to have taken place within the territory. The issuer may be identified by the tax authorities as the purchaser of the loan services and still be required to withhold and pay 6 per cent VAT on the interest income from the bonds on behalf of the foreign investor.

②Trading spread income

According to Article (22) of "Appendix 3: Provisions on the Transitional Policy for the Pilot Scheme of Business Tax to Value-added Tax" of Circular No. 36 and the Supplementary Circular of the Ministry of Finance and the State Administration of Taxation on the VAT Policy on Interbank Transactions of Financial Institutions, the income from the transfer of financial commodities generated by the domestic enterprises entrusted by QFIIs/RQFIIs to engage in the business of buying and selling securities in China is exempted from VAT. Income from the transfer of financial commodities entrusted by QFIIs/RQFIIs to domestic enterprises engaged in securities trading in China is exempt from VAT.

As to whether QFII/RQFII investment in the subscription of Pearl bonds is part of "engaging in the business of securities trading in China", consistent with the above analysis, there is no clear provision or official interpretation at the regulatory level as to whether it can be recognised as "engaging in the business of securities trading in China". "There is room for interpretation. 

According to the Circular of the State Administration of Taxation on Issues Relating to the Withholding and Payment of Enterprise Income Tax on Behalf of Chinese Resident Enterprises Paying Dividends, Bonuses and Interest to QFIIs (Guo Shui Han [2009] No. 47), "I. QFIIs receiving income from dividends, bonuses and interest originating in the territory of China shall be subject to enterprise income tax at a rate of 10 per cent in accordance with the provisions of the Enterprise Income Tax Law. In the case of dividends and bonuses, they shall be withheld and paid on behalf of the enterprises paying them; in the case of interest, they shall be withheld and paid on behalf of the enterprises when paid or due. Second, when QFIIs receive dividends, bonuses and interest income and need to enjoy the treatment of tax treaties (arrangements), they may apply to the relevant tax authorities, which shall, after examining and approving the application, implement the application in accordance with the provisions of the tax treaties; if the application involves a refund of tax, it shall be processed in a timely manner".

Accordingly, the subscription of Pearl bonds by QFII/RQFII may be subject to tax in accordance with the provisions of the Tax Arrangement with reference to the relevant tax treaties of both the Mainland and overseas jurisdictions. For example, according to the Arrangement between the Mainland of China and the Hong Kong Special Administrative Region for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income ("Tax Arrangement"), "I. Interest earned in one Party and paid to a resident of the other Party may be taxed in that other Party. However, such interest may also be taxed in the Contracting State in which it arises in accordance with the laws of that Contracting State. However, if the beneficial owner of the interest is a resident of the other Contracting State, the tax imposed shall not exceed 7 per cent of the total amount of the interest. The competent authorities of both Parties shall consult each other to determine the manner in which the maximum rate of tax is to be applied. III. Notwithstanding the provisions of paragraph 2 of this Article, interest accrued in a Contracting Party and acquired for the government of the other Contracting Party or by an entity recognised by the competent authorities of both Contracting Parties shall be exempt from tax in that Contracting Party. Under the Tax Arrangement, if the place of registration of the QFII/RQFII is in Hong Kong, they may apply in advance to the Inland Revenue for the implementation of the Tax Arrangement and, upon the examination and approval of the Inland Revenue, the interest income derived from the subscription of Pearl bonds will be subject to capital gains tax at the rate of 7%.

① Interest income

As mentioned earlier, the issuer may be recognised by the tax authorities as a purchaser of loan services and still be required to withhold and pay 6% VAT on the interest income from the FTZbonds.

② Trading spread income

According to Appendix 1 to Document No. 36, "Notes on Sales of Services, Intangible Assets and Real Estate", Article 1(5), fourth subparagraph states that "The transfer of financial commodities refers to the business activities of transferring the ownership of foreign exchange, marketable securities, non-goods futures and other financial commodities"; Article 1(3) of Annex 2 "Provisions on Matters Relating to the Pilot Scheme of Business Tax Conversion to Value Added Tax" stipulates that: "The transfer of financial commodities shall be regarded as a sale according to the balance of the selling price after deducting the purchase price. If there is a positive or negative difference in the transfer of financial instruments, the balance after offsetting the profit or loss shall be the sales amount. If there is a negative balance after offsetting, it may be carried forward to the next tax period and offset against the sales of the transferred financial instruments in the next period, but if there is still a negative balance at the end of the year, it may not be carried forward to the next tax year. The purchase price of financial instruments may be elected to be accounted for under the weighted average method or the moving average method and may not be changed within 36 months of the election.

Overseas institutions that buy and sell Pearl bonds directly through FT or NRA accounts are subject to 6% VAT on the sale of the balance of the sale price less the purchase price, which is considered as "income from the transfer of financial commodities". 

According to Article 3(3) of the Enterprise Income Tax Law of the People's Republic of China (as amended in 2018), "A non-resident enterprise that has not established an organisation or a place in China, or that has established an organisation or a place but has obtained income that is not physically connected with the organisation or the place it has established, shall pay enterprise income tax on the income derived from its sources in China"; Article 27: "Enterprises may be exempted from, or have their enterprise income tax reduced for, the following income ...... (e) the income provided for in Paragraph 3 of Article 3 of this Law"; Article 37: "With respect to the non-resident income tax payable by an enterprise on the income specified in paragraph 3 of Article 3 of this Law, withholding tax shall be levied with the payer as the withholding agent. The tax shall be withheld by the withholding agent from the amount paid or to be paid each time the payment is made or to be made". Pursuant to Article 91 of the Regulations for the Implementation of the Enterprise Income Tax Law of the People's Republic of China (as revised in 2019), "non-resident enterprises earning the income provided for in Article 27(5) of the Enterprise Income Tax Law shall be subject to enterprise income tax at a reduced rate of 10%".

Pursuant to the above provisions, the domestic issuer is required to withhold and remit income tax on behalf of the foreign non-resident bondholders prior to the payment of interest. If a tax treaty exists between the domestic and foreign jurisdictions, an application may be made in advance to the tax authorities for the implementation of the tax treaty between the two jurisdictions.

As an emerging financial product, Pearl bonds provide diversified financing opportunities for domestic and foreign investors. In the long run, with the progress of financial innovation and opening up, Pearl bonds are expected to gain more recognition and influence in the international financial market.