Dr. Lefan Gong, Zhong Lun Law Firm, Shanghai
Moving assets out of the country often poses a unique challenge for clients from the People’s Republic of China (PRC) and the wealth planners advising them on global assets allocation and strategic asset protection. There is cap of USD 50,000 per year on the amount of money that can be moved under the current foreign exchange control regime and, due to the complex restructuring process and substantial tax leakage, moving equity interests of PRC domestic companies and real estate located in mainland China into a trust abroad is no easy task either.
Moreover, the PRC trust law and its associated rules are not developed enough to gain full confidence from ultra high net worth individuals (UHNWIs) in China to use PRC trusts as the primary tool for wealth-planning purposes.
Many wealth planners simply give up trying when their local advisors tell them that moving assets abroad is impossible. However, in some recent cases, we have designed and customized certain cross-border structures to help UHNWI clients use overseas trusts to indirectly hold assets within the PRC. These structures are designed to address and overcome the obstacles or restrictions arising from the current PRC legal and regulatory regime.
This article is intended to summarize the challenges that planners need to overcome and highlight that some of those obstacles are often overlooked by those not familiar with the typical corporate restructuring under PRC law, leading to compliance ‘time bombs’ that are left ticking.
This diagram is a simple representation of a typical cross-border structure using an overseas trust to hold assets within the PRC. However, there is a host of complex matters that would need to be addressed in order to achieve such an apparently simple structure. These range from SAFE compliance and potential MOFCOM approvals, to tax leakage and PRC matrimonial law issues and more.
Most wealth planners working for Chinese UHNWIs are aware of the limit of USD 50,000 per year that may be wired overseas by a PRC national, but not many understand that the State Administration of Foreign Exchange (SAFE) also has restrictions on cross-border restructuring of companies and equity interests owned by PRC nationals. For instance, the SAFE Circular 37 (issued in 2014) requires all PRC nationals to file any interests they have in an overseas entity with their local SAFE. This includes companies, partnerships, and trusts, in particular when the overseas entity holds any direct or indirect interests in a PRC entity.
SAFE Circular 37 and its predecessor, Circular 75 (issued in 2005), both purportedly restrict PRC nationals from using overseas structures to hold PRC entities. At the very least, all such overseas holdings must be reported to SAFE; otherwise the controlling shareholders and the PRC entities could face severe cash penalties and prohibition of any dividend repatriation from PRC entities to parent companies abroad.
In practice, the filing requirement in itself would make many UHNWI clients hesitant to proceed due to privacy concerns, unless restructuring becomes absolutely necessary: for example, due to overseas private equity (PE) or venture capital (VC) financing or a potential initial public offering (IPO) on a foreign stock exchange.
Wealth planners using local lawyers not familiar with the common practice in capital markets and overseas PE and VC financing may not even be told of the risk of exposure arising from SAFE Circular 37. A common approach is to design a structure that would not be subject to the filing requirement in order to address the concerns of clients.
MOFCOM restriction on round-trip investment
In the same vein, the Ministry of Commerce (MOFCOM) also has its separate rules, known as Circular 10, setting out the requirements of MOFCOM-level approval (namely approval at Ministry level in Beijing) when any PRC national intends to use an overseas special-purpose vehicle (SPV) to acquire, directly or indirectly, an affiliated PRC company in which the PRC national holds substantial interests. Creating an overseas trust structure for a PRC settlor holding PRC companies likely falls under Circular 10.
Unless there is a creative way to design a proper restructuring process, approval in Beijing would be inevitable, leading to substantial delays due to the approval authority’s thorough examination of the entire overseas trust structure. This may not be something a private client would welcome.
PRC tax leakage
Few restructurings will go tax free and tax leakage can be one of the toughest challenges faced by the client when considering moving assets from the PRC to a trust abroad. In a normal restructuring process, the UNHWI (a PRC national) would form an overseas holding company to acquire one or more PRC companies, with those companies becoming subsidiaries of the overseas holding company and ultimately being transferred into an overseas trust. Aside from the afore-mentioned SAFE and MOFCOM concerns mentioned, such acquisitions would likely give rise to capital-gains tax imposed on the seller(s), as those companies likely hold valuable assets that have appreciated significantly since their formation.
Although the acquisition is orchestrated by the UNHWI as the controlling person of both the overseas parent company and the PRC companies, the acquisition price cannot be set artificially low as it is subject to the local tax authority’s review and reassessment.
Tax planning will have to be carefully designed and customized to reduce exposure and leakage. The methodologies adopted often depend on the local practice, which may vary according to the officials’ interpretations of the tax code and associated rules on a national level.
Citizenship of the settlor
If the UHNWI (of PRC origin) has completed their immigration and naturalization process and obtained a foreign passport, the restructuring process can occasionally become slightly easier. However, immigration status may also have negative implications.
In a recent case, for example, the UHNWI client received his Australian passport and was in the process of setting up an overseas trust. However, the Australian counsel advised that the client, acting as an Australian tax resident, could face severe tax consequences under Australian law for setting up an overseas trust, even if the assets to be registered to the trust all came from China. Therefore, the settlor’s immigration status and tax residency may also be important considerations in wealth planning and cross-border restructuring.
Matrimonial law and community property
Most of the assets earned and accumulated during a marriage are regarded as community property according to PRC matrimonial law, regardless of whom the assets are registered to. As a result, when setting up an overseas trust, the question usually arises whether transferring the assets (often in the form of shares in an overseas holding company that indirectly holds most of the valuable assets in China) requires express written consent from the spouse, who by default owns 50% of the community property.
Getting such consent can be a challenge if the couple has a delicate relationship. The matter should therefore be carefully addressed and discussed with a team of experts covering the fields of corporate law, matrimonial law and overseas trusts.
Moving cash out of China
With downward pressure on the value of RMB against USD, it is no surprise that SAFE enhances its scrutiny to restrict capital outflows as the urge to transfer RMB assets overseas further intensifies. There has been a growing number of reports in 2015 and 2016 of arrests and crackdowns on underground banks allegedly involved in money laundering and illegal transfers of hundreds of billions of yuan overseas.
Regardless of how comfortable the client feels about such an illicit channel, using underground banks to transfer money carry risks that may not be that evident. At some point, the client may find one or more of their bank accounts frozen by police for investigation, since the accounts appear on transaction records linked to an underground bank.
It is clear that overlooking the risk exposure from such errant practices can lead to serious consequences. However, with the proper structure created, moving certain assets overseas can be achieved in a legitimate way.
A proper cross-border structure can be an increasingly important tool to help UHNWI clients (of PRC origin) with their initiatives of global asset allocation and estate planning. It is vital to create a structure that is not only customized to meet an individual private client’s needs, but can also address unique compliance and tax issues arising from the PRC legal and regulatory regime.