RMB partnership funds face tax trouble

China's domestic private equity industry is already on the defensive, worriedly watching dwindling IPO exit multiples and wondering what it means for opportunistic GPs that bought in at sky-high valuations in expectation of a quick turnaround. Anecdotal evidence suggests the investors who backed these funds - typically wealthy individuals with little or no experience of the asset class - are already losing heart and ignoring capital calls.

On top of everything else, local fund managers are now facing a hefty tax bill as the government seeks to impose tougher regulations on an industry many believe to have spun out of control. China fundraising reached $35.8 billion last year, more than two thirds of the Asian total, with renminbi-denominated vehicles attracting $2 for every $1 that went into their US dollar counterparts. Reports of suspect fundraising - at best unethical, at worst fraudulent - abound.

Recognizing the problems of opaque regulation, the government has already taken steps to formalize fundraising and taxation appears to be next in line. Since late April, the market has been swirling with rumors about a capital gains tax imposed on local currency partnership funds, the structure of choice for most renminbi managers.

"The new circular on capital gain tax is in its drafting stage," Pauline Zhang, a tax partner at Deloitte, tells AVCJ. "Although it will probably provide much-needed guidelines, the Chinese private equity industry's tax burden is likely to increase once it is implemented."

Fact and fiction

The immediate challenge is untangling fact and fiction. Initial reports in the local media suggested that the State Administration of Taxation (SAT) wanted to impose a 35-40% tax on unrealized gains as portfolio companies go public. This would see GPs pay out on paper gains, i.e. when their stakes are still subject to lock-up restrictions.

Such an approach goes against the standard practice in other countries of tax realized gains only, and it provoked an outcry in China. The SAT distanced itself from the reports but private equity professionals remain concerned that the authorities will unify the taxation system for partnership funds, riding roughshod over concessions offered by local governments to attract PE firms. A number of these individual policies are already deemed inconsistent with national tax law.

"The proposed tax rule will primarily serve to supplement Circular 159 issued in 2008 and create a consistent system for taxing the partners of private equity and venture capital funds as well as their management companies," says James Wang, a partner at Han Kun Law Offices.

The directive in question - the Circular on Income Tax Issues of Partners of Partnerships - states that partnership income should be levied at the partner level instead of partnership level, implying a partnership fund is a pass-through vehicle for tax purposes. However, the circular was not intended to address private equity specifically and so it fails to address the confusion over how much tax should be paid by LPs and GPs, and when.

There are currently two schools of thoughts as to how individual LPs in a domestic partnership should be taxed. The first school argues that, under current Chinese individual income tax law, if an individual makes a direct investment and realizes a capital gain, he is entitled to a preferential rate of 20%. This practice already applies to LPs in leading cities such as Shanghai, Beijing and Tianjin.

"The existing circular has not yet determined whether individuals are receiving the income on a true look-through basis," says John Gu, senior M&A tax partner at KPMG. "In such cases, capital gains and dividend income derived by the partnership fund get looked through all the way to the point when received by individuals; then they are only required to pay a flat income tax rate of 20%."

The second school of thought is based on the premise that, under Circular 159, partnership income should be treated as business income: an individual investing in a partnership fund is effectively conducting business through that vehicle, which implies a tax rate of 5-35%.

Deloitte's Zhang agrees the coming circular on capital gains will focus on how LPs should be levied. She adds the government may cancel the 20% tax for pure-function LPs - individual investors without managerial role in the fund - and replace it with the 5-35% progressive rate.
In this way, the tax burden on LPs would likely increase, although if investors receive the proceeds through a company structure they could claim the 25% corporate income tax rate.

GP concerns

The new regulation has also prompted concerns among GPs as to how they should draft their limited partnership agreements (LPA). If the LPA states that carried interest will only be charged on a post-tax basis, the fund manager would suffer alongside its investors. In contrast, if the carried interest is calculated on a pre-tax basis, the GP would be largely unaffected by a higher levy on LPs' capital gains.

Taking it one stage further, there is a similar level of uncertainty on how GPs themselves are taxed once they receive carried interest. "It is unclear whether a GP team member will be subject to 5-35% tax rate or the 20% flat rate when once the carried interest is divided up under a partnership structure," KPMG's Gu says.

While a fund registered under a corporate entity is required to treat all LPs equally, most renminbi vehicles currently operate as partnerships because the tax pass-through approach allows more flexible arrangements between GPs and LPs. For example, the national pension fund would have to pay the standard corporate income tax rate of 25% on gains that come from a company structure; the partnership option means it pays no tax at all.

"If we are talking about a tax rate of 35-40%, there would be no incentive for GPs to form a partnership fund anymore because they could just set up a limited liability vehicle and pay 25%," Gu adds.

A united front

Regardless of the debates on taxation formats, a consensus has at least been reached among private equity players: they feel the government should use reforms as part of efforts to lift PE development and put it in line with international best practice. In the US, for example, long-term capital gains earned by individuals - such as through the transfer of shares after a minimum one-year holding period - are currently subject to 15% rate. Ordinary income tax is 35%.

"Most people think the proposed 35-40% rate is too high when compared with other countries and would probably be the highest among the BRIC countries," says Sook Young Yeu, a partner at Orrick. "The tax rate on capital gains should be no higher than the corporate income tax of 25% if the government wants to encourage private equity and venture capital investment."

Others also argue that as the government is just charging 20% on capital gains from individuals' direct investments, it is unreasonable for the regulator to put higher charge on individuals who cooperate with professionals to manage their money more efficiently. A number of industry players such as Frank Han, executive director of Bohai Industrial Investment Fund Management, are either approaching the regulator directly or voicing discontent through public channels.

"There are two purposes of tax: redistribution of wealth and encourage or discourage selected industries," says Han. "While PE players can achieve the government's goals by encouraging economic reforms and the use of local currency, I don't see a reason for imposing a higher tax."

SIDEBAR: Taxing foreign renminbi-funds

Select foreign private equity firms are jockeying for piece of China's renminbi fundraising boom. Working in collaboration with local governments, the Blackstone Group, TPG Capital and The Carlyle Group have all launched local currency vehicles in the last three years. They hope is that they will be permitted a wider investment remit when operating through renminbi funds.

The central government has still not clearly addressed how capital gains generated by foreign-owned reminibi funds will be taxed. There are two reasons for this. First, these funds are still in their nascent stages, with none having reached a final close. Second, the foreign PE firms' local government partners offer a string of tailored incentives, some of them tax-based.

"As different foreign players have different tax structures and may benefit from special treatment provided by local governments and relevant tax treaties, it may be difficult to decide on a general tax rule for them" says Sook Young Yeu, a partner at Orrick.

However, Deloitte's tax partner Pauline Zhang adds that, although there is still no specific rules for offshore vehicles, GPs that operate in China through local subsidiaries are usually subject to a 25% corporate income tax rate. In cases where a fund is managed entirely from offshore, it is only required to pay a withholding tax of 10%, lower if tax treaty benefits apply.

Nevertheless, local partnership structures are increasingly popular among foreign funds because they permit the conversion of foreign currency into renminbi. "I understand some of the foreign renminbi funds have already set up partnerships in China," says Zhang. "This means they will be theoretically subject to the same local partnerships regulation as domestic funds when they exit their portfolios."

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• Topics
• Greater China
• Regulation
• tax
• China
• GPs
• LPs
• KPMG