China Tightens Rules for Wealth Held Abroad

For decades, founders and investors in Chinese tech companies have used shell companies registered in tax havens to list companies on overseas stock exchanges and hold billions of dollars outside the country. This loophole allowed China’s wealthy to bypass the country’s strict regulatory restrictions and avoid government oversight of their wealth.

Now the party is over. Through a series of new laws and regulations, China is reshaping the rules of the game for the wealthy, aiming to tighten control over how money leaves the country — and the implications extend far beyond its borders.

Authorities are pressuring companies to abandon foreign corporate structures and reincorporate in China. Even companies that choose to list in financial hubs like Hong Kong are now required to ensure that the profits of founders and stakeholders are reinvested back into China. At the same time, wealthy individuals with assets outside the country are facing stricter tax oversight on their overseas earnings.

"The authorities in China simply did not enforce some of the rules they set themselves," explains Erica Tay, an economist at Maybank Investment Banking Group based in Singapore. "Now they are starting to put their house in order."

Impact on the US

China's new rules are causing unease among advisors to Asia's wealthy. The volume of capital flowing from China has grown so much that last year Hong Kong overtook Switzerland to become the world's largest cross-border wealth management center, with $2.9 trillion in assets, according to consulting firm Boston Consulting Group.

Beijing's new rules will also have an impact on the US, because wealthy families in Asia have become significant players in North America: according to Swiss bank UBS, about half of their investment portfolios are invested in the region.

China initially allowed the use of offshore corporate structures because they attracted foreign investors to its young tech companies and helped accelerate their growth. In the early 2000s, internet giant Tencent and other Chinese companies sold shares through a legal structure in which a parent company registered in the Cayman Islands held the economic rights to the company's operations in China.

When these companies went public on exchanges outside China, founders, early investors, and employees accumulated wealth in currencies that were not subject to China's regulatory restrictions.

Over the next two decades, almost every major tech company in China used the same loophole to raise capital through an IPO in Hong Kong or New York, creating billions of dollars in assets outside China for thousands of founders, employees, and early investors. Many of them also used shell companies registered in tax havens to hold their shares. The companies operating in China transferred their profits to entities registered outside the country, and these distributed dividends to shareholders in foreign currencies.

The entire system stood in contrast to Beijing's long-standing principle that the state should have control over the outflow of funds beyond its borders. For two decades, Chinese authorities have limited the amount citizens can transfer abroad to $50,000 per year, a restriction that countries like the US and most developed economies do not typically impose on their citizens.

New Regulations

"Issuing shares by an entity registered outside China but identified with a Chinese company is a simple way to bypass capital control restrictions," said Edmund Leow, a senior partner at the law firm Dentons Rodyk in Singapore.

"If I were the authorities, I wouldn't be happy either," he said. "Now they have decided to act."

In recent months, Beijing has issued a series of new regulations through the government, the central bank, the securities regulator, and the tax authority. The latest government directive, issued by the State Council, China's cabinet, came into effect this month and details how companies and individuals can invest outside the country.

Under the new system established by Beijing, Chinese founders can still list their companies on exchanges outside China and subsequently sell their shares. However, according to lawyers following the changes, entrepreneurs must first return the money to China, pay tax on it — and only then request permission to invest outside the country.

"Simply put, from now on every step is visible to the authorities," said Paul Jebely, a partner at the law firm Sterlington, who lives in Hong Kong and represents wealthy clients.

Hong Kong was one of the hottest markets in the world for initial public offerings, raising capital for companies while generating huge profits for early investors. Directors of companies traded on the Hong Kong Stock Exchange sold $7.6 billion worth of shares last year, the highest level in five years, according to data firm Dealogic.

According to economists and lawyers, Beijing is seeking to tighten its control over capital flows while simultaneously expanding the channels that will allow money to leave the country. It is encouraging all investors, including wealthy entrepreneurs, to invest outside China through closed systems. Under these, yuan are invested outside China, for example on the Hong Kong Stock Exchange or in funds managed by asset managers, and after the sale of the investment or other profit distribution, the money is returned to China in yuan. Thus, the entire investment remains under government supervision.

$271 Million Fine

Caught in this storm is billionaire Leaf Li and his brokerage firm, Futu.

Li was one of the first employees of Tencent, which is now the company with the highest market capitalization in China. When Tencent went public on the Hong Kong Stock Exchange in 2004, he became rich overnight. Later, he founded Futu in Hong Kong to help investors invest around the world. At the end of the first quarter, the company's clients held $156 billion in assets, making it one of the largest online brokerage and wealth management firms in Asia.

In May, authorities fined Futu $271 million, alleging that it illegally facilitated cross-border investments as part of an enforcement operation against similar companies. Following the announcement of the fine, the company's stock plunged nearly 30% in one day.

The company said it is cooperating with Chinese authorities and clarified to investors that only 17% of its total client assets are held in accounts originating from China.

Thanks to China's trade surplus with the rest of the world, which reached $1.2 trillion last year, Chinese companies are accumulating large amounts of foreign currency. If they were to return all the money to China, it could strengthen the yuan against the dollar and hurt the competitiveness of Chinese exports. Capital outflow from the country offsets this pressure, which is why analysts say Beijing is not trying to completely prevent investments outside China.

The new policy is also intended to ensure that profits generated outside China are subject to tax, an area where enforcement has been lax for decades.

China's tax authorities reminded the country's citizens this year that they must report income generated outside China, and highlighted China's participation in the Common Reporting Standard (CRS), a system for sharing information between tax authorities around the world. According to lawyers, the new rules published by the State Council are also intended to regulate transactions carried out by companies registered outside China and owned by the country's wealthy.

"Even if you generated capital gains outside China, from now on you will have to pay tax on it," said Kevin Wu, a partner at the law firm Ince in Hong Kong.

This article was translated by Globes exclusively from The Wall Street Journal.