Why Chinese HNWIs wishing to establish offshore trusts should act now?

Chinese HNWIs should act now as China may introduce estate tax, exit tax on emigration and adopt new rules to tax the contribution of appreciated assets into an offshore trust.

Chinese high net worth individuals (“HNWIs”) are very interested in using offshore trust for wealth planning because of the unique benefits offshore trusts offer and also due to the fact that Chinese domestic trusts are not suitable for wealth planning.  As to the timing, we think Chinese HNWIs should act now so that they could avoid the adverse consequences caused by the next wave of Chinese tax reform.

China may introduce estate tax soon

Estate tax has suddenly become a very hot topic in China recently.  There has been a lot of media coverage on this over the past few months.  In 2004 the Ministry of Finance issued a draft of the Provisional Regulations on Chinese Estate Tax for public comments.  Although the draft was revised again in 2010, it had never become law.  The introduction of estate tax was then repeatedly mentioned as a medium term goal in several important resolutions on reform adopted by the central government over the past few years.  There were even rumors earlier this year that Shenzhen would become the first city to introduce estate tax on a pilot basis, which caused widespread panic among local residents, but those rumors turned out to be a false alarm.

Why estate tax has suddenly become a media focus is the natural result of the widespread frustration and anxiety among Chinese people about the increasing income disparity between the rich and the poor.  The people who are in favor of estate tax argue that estate tax can significantly help to solve this income disparity issue.  However, the opponents take the view that it is simply too early to introduce such tax in China because China doesn’t even have the required basic infrastructure for collecting and administrating such tax (e.g. a nationwide asset registration system and a reliable asset valuation system), let alone certain key technical issues that would need great wisdom to figure out the answers for, such as the exemption amount, the tax rate, etc..

Despite of those hurdles such as the infrastructure and the difficulties in working out those technical issues, in my personal view, because generating additional tax revenue from estate tax is not a top goal for China (at least not yet), the timing for the introduction of estate tax in China would mainly depend on whether and how quickly China can have good control over the income disparity issue.  If China fails to do so, estate tax may arrive much earlier than people would anticipate.

Needless to say, if China introduces estate tax, it will automatically introduce gift tax.  So for those who think they could get around with the estate tax by giving wealth to their children or other family members as gift should think again.

China may also introduce exit tax on emigration

Many countries impose an exit tax on persons who cease to be tax residents in those countries.  This often takes the form of a capital gains tax against unrealized gain attributable to the period in which the taxpayer was a tax resident of the country in question.  Exit tax can be assessed upon change of domicile, habitual residence or citizenship.

China also taxes its tax residents on worldwide income, but nonresidents are taxed only on China sourced income. So if a Chinese individual becomes a nonresident from a resident, under current Chinese tax rules, the person will no longer need to pay Chinese tax on non-China sourced income, even if the income represents the unrealized capital gains attributable to the period when the person was still a Chinese tax resident.  The change of such tax residency often takes place when the person emigrates from China to another country.

We may see a change to such rules soon if the current emigration wave continues to rise.  Although there is no official study confirming this, China is now the largest emigrant source country in the world.  While the emigration is generally not Chinese tax-driven, it will be just a matter of time before the Chinese tax authorities realize the resulting permanent tax revenue loss.  At that time, the introduction of exit tax would likely be inevitable.

China may adopt new rules to tax the contribution of appreciated assets into an offshore trust

China currently doesn’t have any specific tax rules on trust.  As a result, in the case of offshore trust, when a Chinese settlor contributes appreciated assets (e.g. company shares) into a trust, people generally would take a position that the contribution should not give rise to any Chinese tax.  If such appreciated assets are offshore assets, when they are disposed of by the trustee, no Chinese tax would apply because the trustee is not a Chinese tax resident.  If the trustee distributes such income to the beneficiary or beneficiaries, under current Chinese individual income tax rules, another position could be generally taken that the distribution should be considered gift and thus not taxable in China.   In other words, the use of offshore trust could minimize the Chinese tax that the settlor should have paid if he or she disposed of such assets directly.  The current capital gains tax rate for individuals is 20%.

China will soon reform its individual income tax law. The trust taxation rules will certainly be part of the reform and it won’t be too difficult for the Chinese tax authorities to detect the loophole mentioned above.  Or they may fix it earlier simply by introducing a deemed sale rule or a general anti-avoidance rule