I. Introduction

The issuance and trading of Free Trade Zone offshore bonds ("FTZ bonds" or “Pearl bonds” ) is one of the significant outcomes of the financial reforms in the Shanghai Free Trade Zone (FTZ) in China. Pearl bonds refer to bonds issued by entities within the China (Shanghai) Pilot Free Trade Zone to qualified domestic and international investors. In recent years, Pearl bonds have gained increasing attention. The issuance of Pearl bonds not only expands financing channels for issuers but also attracts domestic and foreign investors to participate in financial activities within the FTZ, promoting the internationalization of the RMB. This is an important aspect of financial openness and innovation in the Shanghai FTZ.

The FTZ bond market lies between the domestic market and the traditional offshore market. Compared to the relatively mature regulatory systems for bonds in China's stock exchanges and interbank markets, the regulation of Pearl bonds still contains many ambiguities, especially in terms of their positioning, regulatory supervision and applicable tax policies. This article aims to analyse and interpret the practical legal issues involved in the issuance and investment of Pearl bonds, focusing on the regulatory framework, key regulatory aspects and applicable tax policies.

II. regulatory system

On 9 May 2016, Shanghai Clearing House Limited ("SHCH") formally released the “ Shanghai Clearing House Business Guidelines for Cross-Border Bonds Registration, Custody, Clearing and Settlement in the China(Shanghai))Pilot Free Trade Zone”and“Shanghai Clearing House Detailed Rules for Implementation of Cross-Border Bonds Registration, Custody, Clearing and Settlement in the China (Shanghai) Pilot Free Trade Zone” ("Guidelines for Cross-border Bond Business"), marking that SHCH can provide registration, custody, clearing and settlement services for the FTZ business . On 7 September 2016, the China Central Depository & Clearing Co., Ltd. ("CCDC") issued the "China Central Depository & Clearing Co., Ltd.Bond Services Guide on China (Shanghai) Pilot Free Trade Zone " ("FTZ Bond Business Guidelines"), which clarified the business processes of FTZ bond issuance, registration, custodianship, clearing, settlement, interest payment and redemption, and information disclosure, and formulated transaction-level rules for the FTZ bond market, signifying the official launch of the FTZ bond business.

When issuing Pearl bonds, issuers must comply with different rules set by either CCDC or the SHCH, depending on their choice of service provider. Pearl bonds most being registered and held by CCDC, and only a few by the SHCH. The primary listing venues include the Macau Financial Exchange, with a few listed on the Singapore Exchange.

On November 10, 2022, the People's Bank of China and the State Administration of Foreign Exchange issued the "Regulations on the Management of Funds for Overseas Institutional Investors Investing in China's Bond Market," which defines the "Chinese bond market" as including only the domestic interbank bond market and exchange bond market. From a literal interpretation, Pearl bonds are not included in the "Chinese bond market." Given the current regulatory framework, the review authority for Pearl bonds is the Foreign Investment Department of the National Development and Reform Commission (NDRC), and the issuance of Pearl bonds requires an external debt approval from this department. In terms of external debt registration, Pearl bonds are similar to offshore bonds. They are mainly issued by following the patterns of offshore USD or EUR bonds, led by foreign underwriters, and listed on offshore markets such as the Macau Financial Exchange or the Singapore Exchange. Therefore, apart from specific regulations, Pearl bonds' issuance, investment, and operation generally adhere to the regulatory rules for offshore bonds, effectively positioning them as domestic offshore bonds.

III. Key Regulatory Aspects in China

A. Audit and registration of NDRC

The NDRC clarified in its "Guide for Enterprise Foreign Debt Registration" that Pearl bonds are treated as offshore bonds for registration purposes.

The NDRC promulgated on 5 January 2023 and formally implemented on 10 February 2023 the Administrative Measures for the “Examination and Registration of Medium and Long-term Foreign Debt of Enterprises”(Order No.56 of the NDRC, hereinafter referred to as "Document No.56"), and the Notice of the NDRC on Promoting the Administrative Reform of the Registration System for Foreign Debt Issuance by Enterprises was accordingly abolished. According to Circular No.56, debt instruments borrowed from overseas, denominated in local currency or foreign currency, where the principal and interest are repaid as agreed, all need to be audited and registered.

The Document No. 56 sets forth higher and more detailed requirements on the scope of management of foreign debt registration, qualification requirements for entities, positive and negative lists of financing purposes, post-event supervision, legal responsibilities of enterprises and intermediaries, etc. At the same time, the examination and approval procedure has been changed from completing the application and issuing the registration certificate of foreign debt issuance by enterprises within 7 working days after acceptance to examining and registering and issuing the registration certificate within 3 months after acceptance.

B. Issuer and Investor Admission

1. Issuer Admission

The CCDC's FTZ Bond Business Guidelines do not specify the qualifications for issuers, while the SHCH's Guidelines for Cross-border Bond Business Guide states that "domestic and foreign issuers registered with the relevant authorities or self-regulatory organizations may issue cross-border RMB-denominated bonds in the FTZ to qualified institutional investors within the zone and abroad."

FTZ bond issuers are not limited to companies registered within the Shanghai FTZ. Based on issued cases, FTZ bond issuers are not restricted by their place of registration and include both domestic and foreign companies. Enterprises with external debt approval from the NDRC can issue bonds within the FTZ. In practice, given the tax, regulatory and use of funds issues, Pearl bonds are often issued directly by domestic companies rather than through offshore SPVs to facilitate the use of the funds raised within China.

2. Investor Admission

The CCDC and the SHCH maintain highly consistent investor admission systems, allowing the following investors to participate in Pearl bonds:

Domestic institutions include various development financial institutions, policy banks, deposit-taking financial institutions, other banking financial institutions, securities institutions, insurance institutions, non-financial institutions and non-corporate products. Foreign institutions include QFIIs, RQFIIs, three types of foreign institutions and other qualified foreign financial institutions and their products.

Eligible domestic and overseas institutions can apply to open bond accounts with CCDC or SHCH and activate dedicated FTZ portfolios to directly participate in the FTZ bond business. Foreign institutions can also participate through settlement agents or qualified foreign custodians, i.e. foreign institutions can hold and settle FTZ cross-border RMB bonds through dedicated custody accounts and fund settlement accounts opened with CCDC or SHCH, or through general accounts opened with qualified foreign custodians.

The CCDC's FTZ Bond Business Guidelines Appendix 2-2 "Basic Information Form for Investors" and the SHCH's Cross-Border Bond Business Guidelines Appendix 3 "National Interbank Bond Market Investor Basic Information Form (Institutional)" list the types of foreign institutions mainly including "international organisations, foreign central banks, RMB clearing banks, foreign participating banks, foreign insurance companies, QFIIs, RQFIIs and others". Therefore, CCDC and SHCH reserve the option for other qualified foreign financial institutions to participate in the subscription of the Bonds.

After consultation with the relevant departments of CCDC, it is currently understood that CCDC will adopt a "case-by-case" approach to foreign investors participating in the subscription of Pearl bonds, generally requiring foreign investors to have a financial licence issued by the competent authority in their country.

C. External Debt Registration

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.

IV. Application of tax policy for investment in Pearl bonds by overseas institutions

The tax policies for Pearl bonds are not clearly defined and the applicability of different tax regimes may be ambiguous. In general, the tax treatment of Pearl bonds follows the principles of bond taxation within China. However, due to their cross-border nature, special considerations may apply:

A. Tax exemption policy

According to the Announcement on the Extension of Enterprise Income Tax and Value Added Tax Policies for Overseas Institutions Investing in the Domestic Bond Market ("Circular No. 34"), "From 7 November 2021 to 31 December 2025, the interest income from bonds received by foreign institutions investing in the domestic bond market shall be temporarily exempted from enterprise income tax and value added tax".

As mentioned above, at present, only the central bank and the State Administration of Foreign Exchange have defined the Chinese bond market to include the domestic interbank bond market and the exchange bond market in the Provisions on the Management of Funds for Investment in the Chinese Bond Market by Foreign Institutional Investors. At the following three levels, it is not yet possible to determine whether Pearl bonds are part of the domestic bond market and thus subject to the corporate income tax and VAT exemption policy.

1. At the level of tax regulations

At the level of tax regulations, there is no provision clarifying whether the "domestic bond market" in Circular No. 34 includes the bond trading market of the FTZ or only refers to the Shanghai and Shenzhen stock exchanges and the interbank bond market in China. If the scope of the "domestic bond market" is not specified in the tax regulations or higher-level regulations, the exemption policy in Circular No. 34 may not apply to foreign institutions subscribing Pearl bonds.

2. The scope of account opening by offshore organisations

There are no laws and regulations or FTZ policies that stipulate that foreign institutions enjoy special tax incentives for investing in Pearl bonds through FT accounts and NRA accounts.

3. Issued case level

Combined with the situation of issued Pearl bonds, there is no case of direct introduction of foreign investment institutions, which mainly concerns the tax issues of FTZ investors and overseas branches of domestic banks.

From the special status of the FTZ, the FTZ belongs to the "internal customs", the Pearl bonds belong to the offshore bonds, but there is still a difference with the "foreign bonds", whether the subscription of Pearl bonds by foreign institutions can be regarded as "engaging in bond business in China". Whether the subscription of Pearl bonds by foreign institutions can be regarded as "engaging in bond business in China", we believe there is still room for interpretation at the tax level.

If the provisions of Circular No. 34 are applicable, the tax exemption for interest income from FTB investment by foreign institutions is corporate income tax and value added tax. If the provisions of Circular No. 34 are not applicable, the tax and fee on the subscription of FTBs by foreign institutions will be levied in accordance with their subscription of offshore bonds issued by domestic entities. While FTBs are similar to traditional offshore bonds in terms of issuance rules and issuance documents, tax compensation clauses are generally provided for (e.g., if the issuer is required to deduct or withhold PRC tax in excess of the applicable rate, the issuer shall pay such additional amounts as will result in the bondholders receiving such amounts as they would have received had no such deduction or withholding been required). Under the Tax Compensation Clause, the Issuer will pay such additional amounts as will result in the Bondholders receiving such amounts as they would have received had no such withholding or deduction been required. From the point of view of protecting foreign investment institutions, such top-up clauses may to some extent compensate foreign investors for their yield risk.

B. Specific tax implications of FTA bonds

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. Tax implications of subscription through QFII/RQFII

(1) Value added tax

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.

(2) Enterprise Income Tax (Capital Gains Tax)

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%.

2、Tax implications of direct subscription through FT and NRA accounts

(1) Value added tax

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".

(2) Enterprise income tax

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.

V. Conclusion

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.

Source: Change Bridge Law Firm

Authors:

Luo Wenhui, partner, business areas: financial market, capital market. Tel: 8610 8541 9680, E: wenhui.luo@chancebridge.com
Liu Wen, lawyer, business areas: financial market. Tel: 8610 8541 9682, E: wen.liu@chancebridge.com
Li Yang, lawyer, business areas: financial market. Tel: 8610 8541 9681, E: yang.li@chancebridge.com

Special statement: This article is for communication purposes only and does not represent the formal legal opinions or suggestions of Change Bridge Law Firm or its lawyers.

{{ articleCategory.name ? articleCategory.name : 'NEWS' }}