A main issue concerns tax. Government officials have not yet clarified how capital gains tax on China investments will be treated, the firm said in a recent note from its Asia equities team.
Currently China imposes a 10% withholding tax on dividend interest, which is assessed at the source where the net proceeds are received. This tax is applied to programmes such as the Qualified Foreign Institutional Investor (QFII).
“However, the potential for a capital gains tax on China investments has not been clarified, with the government giving no indication on whether one will be levied on a retroactive basis.
“This has, understandably, created uncertainty on the tax status of the through-train before its launch in October.”
Out of synch settlement
Schroders noted other issues with the inititave that need to be addressed, such as the settlement cycle, the exercise of rights issues, and the stipulation on daily quotas.
In terms of settlement, investors with multiple custodians could have problems adjusting with the differing settlement cycles between Hong Kong and Shanghai.
“Anyone selling A shares in Hong Kong will need to make this decision T-1 and transfer stock from custodians to brokers overnight at the end of day T-1 so that it is available for sale T0. This clearly presents considerate counterparty risk issues in particular situations, such as with long only clients with multiple custodians.”
Exercise of rights in A share-listed companies is another area that needs to be addressed, as China currently does not allow rights issue access to overseas investors.
“Daily [net] quotas could be an issue in the early days as the traffic will be inevitably skewed to the buy side in both directions (no day trading is allowed in A-shares).
“But as two-way flows balance out more evenly, they hope that the quotas will be hit less often and be much less of an issue.”
`Far reaching and positive’ benefits
Even as Schroders cites these challenges, the firm believes there are “clearly far-reaching and positive” implications for many parties. The stock exchange of Hong Kong, securities companies and brokerages are expected to benefit from increased transaction volumes and new business opportunities.
In the long-term, the fund house sees the stock connect supporting a more institutional-focussed and balanced investment community in China’s domestic markets.
“By allowing this [bourse linkage], Chinese markets, which have been known to swing in reaction to the ‘short-termism’ of retail investors, may finally start to focus on company fundamentals including dividend yields and value,” the note said.