Cross-border funds and their legal risks

By Ran Lu and Yuan Shiye, Han Kun Law Offices

Issues related to the tax residency of fund managers and individual round-trip investments may impose additional tax burdens on investors

Based on our observations of the PE market in the past two years, the growing prevalence of Chinese fund managers simultaneously managing RMB, USD, and even QFLP (Qualified Foreign Limited Partnership) funds appears to be becoming a new common practice in the industry. And as the practice grows, so too do certain legal risks that Chinese fund managers commonly neglect in managing cross-border funds.

冉璐, Ran Lu, Partner, Han Kun Law Offices
Ran Lu
Han Kun Law Offices

Compliance for overseas USD funds

The actual controller of a Chinese fund manager may be a Chinese individual or a Chinese enterprise. Under the Measures for Administration of Overseas Investments by Enterprises (Decree No 11), a Chinese individual or enterprise is deemed to establish a “sensitive project” where it establishes, through its overseas company an “equity investment fund or investment platform without specific industrial projects”. Such sensitive projects require advance approval of the National Development and Reform Commission (NDRC). For now, based on public information, there are no instances of NDRC-approved fund managers having established equity investment funds or investment platforms.

However, on 5 June 2018, the NDRC released its Answers to Frequently Asked Questions on Outbound Investment on its management and service network system for outbound investment, based on which we interpret potential exemptions to the decree in the following scenarios:

. The decree does not apply where a natural person, who is a resident of China but holds no Chinese nationality, makes outbound investments through overseas enterprises under his or her control. However, provisions governing outbound investment do apply where such an individual undertakes an outbound investment through an overseas enterprise controlled by an onshore entity he or she establishes;

. Where a Chinese enterprise or individual directly or indirectly sets up an overseas manager or general partner entity to set up a PE fund and all funds are raised overseas (no domestic assets or equities are invested in the overseas PE fund, and there is no Chinese financing or guarantees for all capital investments).

From a tax perspective, the setting up of USD funds overseas by Chinese managers may affect the tax positions of such funds. The combination of purely offshore USD funds and Chinese tax resident fund managers may bring tax risks to such funds in terms of potentially giving rise to a permanent establishment or tax residency. Where a USD fund is deemed to be a Chinese tax resident, Chinese corporate income tax will be levied on all gains from its investments. Chinese managers who intend to set up USD funds need to sufficiently manage the tax risks arising from their tax identities.

袁是也, Yuan Shiye, Partner, Han Kun Law Offices
Yuan Shiye
Han Kun Law Offices

Round-trip investments

A Chinese resident individual may undertake outbound investments and financing through a special purpose vehicle (SPV) incorporated or controlled overseas and conduct direct investment activities in China through such an SPV (i.e. a round-trip investment) as set down in the 4 July 2014 Circular of the State Administration of Foreign Exchange on Foreign Exchange Administration of Overseas Investments and Financing and Round-Trip Investments by Domestic Residents via Special Purpose Vehicles.

According to the circular, Chinese resident individuals are required to complete foreign exchange registration formalities prior to contributing capital to an SPV, using their legitimate assets or equity in China or overseas. After the circular specified in detail the foreign exchange registration required for Chinese resident individuals to undertake overseas investments, financing and round-trip investment, a subsequent circular streamlined the registration process. Chinese resident individuals may now apply to their bank for registration.

Chinese fund managers managing cross-border funds may make round-trip investments mainly in the following two ways:

(1) An overseas USD fund has a Chinese individual as an overseas equity holder. This includes both where a Chinese management team holds equity in the general partner of a USD fund, and where a Chinese individual invests in a USD fund using his or her overseas capital. Either scenario will constitute a round-trip investment if the USD fund invests in a Chinese company; and

(2) A QFLP fund has a Chinese individual as an overseas equity holder. This will constitute a round-trip investment because the QFLP fund itself is a foreign-invested enterprise.

In cases of round-trip investment, the FDI filing/registration of the USD fund-invested company, or QFLP fund, will generally review whether Chinese residents are among the ultimate overseas investors. If so, the relevant certificate of legitimate filing/registration may be required, as specified in the circular. Otherwise the fund will be required to provide a written guarantee confirming that there are no Chinese residents among the overseas investors.

The authors offer two solutions to avoid compliance issues: One is that the USD funds invest only in overseas projects in order to avoid round-trip investments; the other is to complete the registration required by the circular. Meanwhile, the authors look forward to detailed developments in the regulatory system so that we can provide more practical guidance in combination with existing practices.

Unfortunately, all the above-mentioned scenarios will lead to the risk of an additional tax burden. This is because, from a general tax perspective, a “sandwich” structure would likely subject investors to double taxation (i.e. one Chinese operating company held by another Chinese parent company through an overseas subsidiary).

More specifically, Chinese withholding tax will be owed when the overseas entity exits from its investment in China, and Chinese corporate or individual income tax may also be owed if the final distribution of income is made to a Chinese entity. Here, the authors stress that Chinese tax residents who fail to fulfill their tax declaration obligations with regard to their overseas earnings face increasingly urgent tax compliance risks due to progressively complete and rigorous policies and methods to prevent tax avoidance.

Ran Lu is a partner at Han Kun Law Offices. She can be contacted on +86 10 8525 5521 or by email at

Yuan Shiye is a partner at Han Kun Law Offices. He can be contacted on +86 138 1129 2255 or by email at