HK Stock Connect's Expected Cut in Dividend Tax Bodes Well for Long-term HK Stock Valuations

Recently, National People's Congress representative and Hong Kong Securities and Futures Commission (SFC) Chairman Mr. Leung Tim Yuen has submitted a proposal during the Two Sessions, advocating for the continuous expansion and optimization of existing connectivity mechanisms, solidifying Hong Kong's role as a bridge linking Mainland China with overseas capital markets, and further enhancing its status as the preferred offshore listing destination for Mainland enterprises.

Among his suggestions is a proposal regarding the substantial dividend income tax imposed on individual investors under the Stock Connect scheme in Hong Kong, which he notes has dampened the attractiveness of the Hong Kong stock market to individual investors from Mainland China. He calls upon the State Administration of Taxation and securities regulators from both sides to proactively study and optimize relevant tax systems, with the aim of reducing the dividend income tax level for individual investors under the Hong Kong Stock Connect to align it with that of the A-share market.

This article will delve into the specific differences in dividend tax regimes between the Hong Kong Stock Connect and A-shares currently, and discuss the potential impacts that such a proposal, if implemented, would have on the Hong Kong stock market.

After 2021, the buying momentum of funds through the Stock Connect to Hong Kong slightly slowed down, but it still remains an important component of the Hong Kong stock market. As of the end of 2023, the annual turnover of Stock Connect funds exceeded 7 trillion Hong Kong dollars, accounting for more than 28% of the total market turnover. The total market capitalization of companies under the Stock Connect is 45 trillion Hong Kong dollars, which represents 86% of the overall market capitalization of the Hong Kong stock market.

Chart: Fund Flows of the Hong Kong Stock Connect

However, mainland investors' preference for undervalued, high-dividend stocks is not easily transmitted to the Hong Kong stock market. There is a significant difference in dividend yield and valuation between high-dividend sectors of Hong Kong stocks and A-shares. Taking China Shenhua, which is listed in both markets, as an example, the dividend yield TTM (Trailing Twelve Months) for A-share China Shenhua is 6.6%, while for Hong Kong-listed China Shenhua, it is 9.7%, with an A/H premium rate of 43%. Similarly, for high-dividend indices in both markets, the dividend yield for the A-share CSI Dividend Index is 5.4%, while the Hang Seng High Dividend Yield Index has a dividend yield of 7.6%.

Based on the primary source of income, companies in the Hong Kong market can be categorized into Chinese-funded stocks (with revenues mainly from Mainland China), local Hong Kong stocks (with revenues mainly from Hong Kong itself), and foreign-funded stocks (with revenues mainly from overseas). Furthermore, Chinese-funded stocks can be further divided based on the location of registration and the nature of the enterprise into H-shares (enterprises registered in Mainland China), red-chip stocks (state-owned enterprises registered overseas), and private Chinese-funded stocks (private enterprises registered overseas).

According to the "Notice on Tax Policies Related to the Shanghai-Hong Kong Stock Market Trading Connectivity Pilot" and the "Notice on Tax Policies Related to the Shenzhen-Hong Kong Stock Market Trading Connectivity Pilot," there are different requirements for the dividend tax system for different types of enterprises:

For individual investors from Mainland China investing in H-shares listed on the Hong Kong Stock Exchange through the Stock Connect, the H-share companies should apply to China Securities Depository and Clearing Corporation Limited (hereinafter referred to as ChinaClear) to provide a register of Mainland individual investors. The H-share companies then withhold individual income tax at the rate of 20% on behalf of the investors. For dividends from non-H-shares listed on the Hong Kong Stock Exchange, ChinaClear withholds individual income tax at the rate of 20%.

The above tax policy is the taxation method for investors at the Stock Connect level. Since the business operations of H-share companies are in Mainland China and the Stock Connect users are also Mainland residents, the dividends do not leave the country, so they are subject to the standard 20% dividend withholding tax. For non-H-shares, there is also a 10% corporate income tax imposed on overseas investors of Chinese enterprises, with the specific tax rate depending on whether the company's announced dividend has already accounted for the 10% corporate income tax.

For cases where dividend income tax has not been provisioned, red-chip companies must first withhold 10% corporate income tax on behalf of corporate investors. The remaining dividends are then subject to a 20% individual income tax withholding by ChinaClear, resulting in a cumulative effective tax rate of 28%. This is because all Stock Connect investors are registered in the shareholder registries of red-chip companies through the Hong Kong Central Clearing Company (the agent) and, in current practice, red-chip companies technically cannot distinguish between individual and corporate investors. Therefore, a 10% corporate income tax is withheld for all investors coming from the Hong Kong Central Clearing Company.

Chart: CNOOC's 2023 Dividend Announcement Regarding the Tax Collection for Shanghai Stock Connect Income

For individual investors, this means that the dividends they receive are subject to double taxation: once as corporate income tax and once as individual income tax. This involves the issue of double taxation. According to the Cai Shui [2014] No. 81 document, individual investors who have paid withholding tax abroad can apply for a tax credit with the competent tax authorities in China by presenting valid tax deduction certificates. However, due to the complex and cumbersome application process, it is practically difficult for Stock Connect investors to enjoy such tax credits.

In contrast, the Cai Shui [2015] No. 101 document stipulates preferential tax policies for individual A-share investors on dividend income tax (halved for holdings over one month, and exempt for holdings over one year), resulting in a significantly lower actual tax burden on dividends for A-share investors compared to those through the Stock Connect. Taking China Shenhua as an example, the actual return for Stock Connect investors after dividend withholding tax would decrease to 6.9%, significantly narrowing the gap with the 6.6% for A-shares.

What are the main obstacles behind the potential reduction of the tax burden for individual investors using the Stock Connect?

The current Shanghai-Hong Kong Stock Connect mechanism involves two intermediaries: China Securities Depository and Clearing Corporation Limited (ChinaClear) and Hong Kong Securities Clearing Company Limited (HKSCC). Compared to domestic corporate investors, mainland Chinese corporate investors who invest in Hong Kong-listed stocks through the Stock Connect and hold H-shares continuously for 12 months are exempt from corporate income tax on the dividend income obtained, in accordance with the law. This suggests that the primary reason for the difference in tax rates between mainland corporate and individual investors may be that corporate accounts are easier to track in terms of holding periods. If regulatory and technological hurdles are overcome, and considering that the Chinese government does not collect a significant amount from dividend taxes annually, tax relief for individual investors is quite possible.