At Legal Week's Private Client Forum Asia earlier this year, KhattarWong's Gurbachan Singh and Baker & McKenzie's Michael Olesnicky discussed the evolution of the private client legal market in China

Gurbachan Singh: The challenge with China is that it is a unique jurisdiction with its own legal and political system. It is easy to be overawed by the multiplicity and complexity of the rules and regulations. And yet there is now so much wealth in China and a need to plan that wealth. How do you assess the Chinese market for wealth management?

Michael Olesnicky: Everybody is aware of China's potential, and the wealth management industry is looking for new frontiers to explore. It is a very competitive landscape for all of us in Asia, and China is still one of those large untapped jurisdictions.

But despite these opportunities, I have a sense that many institutions are still reluctant about tackling the Chinese market head on due to concerns about 'know your customer', exchange control, regulatory and tax issues.

The first reason that people have often cited for staying out of the Chinese market has been internal 'know your customer' rules. The fact is that China has changed dramatically in recent years and is now a legitimate quasi-capitalist economy. There are a lot of people in China who now have legitimate wealth, and getting information to satisfy 'know your client' procedures is not as onerous as it was, say, 20 years ago.

The second reason advisers and institutions have shied away from China is because of foreign exchange controls. These are still problematic, but the good news 
is that China is gradually liberalising its exchange control laws. For example, it is now possible for people in China to hold bank accounts both inside and outside China in foreign currency or in renminbi.

China is also experimenting with a system that permits individuals to invest abroad in offshore securities through local banks.

Furthermore, each citizen is now permitted to remit up to $50,000 (£32,000) a year outside China. If someone has $20m (£12.7m), $50,000 a year is not going to make much of a dent, even if you spread it among family members. But it is a start. A year ago it was $25,000 (£16,000) and the ceiling has already been raised.

Inheritance is another way of getting money abroad. If somebody in China dies and has children abroad, those children can inherit the assets and take them out of China.

There is also a big wave of emigration planning taking place. People are sending their children abroad to be educated and to live, and they are allowed to take their assets abroad if this process is spread over a two-year period.

The third reason for shying away from China is tax. Like America, China operates a worldwide system of taxation for individuals, and the tax rates can be quite high.

beijing-bright-lightsBut exemptions are now available to people who have taken steps to establish international connections. For example, Chinese citizens who obtain foreign passports are no longer treated as Chinese domiciliaries or residents for tax purposes. However, it is important to bear in mind that China does not permit dual citizenship, so people who do this must give up their Chinese passports.

But even by obtaining residency rights in another jurisdiction without giving up Chinese citizenship, it is also possible for wealthy people to avoid being taxed on a worldwide basis and only on locally sourced income. For example, Hong Kong offers a capital entrants' scheme to give residency rights to people who invest HK$6.5m (£533,000) in a bank deposit there, and mainland Chinese have been prime users of this facility.

A number of families in China are sending children abroad for the purpose of not only education but to obtain permanent residency rights abroad. These children can take cash with them and invest it abroad. When they return to China, they have essentially set up a tax efficient structure because they can then be treated as non-domiciliaries. For the first five years, non-domiciliaries are only subject to tax on Chinese-sourced income. This creates a marvellous tax break for offshore income. With proper planning you can extend that five-year exemption period indefinitely.

A fourth deterrent has been regulatory rules that generally prohibit banks and others from marketing securities and investment-related products on the Mainland. This requires careful compliance with Chinese regulatory rules. That said, this is nothing new because these regulatory issues exist in all countries.

GS: Are very wealthy individuals in China able to use trusts, foundations or limited partnerships to structure their wealth for tax or succession reasons?

MO: China does have a domestic trust law but we would not actually recognise a so-called Chinese trust as having some of the fundamental features of a trust in the more traditional sense. It is more of a contractual asset management relationship than a trust. But the reality is that, if you are planning for a high-net-worth individual in China, you would not be considering setting up a Chinese trust. The normal route would be to establish an offshore trust that would in turn set up an offshore company or a local company to manage assets held in China. It is important that the offshore trust is not active in China because, if a trustee does anything in China, then it must be a Chinese trust. Offshore trusts can only operate in China through subsidiaries.

GS: What is the situation in a case where there is an offshore trust with a corporate entity in China? Can income be channelled back into China?

MO: Some offshore trusts are set up with funds that have come out of China and that are then reinvested back into China. If you bring the money back into China through trust distribution, under Chinese tax law there is generally tax applied.

China has gone through a lot of reform of its corporate tax laws. That was done in 2008, and most of the attention of the Chinese tax authorities today is focused on clarifying all of the corporate tax law changes that were made then. This means the taxation rules for individuals remain fairly benign. The Chinese tax authorities have said that they do ultimately want to undertake a full-scale review of the individual income tax laws, and this will eventually happen.

GS: The Chinese trust law is contractual and far removed from the common law trusts many of us are used to. How are issues relating to control and validity raised? Are there published judicial cases that can provide guidance on these issues?

MO: There are almost no judicial cases on trusts and none dealing with the tax position of trusts and trust income.

The issue of how much control a Chinese resident settlor can have over a trust is often overstated. Yes, it is a concern, but it is the same issue that we have faced in the past with UK, Australian, 
New Zealand and other trusts.

If, in reality, the trustee defers to the settlor in China and the settlor tells the trustee what to do, then the result may be that you have made your British Virgin Islands or other offshore company a resident of China, and therefore subjected it to a 25% worldwide tax.

The challenge is to negotiate with clients exactly what powers they are going to reserve. If they just have the power to change the trustee, then we would usually be comfortable with that. But if the settlor really has the power to tell the trustee where to invest the money and when to make distributions and those powers are, in fact, exercised, then this would create a real Chinese tax issue.

GS: What about inheritance rules?

MO: China has no death duties. There was a bill introduced into the National People's Congress some years ago to introduce an estate tax, but that seemed to disappeared and there has been no talk of it since then that I am aware of. China does not have forced heirship rules so essentially you are free to leave your assets in China to whoever you like. Probate procedures are quite simple. For example, if somebody dies leaving a will, you don't actually have to go to court to have your assets administered after death.

It's worth pointing out that China does have a community property regime. The rule is that any assets that are accumulated during a marriage belong to the husband and wife equally. One of the challenges when setting up trusts for Chinese settlors is the issue of who really owns these assets. If you are dealing with a patriarch, for example, it may be that they are not really all his assets because of these rules. You may have to get the matriarch involved too because those assets may be hers as well. It is possible to contract out of the community property rules, but there does have to be full disclosure to the spouse as to what type of assets are involved.

GS: Looking to the future, is this a market that we should focus on? Will there be a market for a wealth planner or a trust lawyer sitting in Hong Kong or Singapore, knowing that China has its own rules and that there are Chinese lawyers there?

MO: The answer has got to be yes because today the most optimal planning for Chinese citizens is to take assets out of China. Once they have their assets out of China, I think the experience is that most people in China do not want to deal with people in China. They want to deal with a fund manager, a trustee, a private bank and a lawyer who are based outside China.

Gurbachan Singh is senior partner at KhattarWong and Michael Olesnicky is 
head of tax for Hong Kong and China at 
Baker & McKenzie.