Escaping the Tax Man in China

Latin America, it seems, is becoming a favored market for Chinese outbound direct investment, claiming more than 12 percent of the Middle Kingdom’s overseas direct investment, according to an April report by HSBC.

However, Brazil, the biggest country in South America, only got 0.2 percent of total overseas investment, followed by Peru and Venezuela, the only two other countries with a share above 0.1 percent.

Most of the rest went to Caribbean island tax havens that together pulled in 93 percent of China’s entire cumulative outward investment into Latin America, according to the HSBC report. Strangely, or maybe not, Bermuda, the British Virgin Islands, Bermuda and the Cayman Islands accounted to 40.6 percent of the cumulative overseas direct investment in Hong Kong as well, according to the 2010 World Investment Report by the United Nations Commission on Trade and Development (UNCTAD). The duchy of Luxemburg, another tax haven, took in another 1 percent of Chinese investment. Thus in strange ways does money move.

"Accurately describing the nature of China’s investments abroad is a challenge," according to a March 2010 report by the US-China Economic and Security Review Commission titled Going Out: An Overview of China’s Outward Direct Investment. "A significant share of Chinese investments is directed through tax havens, making it difficult to discern the ultimate destination of those funds," the report says. It is equally difficult to discern who is originating it from China. Wherever the money is coming from is likely to remain buried in secrecy, given the confidential nature of the banking systems of those countries.

The percentages of the figures, although not the totals, going into tax havens are liable to change considerably when UNCTAD’s 2011 report comes out in mid-July. The UN Economic Commission for Latin America and The Caribbean estimates that FDI into Latin America reached US$15 billion in 2010, doubling China’s cumulative investments for the last two decades. And while the tax havens draw considerable amounts, the fact is that overseas companies have been investing across a broad spectrum from natural resources to manufacturing to telecommunications and other sectors as it builds trade linkages with a vast number of resource-rich countries.

Nonetheless, the money flowing from China into the tax havens created by British aristocrats to protect their interests is formidable as Chinese entrepreneurs and probably illicitly enriched bureaucrats seek to avoid the tax man. It is assumed that most, if not all of that money, is round-tripped from China out to anonymous accounts, then pours back through into Hong Kong and on back into China.

Together with money flowing directly out of China, which accounts for 36.4 percent of direct investment into the territory, it has made Hong Kong, with just 7.1 million people, the world’s fourth-largest recipient of foreign direct investment, at US$48 billion. That is the largest in Asia after China itself and is almost three times its Asian rival, Singapore, at US$17 billion in 2009, according to UNCTAD’s latest figures.

Hong Kong is also the fifth-largest overseas investor in the world after the United States, France, Japan and Germany, at US$52 billion in 2009. What may look like straightforward investment may not be straightforward at all. But wherever it is coming from, and wherever it is going, Hong Kong is a beneficiary.

Hong Kong's total stock of inward direct investment was estimated at US$931 billion at the end of 2009, according to UNCTAD, corresponding to 4.4 times the territory’s GDP in that year. Hong Kong has continued to be the second-largest recipient of foreign direct investment in Asia for 12 consecutive years.

Obviously the territory benefits from being solidly socked into China’s flank. As the 2010 UNCTAD World Investment Report puts it, "One distinct feature of such direct investment was the indirect channeling of capitals from non-operating companies in tax haven economies."

The source of those funds is largely unknown. But as one Hong Kong government official put it,

the trouble with being the world’s freest economy is that "it is not always easy for us to track that."

Hong Kong continues to act as a strong capital-raising center for mainland companies, partly by ignoring mainland accounting procedures and putting the best face on some relatively dodgy initial public offerings. Much of the investment flowing into Hong Kong obviously goes directly back to the mainland, flowing out of a complicated, high-tax and often-arbitrary fiscal system to one of the world’s most simplified, low-tax environments, allowing mainland companies to "mitigate their tax exposure," putting it delicately.

That is exemplified by the fact that, according to Hong Kong officials, the top investor in virtually every major city on the mainland is Hong Kong-based, either from indigenous companies recycling the capital flow back, or from foreign companies using their regional headquarters for investment.

Saying capital flows are difficult to trace is an understatement. Enzio von Pfeil, the chief executive officer of the Economic Time Fund Ltd. estimates that no more than 20 percent of the money flowing from Hong Kong into China is from western sources. The rest, he estimates, is round-tripped, flowing out of China either to Hong Kong or to dummy companies in the British Virgin Islands, where the funds will then be reinvested into a Cayman Islands dummy company to obfuscate its origins once again before it makes its way back to Hong Kong and thus into China.

"I don’t want to decry Hong Kong, but it is obvious that illegal money is flowing into the city," von Pfeil says. "There are a couple of telltale signs. The high end of the property sector is booming, and it is not a bubble. People are coming from the mainland with cash to buy these homes."

Government officials insist that Hong Kong isn’t interested in paper vehicles hiding in holding companies, saying they want companies to come in with new expertise and new services make Hong Kong more competitive. It may well be happening. In any case, whatever is happening, it continues to enrich the territory.

Nor does it seem likely to be slowing any time soon, as long as Hong Kong, in the words of Enzio von Pfeil, remains the water skier being towed by the Chinese speedboat.