China to tax bond interest income after decades of exemption

China said that it plans to tax interest income on bonds issued by the government and financial institutions, in a surprise move that’s prompted investors to reevaluate their debt market positions.

The government will resume collection of value-added tax on interest income from bonds sold by central and local governments, as well as those from financial institutions, starting Aug 8, the Ministry of Finance said in a statement released on Friday (Aug 1). Bonds issued before that, including the reopening sales on these notes, will be exempted from the tax.

The new rule is likely to push up the cost of borrowing new debt, especially as the interest income on sovereign bonds had been tax-exempt since the 1990s. It has also spurred investors to lap up existing bonds, pushing yields further down, as they seek to avoid the tax on new bonds.

Taking the general 6 per cent rate on value-added tax into consideration, “the change in tax policy will introduce a cost for investing in newly-issued bonds, and make the old notes appealing”, Huatai Securities analysts, including Zhang Jiqian,g wrote in a note. This may widen the yield gap between existing and new bonds by about five to ten basis points, they estimate.

An outstanding amount of bonds issued by the central and local governments, as well as those from financial institutions, accounted for nearly 70 per cent of the nation’s total as of end-June. The tax on these notes would provide another route for Beijing to expand its revenue and support growth, but it could also raise the cost of funding at a time when the economy remains vulnerable.

Yields on China’s 30-year bonds initially edged lower on Friday on the news, before paring the drop on Monday to 1.94 per cent. The nation’s 10-year yield steadied at 1.7 per cent after falling one basis point in the past session.

Tax exemption on sovereign bonds’ interest income was initially introduced to encourage buying and to facilitate fund-raising by the government, China Financial and Economic News, a newspaper overseen by the finance ministry, reported on Friday. These policies were extended in China’s value-added tax system overhaul in 2016.

“With China’s bond market now ranking second largest in the world, the preferential policy of exempting bond interest income from value-added tax has completed its historical mission,” the report said, citing Liang Ji, a research director at the Chinese Academy of Fiscal Sciences. BLOOMBERG