Proposals to extend the Hong Kong offshore fund exemption regime
In brief
In his 2013/14 Budget, the Hong Kong Financial Secretary committed “to extend the profits tax exemption for offshore funds to include transactions in private companies which are incorporated or registered outside Hong Kong and do not hold any Hong Kong properties nor carry out any business in Hong Kong” in order to allow private equity (PE) funds to enjoy the same tax exemption as other offshore funds. The Financial Services and the Treasury Bureau tabled a briefing paper on the proposals before the Legislative Council Panel on Financial Affairs on 5 January 2015. The briefing paper reveals three key proposals, namely (a) extending the current tax exemption to offshore PE funds, (b) relaxing the criteria for specified transactions arranged by or carried out through persons who are not licensed under the Securities and Future Ordinance (SFO), and (c) an exemption for Special Purpose Vehicles (SPV) commonly used in PE funds.
In detail
According to the annual Fund Management Activities Survey conducted by the Securities and Futures Commission in July 2014, the asset management business of Hong Kong as at the end of 2013 is over HK$11 trillion The Fund Management Activities Survey 2013 conducted by the SFC is available at the Hong Kong Securities and Futures Commission . At the end of 2013, the combined fund management business amounted to HK$16 trillion, of which asset management business other than REITs and those carried by registered institutions amounted to HK$11 trillion*. Over 51% of this (HK$5,827 billion) was managed in Hong Kong. Hong Kong's sound legal and financial infrastructure together with its strong ties with the PRC makes it one of the preferred locations for foreign investment capital. To further strengthen Hong Kong's position as a premier international asset management centre, the Hong Kong Financial Secretary announced in his 2013/14 Budget to consult the fund industry on the legislative amendments to the existing offshore fund exemption regime, which extends the exemption to PE funds.
Subsequent to a series of consultations with the fund industry (the latest ones were held in November and December 2014), a briefing paper was tabled before the Legislative Council Panel on Financial Affairs on 5 January 2015.
The existing offshore fund exemption regime
Under the offshore fund exemption regime introduced in March 2006, non-resident funds can enjoy an exemption from Hong Kong profits tax on “specified transactions” carried out through “specified persons”. “Specified transactions” are defined broadly, and include transactions in securities futures, foreign exchange contracts, foreign currencies and exchange traded commodities and the making of certain deposits. However, transactions in shares in private companies are excluded from “specified transactions”.
An anti-avoidance provision was introduced at the same time to prevent abuse or round-tripping by local funds disguising themselves as offshore funds to take advantage of the exemption. The provision attributes the share of income in such an exempted offshore fund (except a bona fide widely held fund) to certain Hong Kong resident investors who hold a beneficial interest in the offshore fund, and deems such Hong Kong resident investors to have devised his/her share of the Hong Kong sourced profits of the offshore fund. The Departmental Interpretation and Practice Note (DIPN) 43 was introduced to provide practical guidance and examples on the implementation of the regime.
Over the years, concerns were raised by the fund industry on the limitations of the regime introduced in 2006.
The proposals
There are three key proposals in the briefing paper:
- Extending the current tax exemption to offshore PE funds
- The major thrust in the briefing paper is to extend the offshore fund exemption to transactions in an “eligible portfolio company” (EPC) even though it is a private company incorporated outside Hong Kong. An EPC is defined to mean one which at all times within the three years before a securities transaction in this portfolio company, it did not (i) carry on any business in Hong Kong, (ii) hold any interests in one or more private companies carrying on business in Hong Kong with aggregate value of which capital and interests exceeding 10% of its assets, and (iii) hold immovable property in Hong Kong directly or indirectly with aggregate value exceeding 10% of its assets.
- The private company will not be considered as carrying on business in Hong Kong for the purpose of the exemption if the business activities are of purely preparatory or auxiliary nature.
- Relaxing the criteria for specified transactions arranged by or carried out through persons who are licensed under the SFO
- Under the current regime, only specified transactions carried out through a specified person (being corporations and authorised financial institutions licensed or registered under the SFO) are exempted. The proposed change will relax this requirement by exempting specified transactions of an offshore fund which is a “qualifying fund” even if these transactions are not carried out through a specified person.
- A “qualifying fund” is a fund which at all times after the final close of sale of interests (i) has five or more investors who are not associates of the originator of the fund, (ii) the capital commitments of these investors exceed 90% of the total capital commitment, and (iii) the net proceeds to be received from the fund by the originator does not exceed 30% of the net proceeds arising from the transactions of the fund.
- PE funds are typically collective investment schemes, with managers which may or may not be SFC licensed or registered. It is also common for the fund manager or its associate to be entitled to carried interest. The relaxation in the proposal takes into account these common practices in the PE fund industry.
- Allowing an exemption for SPVs
- It is common for PE funds to set up SPVs to hold their investment portfolios. The proposals are (i) not to exclude transactions in securities in an SPV from “specified transactions”, and (ii) to provide exemptions to SPVs in respect of profits from a “specified transaction”.
- The proposals will allow flexibility in PE fund structure.
Conclusion
Although the proposals address a number of concerns that the fund industry has over the years, there are areas where further clarifications or enhancements need to be made. The current proposal allows a “qualifying fund” to be exempted on certain conditions. However, it is unclear how “five or more investors” in a “qualifying fund” is counted, especially when master feeder funds or co-investors are involved. We expect this will be addressed in the legislation.
The potential tax exposure of carried interest of fund managers under the deeming provision (the anti-avoidance provision) also needs to be considered. The existing deeming provision (section 20AE(8)) specifies that only interests in “bona fide widely held” offshore funds are exempted. It is unclear whether “five or more investors” used in defining a “qualifying fund” would be considered as “bona fide widely held”. To avoid ambiguity, section 20AE should be aligned with the proposed change in the exemption.
It is not uncommon for PE funds to make investments in a portfolio company in the form of equity, debts or/and convertible loans. Under the current proposal, transactions in non-listed debts of a private company remain outside the exemption. Going forward, in order to uplift Hong Kong's status as an attractive fund management centre, the HKSAR Government may consider extending the exemption regime to credit funds.
Overall, these proposals should be welcomed by the PE fund industry. They will enhance Hong Kong's competitiveness in attracting offshore funds to be managed in Hong Kong and strengthen Hong Kong's position as the international asset management centre. It is expected that the legislation will be finalised in the summer of 2015. We will continuously monitor this development.
* The Fund Management Activities Survey 2013 conducted by the SFC is available at the Securities and Futures Commission of Hong Kong. At the end of 2013, the combined fund management business amounted to HK$16 trillion, of which asset management business other than REITs and those carried by registered institutions amounted to HK$11 trillion.
