Hong Kong removes tax impediments for offshore private equity fund managers

In July 2015 the Hong Kong government gazetted changes to the Inland Revenue Ordinance (Cap 112) to extend the existing profits tax exemption for offshore funds to private equity funds.

The recent amendments are a proactive move by the Hong Kong Government to encourage private equity fund managers to set up new and expand existing businesses in Hong Kong. Private equity managers can now perform more asset management activities in Hong Kong without the risk of their offshore private equity funds incurring a Hong Kong profits tax liability. However such managers do need to keep in mind the licensing implications of increasing management activity conducted in Hong Kong.

Limitations of the existing exemption

In Hong Kong, profits from the disposal of securities may be taxed when they arise there from the carrying on of a trade or business there and the securities disposed of are not capital assets. This potentially made offshore funds with managers acting on their behalf in Hong Kong (and therefore carrying on their trade or business in Hong Kong) subject to profits tax on their gains on disposal of securities.

Since 2006 an offshore funds profit tax exemption has been available to certain non-resident funds, which has been most commonly utilised by hedge funds. The exemption applies to profits derived from “Specified Transactions” carried out through “Specified Persons”. However, while the “Specified Transactions” definition included six categories of transactions that are commonly undertaken by hedge funds (e.g. futures contracts, foreign exchange contracts, etc), it did not include transactions in the securities of private companies, which are commonly undertaken by private equity funds.

Furthermore “Specified Persons” included only entities licensed or registered in Hong Kong under the Securities and Futures Ordinance (Cap 571). This was an additional hurdle for offshore private equity funds as often their investments are arranged by entities that do not otherwise require such a licence or registration in Hong Kong.

The new broadened definitions

The amendments to the offshore fund exemption make three specific changes to allow private equity funds to avail themselves of it.

Firstly, the amendments expand the definition of “Specified Transactions” to include transactions in most non-Hong Kong private companies (“Excepted Private Company”). An Excepted Private Company must be incorporated outside of Hong Kong and for three years prior to the relevant disposal must not have:

a. carried on any business through a permanent establishment in Hong Kong;

b. held shares in another private company which carries on business through a permanent establishment in Hong Kong if the total value of these shares exceeds 10% of the private company’s assets; or

c. held immovable property in Hong Kong, or held shares in another private company which held immovable property in Hong Kong, if the total value of these immoveable properties and shares exceeds 10% of the private company’s assets.

Secondly, the amendments have removed the requirement for transactions to be carried out by “Specified Persons” in circumstances where the offshore fund is a “Qualified Fund”. To be a Qualifying Fund, a fund must have at least five investors (excluding the fund sponsor/originator) who, in aggregate, commit more than 90% of the capital of the fund. In addition, the sponsor/originator must not have received more than 30% of the net proceeds arising from the transactions of the fund.

Finally, the amendments have extended the exemption to include special purpose vehicles (“SPVs”). This is to facilitate the common practice of private equity funds whereby they use single or multi-tiered SPVs to hold or transact investments. The amendments provide that SPVs (whether resident or non-resident) may be exempt from profits tax arising from transactions involving Excepted Private Companies or the securities of an interposed SPV. In addition, the definition of “Securities” (relevant to determining whether a transaction is a Specified Transaction) has been amended to include securities of SPVs.

Licensing of Hong Kong entities

While the changes remove a tax impediment to private equity funds being managed from Hong Kong, any manager seeking to conduct management activities in Hong Kong should be mindful of the licensing implications of doing so.

Many Hong Kong based private equity advisers are able to use a number of licensing exemptions – most commonly because their activity is restricted to providing advice to other entities in their group. However if such entities bring their asset management activities into Hong Kong they are likely to need to obtain a Type 9 (asset management) license from the Securities and Futures Commission (SFC.) This may add an increased regulatory burden on such entities.

Conclusion

These changes are designed to attract more offshore private equity fund managers to set up or expand their businesses in Hong Kong. Meanwhile those already established in Hong Kong can operate and expand with greater certainty as to their tax liability and without the strict operational procedures previously relied on to ensure that they are only acting as advisers and are not transacting on behalf of the offshore fund itself.