Open-Ended Fund Companies: Are they Right for Hedge Funds?
Hong Kong launched the new Open-Ended Fund Companies regime in Hong Kong on July 30, 2018. The regime offers an opportunity for Hong Kong based asset managers to establish hedge funds relying only on Hong Kong law. This means that asset managers can minimize compliance burdens as funds will no longer need to comply with offshore laws and regulations. One consequence is that they can minimize costs as there will no longer be a need for offshore counsel, auditors and fund administrators. At the same time, investors in the Greater China region can invest with an even greater degree of confidence as OFCs will be governed by a single legal regime that is familiar to them, that offers a higher degree of transparency and that provides accessible dispute resolution in Hong Kong through the Hong Kong courts and the Hong Kong regulators instead of in an unfamiliar offshore jurisdiction.
Hong Kong launched the new Open-Ended Fund Companies (“OFCs”) regime on July 30, 2018. OFCs offer 3 main advantages. First, they allow for the redemption of shares from paid-up capital, thus providing for the first time a Hong Kong domiciled corporate vehicle suitable for open-ended investment funds. Secondly, as corporate vehicles, OFCs offer not only limited liability but statutory segregation of assets and liabilities between sub-funds so that the liabilities of one sub-fund cannot be satisfied from the assets of another sub-fund. Finally, as corporate vehicles, OFCs benefit from a wider range of exemptions from authorization by the Securities and Futures Commission (“SFC”) and thus, can raise capital more flexibly than unit trusts or limited partnerships.
Though it seems that OFCs are likely to become favoured over unit trusts in the case of funds authorized by the SFC for sale to the retail public, their prospect of success in displacing offshore vehicles such as those incorporated in the Cayman Islands in the hedge fund universe is less clear.
One key factor will be how heavy handed the SFC will be in registering OFCs. Disbursement costs for OFCs, which are low, compare very favourably to offshore jurisdictions. However, if applicants face unnecessary delays in registration, the OFC regime will be stillborn. The SFC has estimated that OFC which are sold pursuant to exemption from authorization (“private OFCs”) will be registered in less than 1 month. If this is so, the OFC regime might thrive. However, if the SFC plays a game of delaying acceptance of applications to meet this timeframe, applicants will quickly lose interest. The fact that the SFC does not vet the offering document of an OFC as part of the registration process is promising.
Tax Exemption for the OFC
Another key factor will be how the Inland Revenue Department (“IRD”) taxes OFCs. Tax legislation provides for a purpose-built exemption (“OFC tax exemption”) for OFCs but the exemption is unlikely to be viable for the average asset manager. First, it requires that the OFC not just raise at least HK$200 million in capital but that it keep that capital. Redemptions which cause the OFC to fall below this threshold may result in retroactive loss of tax exemption, introducing unnecessary uncertainty into the investment raising process.
Fortunately, for the average asset manager, it appears that OFCs need not rely upon the OFC tax exemption. Instead, it seems they can rely upon the current exemption for offshore funds. The criteria are simple. First, the OFC must carry out transactions in prescribed asset classes, which includes securities, futures and foreign exchange contracts, through an SFC licensed person. Private OFCs will normally meet this requirement given they are restricted to these types of assets and must be managed by an SFC licensed asset manager. Secondly, the “central management and control” of the OFC must be outside of Hong Kong. The location of the “central management and control” of a company normally refers to where the board carries out its activities. Historically, the IRD has shown considerable flexibility in applying this criteria to Cayman funds and a continued flexible approach to applying this criteria to OFCs will circumvent the unfortunately challenging requirements under the OFC tax exemption.
The enabling legislation for the OFC regime requires that all assets of an OFC are entrusted to a custodian for safekeeping. However, the OFC rules then require that the custodian be a bank or a trust company. As a result, it seems that prime brokers will not generally qualify as OFC custodians. Given that OFCs were presumably designed for higher liability strategies (why else provide for limited liability between sub-funds), the absence of an obvious role for prime brokers is curious.
One solution is for the SFC to relax its rules on a case-by-case basis to allow prime brokers to act as custodians. A more immediate and pragmatic solution may be for custodians to enter into agreements with prime brokers by which for a specific OFC they will not allow the withdrawal of assets except at the instructions of the prime broker, thus giving the prime broker control over assets which, though held by the custodian, are subject to security interests in favour of the broker. Failing that, OFCs and their prime brokers will need to discuss the transfer to such brokers of title to collateral to secure financing provided by the prime brokers in lieu of charges, pledges and other true security interests.
Taxation of the Manager
The OFC regime mandates the investment manager be licensed by the SFC. This implies that managers of OFCs will be based in Hong Kong and hence, subject to Hong Kong profits tax. It is clear therefore that management fees and performances fees cannot be sheltered offshore (though, in any event, with the introduction of the Base Erosion and Profit Shifting legislative package, the extent to which such sheltering is now viable for Cayman and other offshore funds is questionable).
The OFC regime thus calls for a new paradigm for tax planning, possibly through the use of special classes of management shares which, like carried interest in the private equity context, represent “sweat equity” and provide a conduit through which returns equivalent to performance fees may be received on a tax neutral basis.
The new OFC regime has the potential to transform the hedge fund landscape in Hong Kong. For investors, they offer a more credible and transparent investment vehicle than an offshore vehicle. Information about the status of OFCs, their directors and their investment managers is readily available in Hong Kong. Disputes between investors and OFCs can be resolved in the Hong Kong courts and investors have ready access to redress from a strong regulator in Hong Kong.
For asset managers, OFCs offer a means to establish a pooled investment vehicle in a single jurisdiction, saving the additional cost of offshore counsel, offshore auditors and the burdens of complying with not only the laws of Hong Kong but the laws of the offshore jurisdiction. They offer greater certainty of limitation in liability than offshore structures which trade in Hong Kong and, for the reasons in the paragraph above, they offer a more compelling proposition for capital raising from investors in the Greater China region.
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