Grounded Ingenuity | Refined Results

December 7, 2020
By Gavin Cumming, Timothy Loh and Sally Lau
Hong Kong introduced Open-Ended Fund Companies (‘OFCs”) in 2018 to provide a domestic fund vehicle option for Hong Kong funds including hedge funds. Investment restrictions and custodian qualification requirements have limited hedge fund take-up. However, changes announced by the Securities and Futures Commission (“SFC”) in September, 2020 make OFCs the most compelling fund vehicle choice now available to Hong Kong hedge funds. The changes remove investment restrictions, not only giving hedge funds structured as OFCs more flexibility in their investment choices but, perhaps more importantly, enhancing availability of exemptive relief from Hong Kong profits tax and tax certainty for hedge funds structured as OFCs. Hedge funds in the form of OFCs are now uniquely positioned to be exempt from Hong Kong profits tax in a way that non-OFC hedge funds are not. At the same time, these changes allow brokerage firms to act as custodians, thus allowing hedge funds to use their prime brokers as custodians. If you would like more information about whether an OFC may be suitable for your hedge fund setup, please refer to our articles Hong Kong OFCs: The Alternative to the Cayman Islands for Hedge Funds and Hong Kong Government Subsidy for Hedge Funds and Mutual Funds Setup as OFCs, or contact one of our Hedge Fund or Hedge Fund Taxation lawyers.

Background to the OFC Regime

Hong Kong launched the OFC regime on July 30, 2018 to address the deficit in domestic Hong Kong structural options for an open-ended corporate vehicle which could be used as a mutual fund or hedge fund vehicle.

As with the Cayman Islands corporate structures that have traditionally been used, such as Cayman segregated portfolio companies (“Cayman SPCs”), OFCs offer a number of advantages.

OFCs Offer Redeemable Share Capital

As open-ended vehicles, OFCs allow not only for the ongoing issuance of shares but also for the ongoing redemption of shares from paid-up capital. An OFC thus provides for the first time a Hong Kong domiciled corporate vehicle suitable for open-ended investment funds including hedge funds.

OFCs Offer Segregation of Assets and Liabilities of Different Sub-Funds

OFCs offer not only limited liability for shareholders but also statutory segregation of assets and liabilities between sub-funds. This means that the liabilities of one sub-fund cannot be satisfied from the assets of another sub-fund.

OFCs Enjoy a Wider Range of Exemptions for Capital Raising

As corporate vehicles, OFCs benefit from a wider range of exemptions from authorization by the SFC. This means that OFCs can raise capital more flexibly than unit trusts and limited partnerships.

OFCs Enjoy Onshore Profits Tax Exemption

In addition, since the enactment of the Inland Revenue (Profits Tax Exemption for Funds) (Amendment) Ordinance in 2019 (“Unified Funds Exemption Ordinance”) which created a new tax exemption (“Unified Funds Exemption”), it is no longer necessary to situate the central management and control of a hedge fund outside of Hong Kong for it to qualify for relief from Hong Kong profits tax.

As a result, it is now possible for a hedge fund to be incorporated in Hong Kong as an OFC and for the hedge fund’s directors not only to be resident in Hong Kong but to exercise their functions as members of the board in Hong Kong without loss of profits tax exemption.

Recent Enhancements to the OFC Regime

On September 11, 2020, a number of changes took effect to enhance the attractiveness of the OFC regime to hedge funds. The effect of these changes is that, in many cases, an OFC will now be a superior option for a hedge fund as compared to a to Cayman SPC or other offshore fund vehicle.

No Investment Restrictions

One change was to remove the requirement under the Code on Open-Ended Fund Companies (“OFC Code”) for a private OFC to invest at least 90% of its gross asset value (“GAV”) in securities and futures contracts (as defined under the Securities and Futures Ordinance (“SFO”)), cash, bank deposits, certificates of deposit, foreign currencies, foreign exchange contracts, or any combination thereof. As hedge funds will invariably be expected to take the form of a private OFC, hedge funds in the form of an OFC now face no restrictions under the regulatory framework on the types of investments they can make or on the size of their position in any given investment. This means that a hedge fund can now invest in all asset classes, subject only to any investment restrictions in its offering document.

However, consistent with SFC licensing requirements, the manager of an OFC (and the appointed custodian of the OFC) must have sufficient expertise and experience in managing and safekeeping the asset classes in which the OFC invests.

Each OFC must clearly disclose in its offering document all material risks specific to the type and nature of assets in which the OFC will invest, particularly where the OFC intends to invest 10% or more of its gross asset value in non-financial or other less common asset classes.

Brokers Can Serve as Custodians

Similarly, until the recent enhancements took effect, the custodian of an OFC (whether public or private) was required to meet the same eligibility requirements as a custodian of an SFC authorized fund as are set out in the Code on Unit Trusts and Mutual Funds (“Mutual Fund Code”), essentially meaning that a custodian was required to be a Hong Kong or overseas bank, or a trustee of a registered scheme under the Mandatory Provident Fund Schemes Ordinance.

Following the changes, the OFC Code now provides that brokerage firms and other corporations holding an SFC Type 1 license or registration (dealing in securities) under the SFO are eligible to act as custodians of private OFCs provided that the private OFC is a client of that corporation or institution for Type 1 regulated activity (“RA1”). In other words, an SFC Type 1 licensed corporation or registered institution must provide RA1 dealing services in securities to qualify as the custodian. As hedge funds will invariably take the form of a private OFC rather than a public OFC, a hedge fund in the form of an OFC can now appoint its prime broker as its custodian.

The SFC has also clarified that a private OFC may appoint multiple custodians and sub-custodians. Thus, for example, a private OFC can appoint a bank as a cash custodian and a prime broker licensed for RA 1 (dealing in securities) as a custodian of both securities and cash.

As brokers and other corporations holding an SFC Type 1 license or registration are now eligible to serve as custodians of private OFCs, the OFC Code sets out requirements to ensure that custodians are suitably qualified:

  • SFC Approval - an SFC Type 1 licensed or registered custodian must be permitted under its license to hold client assets (i.e. it must not be subject to a condition that it shall not hold clients assets) and the SFC will impose a condition on its license or registration to the effect that it must comply with all requirements applicable to it as a custodian of an OFC, including the requirements in the OFC Code and related guidance issued by the SFC from time to time;
  • Minimum Capital - an SFC Type 1 licensed or registered custodian must maintain minimum paid-up share capital of HK$10 million and minimum liquid capital of HK$3 million;
  • Independence - an SFC Type 1 licensed or registered custodian must be independent of the investment manager of the private OFC;
  • Governance - an SFC Type 1 licensed or registered custodian must provide details to the SFC about the responsible officers or executive officers responsible for the overall management and supervision of its custodial function.

More generally, under the OFC Code, custodians must meet a number of requirements, including the following:

  • a custodian must have sufficient experience, expertise and competence in safekeeping the asset types in which the OFC invests;
  • a custodian must have internal controls and systems commensurate with the custodial risks specific to the type and nature of assets in which the OFC invests;
  • a custodian must segregate the property of the OFC from the assets of the custodian;
  • a custodian must oversee any sub-custodian(s) to ensure that the sub-custodian(s) are suitably qualified and competent, and must maintain written internal control policies and procedures for the selection and ongoing monitoring of sub-custodians;
  • a custodian must keep relevant accounting and other records; and
  • a custodian must manage custody risks.

Existing custodians of private OFCs have a six month transition period to comply with the new safekeeping requirements.

Consequential Enhanced Availability of Unified Funds Exemption

The relaxation of investment restrictions means that the Unified Funds Exemption will now generally exempt OFCs from profits tax on profits earned from transactions in all asset classes. In contrast, non-OFCs are generally exempt only from profits tax on profits earned in transactions (“qualifying transactions”) in securities (including shares, and debentures issued by a private company), futures contracts, exchange traded commodities, foreign exchange contracts, deposits and other assets specified in Schedule 16C of the Inland Revenue Ordinance.

Whilst non-OFCs may be exempt from profits tax on profits earned from transactions (“incidental transactions”) incidental to qualifying transactions, exemptive relief for such incidental transactions is capped at 5%. This means that profits from incidental transactions which exceed 5% of a non-OFC fund’s total profits (including both qualifying transactions and incidental transactions) are subject to profits tax and are not exempt.

OFCs do not share this disadvantage. OFCs are exempt from profits tax on profits from all transactions, whether or not such transactions are qualifying transactions or incidental transactions. OFCs need not distinguish between qualifying transactions, incidental transactions or transactions that are neither qualifying transactions nor incidental transactions to qualify for exemption from profits tax.

OFCs will only be subject to Hong Kong profits tax where they:

  • carry on a direct trading or direct business undertaking in Hong Kong in non-Schedule 16C assets, or
  • hold non-Schedule 16C assets that are utilized to generate income.

Guidance from the Inland Revenue Department in the form of Department and Interpretation Practice Note 61 (“DIPN 61”) suggests this limitation in the profits tax exemption for OFCs relates to Hong Kong based assets which are “normally purchased and sold in the normal course of business of a commercial or industrial enterprise” as well Hong Kong and non-Hong Kong real property holdings and intellectual property. As hedge funds would not normally be expected to deal in these types of assets, it is unlikely that Hong Kong profits tax should apply to a typical hedge fund in the form of an OFC.

On this basis, OFCs seem to be particularly well suited for hedge funds trading in non-traditional assets, such as digital assets. Similarly, OFCs would seem ideal for hedge funds which earn significant income from incidental transactions such as custodying securities, or receiving interest on bonds or notes, or receiving dividends on securities.

Re-Domiciliation: From Cayman to Hong Kong OFC

At present, there is no mechanism for the re-domiciliation of funds established in other jurisdictions. This means there is no statutory procedure by which, for example, a Cayman incorporated fund, such as a Cayman SPC, can convert into a Hong Kong OFC. The only way of effecting such a conversion is for the Cayman fund to transfer its assets and investors to a new Hong Kong OFC.

The SFC announced in September, 2020 that it will seek to introduce legislation to facilitate corporate funds established overseas to re-domicile to Hong Kong as OFCs, provided that such overseas funds satisfy the requirements currently applicable to the registration of newly established OFCs. The SFC is still working on the legislative amendments to introduce the re-domiciliation mechanism as it will involve the introduction of a new bill to the Legislative Council.

Future Prospects for OFCs

In addition to the new enhancements outlined above, the continuing evolution of international tax requirements, especially in connection with the Organisation for Economic Co-operation and Development’s upcoming Base Erosion and Profit Shifting 2.0 (“BEPS 2.0”) initiative means that hedge funds and associated tax arrangements structured in the Cayman Islands will face increased scrutiny and uncertainty.

At the same time, it is now clear that a hedge fund structured as an OFC in Hong Kong will be able to invest in what it wants, have its real central management and control in Hong Kong, and yet still be exempt from Hong Kong profits tax on all its profits.

We expect these developments will allow Hong Kong to establish itself as a preferred jurisdiction in which to establish a hedge fund, in addition to cementing its position as the asset management hub of Asia. As a result, hedge fund managers based in Hong Kong may wish to consult with legal counsel specialized in hedge funds and hedge fund taxation to find out whether OFCs can help them to minimize administrative costs and tax liabilities.

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