HKCFI rules letters of no consent regime unconstitutional; Hong Kong Police & JFIU cannot issue LNCs to freeze bank accounts before STR filing
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December 1, 2020
By Timothy Loh
On December 4, 2018, the Hong Kong Government introduced legislation introducing a new exemption (“Unified Funds Tax Exemption”) for hedge funds, private equity funds and other private investment funds. Under the proposed legislation, both onshore and offshore funds (i.e. both Hong Kong and non-Hong Kong resident funds) may now qualify for full exemption from Hong Kong profits tax on the same basis and may now invest in a wider range of investments. If passed, into law, the Unified Funds Exemption will provide bright line guidance to exempt Hong Kong incorporated open-ended fund companies (“OFCs”) from Hong Kong profits tax and will mark an important step towards reducing Hong Kong’s reliance on offshore jurisdictions for asset management activities.
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On December 4, 2018, the Inland Revenue (Profits Tax Exemption for Funds) (Amendment) Bill 2018 (“Unified Funds Tax Exemption Bill”) was introduced into the Legislative Council. Prompted by criticisms from the Council of the European Union and with the objective of developing a more tax friendly environment for hedge funds and private equity funds in Hong Kong, the Unified Funds Tax Exemption Bill aims to ensure that both onshore and offshore (i.e. both Hong Kong and non-Hong Kong resident) funds may be eligible for exemption from profits tax on the same basis and to relax existing restrictions on investments with a Hong Kong nexus.
The Inland Revenue Ordinance (“IRO”) presently provides 2 exemptions for funds not authorized by the Securities and Futures Commission (“SFC”). One exemption (“Offshore Funds Exemption”) under s. 20AC is aimed specifically at funds (and other investment vehicles) which are “not resident” in Hong Kong. This means that the exemption is unavailable to a fund unless the “central management and control” of the fund is outside of Hong Kong. The second exemption (“OFC Exemption”), under s. 20AH, is aimed specifically at Hong Kong incorporated OFCs.
Both the Offshore Funds Exemption and the OFC Exemption were designed to minimize the risk that Hong Kong businesses would use these exemptions to avoid profits tax through the establishment of non-genuine fund structures. Both exemptions restrict funds from making certain investments with a Hong Kong nexus.
At the same time, the Offshore Funds Exemption has encouraged asset managers based in Hong Kong to create artificial offshore governance structures to relocate the “central management and control” of the fund outside of Hong Kong, thus ensuring that the funds they manage are eligible for relief.
Finally, in an attempt to ensure that OFCs are genuine, the OFC Exemption requires a minimum threshold level of investment and spread of investors in an OFC to qualify for exemption. Many industry players regard this threshold as being too high. The exception also retrospectively reverses exemptive relief given if those thresholds are not met. Not surprisingly, the OFC Exemption has widely been criticized as being uncommercial.
The Unified Funds Tax Exemption Bill aims to level the playing field, removing distinctions which, though intended to combat anti-avoidance, in effect, discriminate against Hong Kong.
The Unified Funds Tax Exemption Bill repeals the OFC Exemption, replacing it with the Unified Funds Tax Exemption. As proposed, the Unified Funds Tax Exemption will apply to arrangements which qualify as “funds” and which invest in prescribed types of transactions.
Though the Unified Funds Tax Exemption Bill does not repeal the Offshore Funds Exemption, any arrangement which qualifies as a “fund” no longer qualifies as a “non-resident person” for the purpose of the Offshore Funds Exemption and thus, no longer qualifies for relief under that exemption. This means that non-resident persons whose assets are managed by SFC regulated asset managers other than “funds” may continue to qualify for exemption under the Offshore Funds Exemption. However, funds which previously relied upon the Offshore Funds Exemption must now qualify under the new Unified Funds Tax Exemption to obtain relief.
Under the Unified Funds Tax Exemption Bill, unless excluded, a “fund” includes both pooled investment vehicles as well as sovereign wealth funds. In simplified terms, the former is an arrangement in which the following conditions are satisfied:
either (i) the property is managed as a whole by, or on behalf of, the person operating the arrangement, or (ii) the contributions of the participating persons, and the profits or income from which payment is made to them, are pooled under the arrangement, or both;
under the arrangement, the participating persons do not have day-to-day control over the management of the property (whether or not they have the right to be consulted on, or to give directions in respect of, the management); and
the (pretended) purpose or effect of the arrangement is to enable the participating persons, whether by acquiring any right, interest, title or benefit in the property or any part of the property or otherwise, to participate in or receive profits, income, a payment or other returns.
These conditions broadly mirror those in the definition of a “collective investment scheme” under the Securities and Futures Ordinance (“SFO”), subject to a few exceptions.
As proposed, there is no requirement under the Unified Funds Tax Exemption for a “fund” to be non-resident. The absence of this requirement widens the availability of exemptive relief and means that in the case of a fund in the form of a corporation or a limited partnership with a corporate general partner, the board of directors of the corporation or the general partner of the limited partnership will be able to meet and conduct its business in Hong Kong without losing exemptive relief.
The Unified Funds Tax Exemption Bill specifically excludes from the definition of a “fund” a number of different arrangements (i.e. these arrangements will not qualify for relief under this new Unified Funds Tax Exemption):
Public Fund – Mutual funds, unit trusts and similar pooled investment vehicles which are eligible for relief from profits tax under the exemption (“Public Funds Exemption”) in the IRO, s. 26A(1A) on the basis that they are authorized by the SFC.
Business Undertakings – A business undertaking for general commercial or industrial purposes. Such an undertaking would include not only any activity involving the purchase and sale of goods or the supply or services but also the property development, property holding, insurance and finance (other than through eligible private equity investments). Though the scope of the term “goods” is not clear, presumably it excludes intangibles as otherwise, dealings in securities, futures contracts and currencies would result in a business undertaking for general or industrial purposes.
Intra-Group Arrangements - Arrangements in which all the participants in the arrangement are corporations in the same group of companies as the operator of the arrangement or arrangements in which all the participants in the arrangement are employees (or close relatives of such employees) of the same corporate group as the operator of the arrangement.
It would appear nevertheless that these arrangements could continue to be eligible for relief under the Offshore Funds Exemption.
As proposed under the Unified Funds Tax Exemption Bill, subject to anti-avoidance provisions, a “fund” may be eligible for exemption from profits tax in respect of profits earned from 3 types of transactions:
Qualifying Transactions – A transaction (“Qualifying Transaction”) will qualify if the transaction is in a prescribed asset class and either (i) the transaction is carried out in Hong Kong by or through a person licensed or registered by the SFC or arranged in Hong Kong by such a person, or (ii) the fund is a “qualified investment fund”. The term “qualified fund” is aligned with the existing definition under the Offshore Funds Exemption. In broad terms, a qualified fund means a fund where (i) there are more than 4 investors independent of the fund sponsor, (ii) the capital commitments of the investors independent of the fund sponsor exceed 90 per cent. of aggregate capital commitments, and (iii) the fund sponsor is entitled to carried interest of not more than 30 per cent. of the net proceeds from the transactions of the fund.
Incidental Transactions – A transaction incidental to such Qualifying Transactions. Trading receipts from such incidental transactions are ineligible for relief under the Unified Funds Tax Exemption if such receipts exceed 5% of the total receipts of the fund (including both Qualifying Transactions and transactions incidental thereto).
OFC Exempt Transactions - In the case of an OFC, transactions (“OFC Exempt Transactions”) otherwise than in Qualifying Transactions.
Unlike the Offshore Investment Funds Exemption, there is no provision for the proposed Unified Funds Tax Exemption to be lost in its entirety if a “fund” carries on transactions outside the prescribed asset classes.
Qualifying Transactions includes transactions in securities, including shares, stocks, debentures, bonds and notes issued by a private company, as well as futures contracts, foreign exchange contracts, deposits, gold and silver contracts traded in Hong Kong, foreign currencies, OTC derivative contracts and other assets specified in Schedule 16C of the IRO.
As the list of assets transactions in which may be eligible as Qualifying Transactions includes OTC derivative contracts, the range of assets qualifying for relief under the Unified Funds Tax Exemptions is broader than the range of assets under the existing Offshore Funds Exemption.
As compared to Cayman and other offshore incorporated funds, the Unified Funds Tax Exemption Bill will give OFCs greater latitude for exemption from Hong Kong profits tax. OFCs will not be limited to carrying out Qualifying Transactions.
This does not mean, however, that OFCs are unrestricted in their scope of activities. As set out above, as proposed, an OFC which is a “business undertaking for general commercial or industrial purposes” is excluded from the definition of a “fund” and thus, would not be eligible for relief at all. Similarly, an OFC will not be eligible for exemption from profits tax on profits earned from carrying on a direct trading or direct business undertaking in Hong Kong in assets outside Schedule 16C or from holding of assets outside Schedule 16C that are utilized to generate income. Thus, an OFC which, for example, holds art which it lends out at a fee may not be eligible for tax relief in respect of that fee.
In any event, it should be borne in mind that private OFCs are subject to investment restrictions prescribed under the Code on Open-Ended Fund Companies issued by the SFC, namely that at least 90 per cent. of the gross asset value of a private OFC must consist of securities, futures contracts, real estate under a real estate investment trust, cash, bank deposits, certificates of deposit, foreign currencies or foreign exchange contracts.
Like the current Offshore Funds Exemption, subject to anti-avoidance provisions, in addition to profits tax exemption from transactions in private equity made directly by a “fund”, the Unified Funds Tax Exemption Bill extends the profits tax exemption to transactions in private equity by special purpose entities (“SPEs”) to the extent they are held by qualifying “funds”. In broad terms, these private equity transactions will include (i) transactions in shares, stocks, debentures, bonds or notes issued by private companies, whether incorporated in Hong Kong or elsewhere, or special purpose entities interposed between “funds” and such private companies, and (ii) transactions in rights, options or interests in such securities.
To qualify as an SPE, an entity must be established solely for the purpose of holding, whether directly or indirectly, one or more eligible private equity investments.
Unlike the Offshore Funds Exemption, the proposed new Unified Funds Tax Exemption does not restrict private equity investments in companies carrying on a business through or from a permanent establishment in Hong Kong. However, to qualify for exemption from profits tax, such investments will need to comply with at least one of the following holding restrictions:
No Control - When a “fund” or an SPE invests in securities of a private company, the fund or the SPE may be eligible for profits tax exemption if it does not have control over that company.
Holding Period - When a “fund” or an SPE invests in securities of a private company, the fund or the SPE may be eligible for profits tax exemption if it has held those securities for 2 or more years after they were acquired.
Cap on Asset Mix – When a “fund” or an SPE invests in securities of a private company and cannot meet either of the above tests, the fund or the SPE may still be eligible for profits tax exemption if the company holds no more than 50 per cent. of its assets by value in short-term assets. In broad terms, “short-term assets” are assets that have not been held for 3 or more years, that are not Hong Kong real estate and that are not assets which qualify as assets for Qualifying Transactions.
Special relaxation of these holding restrictions is given to partner funds of The Innovation and Technology Venture Fund Corporation.
In common with the Offshore Funds Exemption, the proposed new Unified Funds Tax Exemption continues to restrict investments in Hong Kong immovable property, albeit in a more relaxed fashion. Under the new formulation, in simplified terms, where a “fund” or an SPE invests in securities of a private company which in turn holds Hong Kong immovable property (excluding infrastructure and interests in property held through public companies), the Unified Funds Tax Exemption will only be available if the aggregate value of the interest in Hong Kong immovable property held by that private company (rather than the “fund”) does not exceed 10 per cent. of the value of its assets and the normal holding restrictions for private equity above are satisfied.
As the assets and liabilities of sub-funds of OFCs may be segregated by law, where sub-funds are so segregated, the Unified Funds Tax Exemption Bill provides for the separate taxation of each sub-fund using the model under the existing OFC Exemption. The fact that a sub-fund is unable to qualify for relief under the Unified Funds Tax Exemption does not affect the availability of relief under that exemption for other sub-funds of the same OFC.
The Unified Funds Tax Exemption Bill aims to keep the current anti-round tripping provisions in the IRO to prevent Hong Kong residents who are associates of a “fund” from using the “fund” (and its SPEs) to minimize their tax liability. Under these provisions, such residents will bear the proportionate liability for the tax that otherwise would have been paid by the “fund” (or the SPE) but for the profits tax exemption.
The changes proposed under the Unified Funds Tax Exemption Bill are welcome. If adopted, managers of Hong Kong based hedge funds and private equity funds will no longer need to artificially move the central management and control of funds sponsored by them outside of Hong Kong. They will be able to invest in a wider range of investments. Perhaps most importantly, they can adopt OFCs in lieu of offshore vehicles, reducing overall ongoing compliance and operational costs, minimizing reliance on offshore laws and minimizing the risk of failure of offshore structures designed to segregate assets and liabilities.
The Bill was gazetted on December 7, 2018 and will be going through the first reading on December 12, 2018.
HKCFI rules letters of no consent regime unconstitutional; Hong Kong Police & JFIU cannot issue LNCs to freeze bank accounts before STR filing
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