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Though Hong Kong has been a major centre for private equity in the Greater China region for many years, historically, Hong Kong private equity fund sponsors have opted for offshore fund structures, with a particular emphasis on Cayman limited partnerships. However, beginning in 2019, the Hong Kong Government introduced a number of legislative changes to encourage the formation of domestic Hong Kong private equity funds. These changes create a new Hong Kong private equity fund vehicle in the form of limited partnership funds, exempt Hong Kong private equity funds from profits tax in respect of profits earned from qualifying private equity transactions and minimize profits tax in respect of Hong Kong earned carried interest distributed by such funds. In this article, we explore legal, regulatory and tax considerations for Hong Kong private equity firms in light of these changes.
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The legal and tax landscape for Hong Kong private equity has seen significant changes since 2019. These changes include the introduction of a new private equity fund structure in the form of limited partnership funds under the Limited Partnership Funds Ordinance (“LPFO”) as well as tax relief not only in respect of Hong Kong private equity funds (i.e. funds operated from Hong Kong) but also in respect of carried interest earned in Hong Kong from such funds. These changes, together with an increasingly hostile environment in the Cayman Islands and other offshore jurisdictions, have created a paradigm shift as Hong Kong private equity sponsors have begun to turn away from the traditional offshore fund structures in favour of domestic Hong Kong structures. In the 2 months since the introduction in August, 2020 of the limited partnership fund structure, 29 funds have registered as limited partnership funds under the LPFO.
Historically, Hong Kong private equity fund sponsors have opted for Cayman exempted limited partnership structures. In part, this was because Hong Kong limited partnerships under the Limited Partnership Ordinance (“LPO”) were poorly adapted for private equity, lacking for example flexibility in capital withdrawal and limited partner privacy. In part, this was because the Cayman Islands offered an efficient alternative that was well understood by investors.
However, changes in the Cayman Islands to comply with global base erosion and profit shifting (“BEPS”) and money laundering and terrorist counter-financing (“AML”) initiatives have undermined the offshore haven’s attractiveness to Hong Kong private equity fund sponsors. For example, the Private Funds Law (“PFL”), introduced in February 2020, requires private equity funds for the first time to register with the Cayman Islands Monetary Authority (“CIMA”), to file their offering document with CIMA and to comply with ongoing operational requirements including in respect of the valuation and safe keeping of assets, cash monitoring, and the filing of annual accounts.
As in many common law jurisdictions, under the LPFO, limited partnership funds are not separate legal entities. Instead, they are partnerships of persons who, by means of registration under the LPFO, limit the liability of their investor partners as limited partners.
Under the LPFO, a partnership can qualify as a limited partnership fund if it meets prescribed criteria. These criteria include:
Under the LPFO, the rules of equity and common law applicable to partnerships apply to limited partnership funds to the extent they are not inconsistent with the LPFO. Similarly, the LPFO implies into limited partnership funds a number of default partnership provisions of the Partnership Ordinance. Otherwise, the LPFO has few restrictions on the terms of the partnership agreement, meaning that partners are generally free to agree upon the terms and conditions of the fund. Thus, the partnership agreement may, amongst other things, provide for:
The LPFO prohibits the partners of the fund from all being corporations in the same group of companies. This prohibition effectively requires that at least one of the LPs in the fund be an external investor unrelated to the GP.
The LPFO however, recognizes that until the completion of capital raising, the sole and initial LP may be related to the GP. As a result, a fund can still be registered as a limited partnership fund if the applicant can ensure that all the fund partners are no longer corporations in the same group of companies after two years of the issuance of its certificate of registration. If all the partners remain in the same group of companies after the two-year period, the Registrar of Companies (“Registrar”) may strike the fund’s name off the register of limited partnership funds (“LPF Register”).
In common with limited partnership structures in other jurisdictions, the LPFO provides that an LP is not liable for the debts and obligations of the limited partnership fund beyond the amount of the partner’s agreed contribution provided that the LP does not have day-to-day management rights or control over the assets held by the limited partnership fund and does not take part in the management of the limited partnership fund.
For these purposes, an LP is not regarded as taking part in the management of the limited partnership fund only because the LP:
It is significant to note that, like other jurisdictions, the limited liability afforded to LPs under the LPFO may offer no protection in jurisdictions outside of Hong Kong. A limited partnership fund is not a separate legal person. It is merely a partnership of persons, the LPs of which are given statutory protection from liability as a result of compliance with Hong Kong legislation.
Though there are no requirements to maintain capital contributed to the limited partnership fund, withdrawals of capital contributions and distributions of profits and assets is only permitted if the limited partnership fund remains solvent following such withdrawal or distribution.
A limited partnership fund is registered by filing an application to the Registrar of Companies. The application must be submitted by a Hong Kong law firm or solicitor and must, amongst other things:
There is no requirement to file any copy of any private placement memorandum or similar offering document which the limited partnership fund may use for capital raising purposes. Similarly, there is no requirement to file a copy of the limited partnership agreement governing the limited partnership fund.
There is no requirement to make any filings with the Registrar of Companies in respect of the identity of the LPs either at the time of the application for registration or thereafter. However, as noted below, for anti-money laundering control purposes, a responsible officer of the GP must maintain a register of LPs and make this register available to prescribed government authorities including the Companies Registry (“CR”), Securities and Futures Commission (“SFC”), the Hong Kong Monetary Authority (“HKMA”), the Insurance Authority (“IA”), the Hong Kong Police Force, and the Inland Revenue Department (“IRD”).
Unlike the LPO, there is no capital duty on capital contributions to a limited partnership fund.
Every limited partnership fund must file an annual return. The annual return must contain a declaration by the GP that the fund has been in operation or has carried on business as a fund during the preceding 12 months and will be in operation or will carry on business as a fund in the following 12 months.
The Registrar of Companies must make available to the public for inspection a register of limited partnership funds, such register to enable the public to ascertain (i) whether a member of the public is dealing with the GP of the fund, the investment manager of the fund and (ii) the particulars of the limited partnership fund, the GP, the investment manager and any former GP or investment manager.
There is no public access to the annual returns or to the register of LPs to which the Registrar of Companies has access.
The GP of every limited partnership fund must appoint a person as a responsible officer for money laundering control purposes. A responsible officer must be a bank (i.e. an authorized institution under the Banking Ordinance), an SFC licensed corporation, a Hong Kong accountant or accounting firm, a Hong Kong solicitor or foreign lawyer registered in Hong Kong. A responsible officer must conduct due diligence on LPs to comply with requirements of the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (“AMLO”).
Though the LPFO permits a GP of a limited partnership fund to serve as the investment manager, because the GP bears all the liabilities of the limited partnership fund, it is desirable for the GP to be a special purpose vehicle created specifically for each limited partnership fund. It follows that the investment manager will ideally be a legal entity separate from the GP.
Traditionally, in a limited partnership private equity fund, the GP exercises investment discretion and retains an investment manager to advise it. Under this arrangement, the investment manager helps in the capital raising process, the sourcing and identification of investment opportunities, the execution of investments and the provision of corporate finance services to portfolio investments.
An issue in this context is whether the GP or the investment manager must be SFC licensed. The LPFO sets no express requirements as regards SFC licensing of the GP or the investment manager. Historically, some Hong Kong private equity sponsors have taken the view that SFC licensing requirements do not apply to either the GP or the investment manager as fund investments are limited to unlisted securities. Indeed, under the SFO, each of the regulated activities subject to licensing requirements is defined by reference to “securities”, which is in turn defined to exclude shares of private companies under the Companies Ordinance ("CO"). However, private companies under the CO refers only to Hong Kong incorporated companies.
Given the foregoing, a key question is whether the GP needs to be licensed for Type 9 (asset management) regulated activity, particularly if it exercises investment discretion. This is a difficult question for which there is no clear authority.
Under the SFO, licensing requirements may arise where a person carries on a business (or holds himself out as carrying on a business) in a regulated activity. Type 9 regulated activity (asset management) includes, subject to exemptions, managing a portfolio of securities for another person. Whilst it may appear that in managing a limited partnership fund the GP may be managing a portfolio of securities for the LPs, under the common law, the portfolio would appear to be held by the GP on its own behalf and as trustee for the LPs. On this basis, it may be the case that while the GP does manage a portfolio of securities, it does so as principal both for itself and in its capacity as the trustee for the LPs.
It is likely that a Hong Kong based investment manager of a limited partnership fund will need to be SFC licensed. However, the license required will depend upon the scope of the investment manager’s activities.
To the extent that a limited partnership fund may be said to be carrying on a business in Hong Kong, profits which arise in or derive from that business in Hong Kong may be subject to profits tax. In the former regard, whether a limited partnership fund carries on a business in Hong Kong is a question of fact. One significant consideration in this respect is whether the GP or the investment manager is located in Hong Kong and has general authority to contract on behalf of the fund.
Whilst some jurisdictions treat gains on the value of private equity investments as capital gains subject to preferential tax treatment, the Hong Kong Inland Revenue Department ("IRD")does not take that view. Hong Kong does exempt from profits tax profits from the sale of capital assets. However, on the IRD's view, the intention at the time of acquisition of an asset is a primary consideration in determining whether the asset is or is not a capital asset. As a result, gains in the value of private equity investments may not be regarded as profits from the sale of capital assets. This is because in a typical private equity investment, at the time of the investment, there is an intention to sell that investment.
In the past, it was common for the Hong Kong private equity fund sponsors to locate the GP and its activities outside of Hong Kong with a view to taking the fund outside the territorial ambit of Hong Kong profits tax. Indeed, the Hong Kong Government actively supported this approach, with an earlier tax exemption (“Offshore Funds Exemption”) requiring the GP and hence, the fund, to be non-resident as a condition for relief.
Consistent with Hong Kong Government policy to ensure that Hong Kong is a tax neutral fund destination, in 2018 the Hong Kong Government introduced proposals to relax conditions by which private funds, including Hong Kong private equity funds, may be exempt from profits tax, and following that the Inland Revenue (Profits Tax Exemption for Funds) (Amendment) Ordinance 2019 created a new exemption (“Unified Funds Exemption”) from profits tax for qualifying private equity transactions which, unlike the Offshore Funds Exemption, applies even if the fund is resident in Hong Kong. As a result, the Unified Funds Exemption may provide tax relief for a Hon Kong private equity fund in the form of limited partnership fund even if the GP were based in Hong Kong.
Though the statutory language of the Unified Funds Exemption is unclear in some key respects, the IRD has clarified its approach. In broad terms, under the Unified Funds Exemption, the profits of a limited partnership fund may be exempt from Hong Kong profits tax if:
Under the IRO, transactions eligible for relief are transactions in shares, debentures and other prescribed asset of or issued by a private company. In this respect, prior limits in respect of investments in Hong Kong private companies have been relaxed but restrictions remain in respect of investments in Hong Kong real estate.
If the limited partnership fund is not managed by an SFC licensed corporation or an SFC registered authorized institution (i.e. a bank), the fund may need to meet qualification criteria in order for its profits to be eligible for exemptive relief from Hong Kong profits tax. These criteria include a minimum of 4 outside LPs who together account for more than 90% of capital commitments as well as a 30% cap on the carried interest payable to the GP, the investment manager and their affiliates.
The GP and the investment manager may be subject to profits tax in Hong Kong on the basis that either or both carries on a business in Hong Kong with profits arising in or derived from Hong Kong.
As noted above, the traditional approach has been to situate the GP outside of Hong Kong for tax purposes and to situate the investment manager in Hong Kong, thereby minimizing tax on the basis that carried interest and management fees earned by the GP is outside the territorial ambit of Hong Kong profits tax. The investment manager would only receive a portion of the management fees earned by the GP, thereby limiting the extent of management fee subject to Hong Kong profits tax.
The traditional approach has come under significant attack with governments around the world increasingly focused on ensuring that taxes reflect the substance of underlying economic activities. In Hong Kong, the focus has culminated not only in more aggressive enforcement and reliance on anti-avoidance provisions but also in the introduction of BEPS legislation which, empower the IRD to assess tax on the assumption that transactions between affiliated persons are conducted on an arm’s length basis even if, in fact, they are not.
To attract more private equity funds to domicile and operate in Hong Kong, in August 2020, the Government issued a consultation paper proposing to introduce a tax concession for carried interest distributed by eligible Hong Kong private equity funds. The tax concession is retroactive, taking effect from April 1, 2020.
Under the proposal, a GP or an investment manager of a Hong Kong private equity fund may be eligible to a concessionary rate of tax on carried interest distributed to it by the fund if a number of conditions are satisfied. These conditions include:
The SFO requires offers to the public to subscribe for interests in limited partnership funds to be authorized by the SFC unless exempted. One exemption is for offers to professional investors, as defined under the SFO.
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