Private Equity in Hong Kong: Fund Formation, Management & Operations
Private equity is an asset class with specialized legal, regulatory and tax considerations. In this guide, we outline considerations for private equity firms operating in Hong Kong, the Greater China base for many private equity firms.
Private equity funds are often structured as limited partnerships with the private equity sponsor serving as the general partner and investors serving as limited partners. However, from time to time, such funds may take the form of a company with limited liability, typically established in an offshore tax neutral jurisdiction. Limited partnerships have historically been favoured because they offer limited liability for investors, are treated (to varying degrees) as flow-through vehicles for tax purposes, allow for considerable flexibility in the terms of their constitution and are already familiar to investors in the private equity arena.
In Hong Kong, as in many common law jurisdictions, limited partnerships are not separate legal entities. Instead, they are partnerships of persons who, by means of registration under the Limited Partnership Ordinance (“LPO”), limit the liability of their investors as limited partners.
Partnerships registered outside of Hong Kong may register in Hong Kong to achieve limited liability for their limited partners in Hong Kong. If such partnerships choose not to register in Hong Kong, they may be regarded as general partnerships whose partners, even those described as limited partners, bear unlimited liability in Hong Kong. This may be significant to the extent that a fund, established as a limited partnership and registered outside of Hong Kong, assumes liabilities in Hong Kong.
Such a fund should consider how to manage its Hong Kong liabilities. These liabilities may sometimes be managed by assuming them through limited liability special purpose vehicles held by the fund but other times, as for example in the case of tax liabilities of the fund, such liabilities are the fund’s direct responsibility. Where liabilities cannot be managed through special purpose vehicles, private equity fund sponsors should be careful to ensure either that their funds do not carry on a business in Hong Kong (so as to avoid onshore liability) or that their funds are registered in Hong Kong (so that statutory limitations in liability apply).
In this latter regard, registration in Hong Kong does not by itself offer absolute protection to limited partners from Hong Kong liabilities. As in many common law jurisdictions, in Hong Kong, a limited partner may “advise with the partners” on the “state and prospects of the partnership business” but if he participates in the “management of the partnership business”, he may lose his limited liability. This is an area of some uncertainty, particularly in cases where a limited partner is involved in making any decision otherwise than relating to the structure or terms of the partnership.
The possible loss of liability may concern, for example, limited partners who serve on an LP Advisory Committee or other advisory committee for a fund. It is common for a private equity fund to establish an LP Advisory Committee which may, for example, be tasked with reviewing transactions in which there is a conflict of interest involving the general partner or follow-on investments subsequent to the end of the investment period. In each of these cases, if the fund may have liabilities in Hong Kong, members of the LP Advisory Committee must be careful to ensure that they are merely “advising with partners” as to the prospects and state of the fund’s business rather than participating in the “management of the fund’s business”.
A private equity fund which is structured as a limited partnership and which may register in Hong Kong should consider accepting investor commitments through a combination of equity and debt, with the equity portion being a nominal amount only. Under these arrangements, the fund may wish to take the equity up front and the debt in the form of loans in various drawdowns. For example, the fund may structure its capital so that for every US$500,000 invested, a limited partner will contribute US$5 in equity capital and US$499,995 in loans as and when drawn down.
First, in Hong Kong, on registration as a limited partnership, a private equity fund will be liable to pay capital duty at the rate of HK$8 for every HK$1,000 (or part thereof) of capital contributed by each limited partner. This means that in the case of a private equity fund which raises, say, US$100 million from limited partners in the form of equity capital, the capital duty will be about US$800,000. In contrast, debt capital contributed by limited partners is not subject to capital duty. Whilst private equity sponsors do not themselves bear the capital duty as general partners, they will no doubt be concerned to reduce this duty.
Secondly, the LPO prohibits a limited partner from withdrawing any part of his equity capital contribution. If he does so, he will be liable for the debts and obligations of the limited partnership up to the amount so withdrawn. By requesting capital to be contributed in the form of debt, the fund will have greater flexibility to return capital before winding-up.
In light of the foregoing, a foreign limited partnership which may, at some future time, wish to register in Hong Kong (or at least keep this option open) may wish to ensure that its capital structure includes a significant debt contribution element.
Typically, a sponsor of a private equity fund in the form of a limited partnership will establish a separate legal entity to serve as the general partner of the limited partnership and another separate legal entity to serve as the manager of the fund. Under these arrangements, the general partner will be entitled to a share of the profits of the fund in the form of “carried interest” and the manager will be entitled to management fees from the fund.
Because the general partner bears unlimited liability in a limited partnership structure, the use of a separate entity to serve as the general partner serves to insulate that liability provided that the general partner is organized in a form that limits the liability of its owners. A corollary is that on the basis that the general partner is a special purpose vehicle designed to provide liability insulation, it is essential that the general partner be organized in a form that allows for convenient and tax efficient upstream distribution of any carried interest earned. For private equity sponsors headquartered in Hong Kong, it is common to employ a company limited by shares as the general partner.
Sometimes, a sponsor of a private equity fund may establish one or more advisers to the manager. Under this arrangement, for sponsors based in Hong Kong, the manager will typically conduct high level operations outside of Hong Kong and an adviser conduct day-today operations in or from Hong Kong. If the management team will be spread out across a number of different jurisdictions, the sponsor may establish separate advisers in each jurisdiction.
Private equity sponsors with offices in Hong Kong, whether in the form of a fund manager or adviser to the fund, may be subject to licensing requirements under the Securities and Futures Ordinance (“SFO”). Historically, many private equity sponsors did not license their Hong Kong offices with the Securities and Futures Commission (“SFC”). However, this trend appears to be reversing and the modern trend appears to be that such sponsors will license their Hong Kong offices.
Whether a private equity sponsor is required to license its Hong Kong office will depend upon whether the Hong Kong office carries on a business in a regulated activity. There are 3 relevant regulated activities, namely Type 1 (dealing in securities), Type 4 (advising on securities) and Type 9 (asset management).
- Dealing in Securities – Generally, a person deals in securities if he makes or offers to make an agreement with another person or induces or attempts to induce another person to enter into an agreement for or with a view to acquiring, disposing of or subscribing for securities. A private equity sponsor may deal in securities, for example, by raising capital on behalf of a fund sponsored by it as, in this case, the sponsor may be inducing or attempting to induce an investor to enter into an agreement to subscribe for securities. Equally, for example, a private equity sponsor may deal in securities by arranging for a fund managed by it (or its special purpose holding vehicle) or an investee company to enter into an agreement by which the fund acquires an interest in the investee company or by arranging for a third party investor to acquire securities of an existing investee company.
Advising on Securities – Subject to exemptions, advising on securities includes advising on whether, which, the time at which or the terms and conditions upon which a person should acquire or dispose of securities. In the private equity context, a sponsor may be advising on securities by recommending an investment to the fund it advises.
Asset Management – Asset management includes, subject to exemptions, managing a portfolio of securities for another person. The concept of “managing” is uncertain and at one time, the SFC would in the normal course accept that a Hong Kong office of a private equity sponsor was engaged in the regulated activity of asset management. However, the current practice of the SFC appears to be to allow licensing for asset management only where the Hong Kong office exercises investment discretion. This means that instead of the general partner making the final investment decision, whether through an investment committee or otherwise, the Hong Kong adviser must make the final investment decision in order for the SFC to accept that the Hong Kong adviser is engaged in asset management. It seems to logically follow that a Hong Kong office of a private equity sponsor responsible for sourcing and advising on deals and monitoring a portfolio may not be regarded as carrying on a business in asset management.
Generally, if private equity sponsors are subject to licensing requirements in Hong Kong, a concern is that the regulatory capital requirements, both as to paid-up capital and ongoing liquid capital, are normally higher for dealing in securities than for advising on securities and asset management.
Private equity sponsors sometimes take the view that their Hong Kong office is exempt from licensing because they only invest in unlisted securities. Indeed, under the SFO, each of the regulated activities described above is defined by reference to “securities”, which is in turn defined to exclude shares of private companies under the Companies Ordinance ("CO"), A concern in relation to relying upon this exclusion alone to avoid licensing requirements is that private companies under the CO likely refers only to Hong Kong incorporated companies. Whatever may be the merits of relying upon this exemption, it is clear that the Hong Kong offices of a private equity sponsor who engage in capital raising for a fund in the form of a limited partnership are not dealing in shares of a company but rather limited partnership interests.
Private equity sponsors may also rely upon the intra-group exemption to minimize licensing requirements. Under the intra-group exemption:
- Sub to Parent - A company is not regarded as advising on securities if it is advising its parent company and the company is a wholly-owned subsidiary of the parent company. Equally, a company is not regarded as engaged in asset management if it manages a portfolio of securities for its parent company and the company is a wholly-owned subsidiary of the parent company.
Parent to Sub - A company is not regarded as advising on securities or being engaged in asset management if it advises or manages the portfolio of its wholly-owned subsidiary.
Sister to Sister – A company is not regarded as advising on securities or being engaged in asset management if it advises or manages the portfolio of another company and both companies are wholly-owned subsidiaries of the same parent company.
However, the intra-group exemption only exempts a Hong Kong adviser from licensing for advising on securities and asset management. It does not exempt such an adviser from licensing for dealing in securities. At the same time, whilst a manager, adviser and general partner may all be commonly owned, the fund will normally have separate ownership.
In broad terms, Hong Kong taxes profits arising in or derived from Hong Kong from a business that is carried on in Hong Kong. Both the fund and the private equity sponsor itself may be subject to profits tax.
To the extent that a private equity fund may be said to be carrying on a business in Hong Kong, profits which arise in or derive from Hong Kong may be subject to profits tax. In this regard, whether a fund carries on a business in Hong Kong is a question of fact.
One significant consideration in this respect is whether there is anyone in Hong Kong who has general authority to contract on behalf of the fund. Private equity sponsors operating on a global basis do not typically make portfolio decisions on behalf of a fund in Hong Kong. Often, the role of such a sponsor’s Hong Kong office is limited to identifying and assessing investment opportunities, negotiating deals, monitoring existing investments and capital raising. Portfolio decisions to invest are made by the general partner outside of Hong Kong. In this case, the general partner may not be carrying on a business in Hong Kong and accordingly, the fund may not be subject to profits tax.
Sometimes, a view is taken that a fund may be beyond the reach of Hong Kong profits tax simply because the fund vehicle is a limited partnership registered outside of Hong Kong and the general partner is incorporated outside of Hong Kong. The place where the fund vehicle or the general partner is established or registered is not generally determinative of whether the fund is carrying on a business in Hong Kong. For example, where, as is sometimes the case, the directors of the general partner are based in Hong Kong and make decisions for the fund from Hong Kong, there is a real risk that the fund is carrying on a business in Hong Kong even though the general partner is not incorporated in Hong Kong.
If the fund may be regarded as carrying on a business in Hong Kong, the fund may nevertheless be exempt from profits tax, possibly, for example, because it qualifies for exemption under the offshore funds tax exemption or because the profits it generates do not arise or derive from Hong Kong.
Offshore Funds Tax Exemption
A fund may be exempted from profits tax if (i) its central management and control is situated outside of Hong Kong, and (ii) it only enters into transactions in securities carried out through or arranged by a person licensed with the SFC and transactions incidental thereto. In this regard, incidental transactions cannot account for more than 5 per cent. of the total trading receipts of the fund.
There is some uncertainty as to the application of this exemption to private equity because the term “securities” excludes shares or debentures of private companies as defined under the CO. At the very least, this means that a fund seeking to rely upon this exemption may not be able to use a special purpose vehicle incorporated in Hong Kong as a holding vehicle for portfolio investments. Funds may wish to do so for tax reasons (e.g. a Hong Kong vehicle may enjoy preferential tax treatment in the upstream distribution of income from a portfolio company back to the fund). However, some professional advisers have expressed concern that even though the CO defines a company as a company incorporated thereunder (i.e. a company incorporated in Hong Kong), on a broad construction, the term “securities” would exclude all shares of private companies, whether incorporated in Hong Kong or not. On this construction, the exemption would be largely be inapplicable to private equity funds since such funds typically invest in private companies. In light of this concern, in the 2013-14 Budget, the Hong Kong Government announced that it would provide bright line clarification that the exemption would apply to investments in private companies so long as such companies do not hold real estate in Hong Kong and do not carry out any business in Hong Kong.
Profits Sourced Outside of Hong Kong
If a fund’s profits do not arise in or derive from Hong Kong, such profits will not be subject to Hong Kong profits tax. There is considerable uncertainty as to whether a profit arises in or derives from Hong Kong. Fundamentally, whether profits arise in or derive from Hong Kong is a question of fact. In broad terms, where portfolio transactions are sourced, negotiated and concluded in Hong Kong, there is a risk that the profits from these transactions will be regarded as arising in or being derived from Hong Kong.
Whilst some jurisdictions treat gains on the value of private equity investments as capital gains subject to preferential tax treatment, Hong Kong does not. Hong Kong does exempt from profits tax profits from the sale of capital assets. However, 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 would not likely 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.
Dividends distributed through Hong Kong are generally not subject to Hong Kong profits tax. The Inland Revenue Ordinance (“IRO”) specifically exempts from Hong Kong profits tax any dividends where the payer of the dividend has already paid profits tax. At the same time, dividends earned from companies carrying on their business outside of Hong Kong are not normally viewed as profits arising from a trade, profession or business arising in or derived from Hong Kong and accordingly, are not subject to profits tax.
Computation of Liability
Where a fund organized as a limited partnership is subject to Hong Kong profits tax, the tax payable by each partner will depend on the applicable profits tax rate of each partner applied to the partner's share of the fund's profits or losses. In this respect, individual partners are taxed at 15 per cent. whereas corporate partner's are taxed at 16.5 per cent. A partner's share of the partnership's losses is deductible against the partner's own profits. However, the deduction is limited to the partner's adjusted capital contribution and share of undistributed profits. If the capital has been structured to favour debt over equity, it becomes even more important therefore to avoid the application of profits tax.
The Hong Kong office of the sponsor will normally be subject to profits tax in Hong Kong because it will be carrying on a business in Hong Kong with profits arising in or derived from Hong Kong.
As noted above, some sponsors will establish a manager in an offshore jurisdiction and an adviser in Hong Kong to whom the manager will delegate various investment and capital raising related functions. In a typical arrangement of this type, the sponsor will arrange for the offshore manager to pay a fee to the Hong Kong adviser with the intent that only that fee will be subject to Hong Kong profits tax. The management fee payable by the fund (less the fee payable to the Hong Kong adviser) as well as the carried interest may thus be outside the ambit of Hong Kong profits tax. However:
Transfer Pricing – As in many jurisdictions, Hong Kong tax laws are concerned with transfer pricing arrangements between affiliated entities, such as an offshore manager and a Hong Kong based adviser who are part of the same sponsor group. In particular, where the offshore manager and the Hong Kong based adviser arrange their business so that the Hong Kong based adviser earns less than the ordinary profits which might otherwise be expected to arise in or derive from Hong Kong, the business of the offshore manager in pursuance of its connection with the Hong Kong adviser may be deemed to be carried on in Hong Kong and the Hong Kong adviser may be assessable and chargeable with tax in respect of its profits from such business in the name of the Hong Kong adviser as if the Hong Kong adviser were its agent.
Tax Avoidance – A related concern is whether the offshore manager is in fact carrying on a business in Hong Kong and thus, subject to profits tax. This is of particular note for sponsors headquartered in Hong Kong as in this case, employees of the sponsor based in Hong Kong may serve as directors of the offshore manager. To the extent that the directors act on behalf of the offshore manager in Hong Kong, there is a risk that the offshore manager will be carrying on a business in Hong Kong. In this regard, as with fund vehicles, the place of the incorporation of the offshore manager is not generally a significant consideration in deciding whether the offshore manager is carrying on a business in Hong Kong.
Hong Kong’s securities law establish parallel regimes governing the offer of investments, one under the Companies (Winding-up and Miscellaneous Provisions) Ordinance ("CWMPO") and one under the SFO. Broadly, both require marketing materials for funds to be authorized by the SFC unless exempted. The CWMPO contains a wider range of exemptions than the SFO, including most significantly, an exemption for offers of investment the minimum investment size of which is HK$500,000 (approx. US$65,000). However, the CWMPO only governs offers in respect of shares and debentures whereas the SFO governs all investment products, whether in the form of shares, debentures or otherwise. Thus, offers in respect of private equity funds structured as limited partnerships fall under the SFO regime rather than the CWMPO regime and accordingly, cannot be exempted from SFC authorization on the basis of any minimum investment size.
Both the CWMPO and SFO regimes exempt offers to professional investors, as defined under the SFO. In this regard, professional investors include both institutional and non-institutional professional investors. Institutional professional investors are generally regulated financial services firms (e.g. brokerage firms, asset managers, investment advisers, banks, and insurers), regulated funds and non-municipal government bodies. Non-institutional professional investors include high-net worth individuals (i.e. individuals with a portfolio of cash, securities and certificates of deposit the value of which exceeds HK$8 million), substantial corporations and partnerships (i.e. organizations with a portfolio of cash, securities and certificates of deposit the value of which exceeds HK$8 million or total assets of more than HK$40 million) and substantial trusts (i.e. trusts with total trust assets of more than HK$40 million).
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