The New Private Funds Exemption: an Update on Discussions with the Inland Revenue Department

February 11, 2019
By Timothy Loh

The Inland Revenue (Profits Tax Exemption Amendment) Bill represents a major step forward in allowing private funds, including hedge funds and private equity funds, managed from Hong Kong to obtain exemption from profits tax. Amongst other things, the Bill will provide bright line tax certainty for open-ended fund companies. At the same time, the Bill will allow funds to maintain their tax residency in Hong Kong, meaning that such funds will no longer be required to undertake board activities outside of Hong Kong and will no longer be required to maintain directors resident outside of Hong Kong to qualify for tax relief. Finally, the Bill will provide greater flexibility for tax relief in the context of private equity investments both in and out of Hong Kong. The Bill is on track to come into effect in April, 2019 and discussions with the IRD to date suggest that the IRD will be helpful in construing the legislation for the benefit of the asset management industry.

The new Inland Revenue (Profits Tax Exemption Amendment) Bill (“Bill”) creates a new tax exemption (“Private Funds Exemptions”) which aims to provide relief for private funds, including hedge funds and private equity funds, from Hong Kong profits tax. The Bill will work in conjunction with the existing exemption (“Offshore Investment Vehicles Exemption”) under the Inland Revenue Ordinance, s. 20AC. It is expected to enable private funds to dispense with the need to be resident outside of Hong Kong to qualify for relief and to invest in a wider range of Hong Kong investments than is available under the Offshore Investment Vehicles Exemption without loss of relief.

Since the introduction of the Bill on December 4, 2018, we have had discussions with the Inland Revenue Department (“IRD”) in relation to technical issues arising under the Bill. These discussions took place in the broader context of a consultation process in which a number of tax practitioners and industry bodies participated. In brief, we understand that the IRD is moving forward with the Bill and will be aiming to address any issues through Departmental Interpretation and Practice Notes (“DIPNs”) rather than through any amendments to the Bill. This appears to have 2 consequences. First, the original timeline for the introduction of the Bill, namely April 1, 2019, remains in place. Secondly, the IRD appears to be signalling an intention to continue an approach to enforcement that will encourage asset management activities in Hong Kong for bona fide funds.

Eligibility for Exemption

The new proposed Private Funds Exemption will apply only to arrangements which qualify as a “fund”.

Day-to-day Control over the Management of the Property

In order to qualify as a “fund”, one of the conditions is that “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)”. “Day-to-day control” is not defined in the Bill.

This condition may pose a problem for investment managers or portfolio managers who wish to invest into funds managed by them. It is not unusual for investment managers and their officers to invest into funds managed by them. Since the investment manager or the portfolio manager of an investment manager would normally have day-to-day control over the management of a fund’s assets, the fund might be disqualified from relief as a result of this condition.

Similarly, in the case of a private equity fund, investors might sometimes appoint a representative to sit on the investment committee that is responsible for making investment decisions. Though the representative is typically a different legal person than the investor and the committee as a whole rather than the representative has the authority to make decisions, from an economic perspective, it may be argued that the same person is both an investor and a person involved in the day-to-day control of the management of the property, thus undermining availability of exemptive relief.

Pooling of Contributions and Profits or Income

To qualify as a “fund” under the Private Funds Exemption, another condition that must be satisfied is that the arrangement must be one under which 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 the payment is made to them, are pooled, or both.

A concern is how this condition is to be applied to a fund or, in the case of an umbrella fund, a sub-fund which has a single investor. This may happen, for example, where a fund is at the beginning stages of a capital raise or where the fund is a parallel fund designed for a single investor. The IRD has indicated that, in its view, “an arrangement may qualify for tax exemption as a fund even though it has one investor at a certain point in time during the year of assessment” on the basis that the term “participating persons” may refer to a single participating person. Though the IRD position will be welcome from a tax perspective, it would suggest that segregated managed accounts could be regarded as collective investment schemes.

Restrictions on Intra-Group Arrangements

Under the proposed Private Funds Exemption, a “fund” does not include an arrangement where each of the participating persons in the arrangement is a corporation in the same group of companies as the operator of the arrangement. The IRD has indicated that this condition is intended to “exclude investment arrangements restricted to a group of companies”. A concern is that this condition would exclude from relief a fund that begins with a single seed investment by an affiliate of the investment manager even if an unrelated investor subsequently makes an investment into the fund.

In a similar vein, under the proposed Private Funds Exemption, a fund excludes an arrangement where each of the participating persons is an employee of a corporation within the investment manager’s corporate group. Again, a concern is that, as a result of this condition, a fund would not be eligible for relief if an employee of a sister company of the investment manager, say the Chief Investment Officer of the Hong Kong sub-manager to whom the investment manager has delegated investment discretion, personally provides the initial seed investment even if an unrelated investor later makes an investment.

In this regard, the IRD seems to suggest that these situations are not intended to deny relief, indicating at least that the latter condition is intended to “prevent turning taxable [employee] remuneration… into tax-exempted income through a fund structure”. The IRD cites examples of taxable employee remuneration so as to include share option and share award schemes and profit sharing plans and so as to underline that these arrangements are subject to tax.

Private Equity Transactions

The new proposed ss. 20AP and 20AQ contain certain anti-avoidance measures applicable to private equity transactions. In order for a transaction in “shares, stocks, loan stocks, funds, bonds or notes” (together, “Specified Securities”) of a private company to qualify for exemptive relief, such an investment must satisfy an overarching restriction (“Real Estate Restriction”) relating to the holding of real estate and at least one of the other restrictions contained in those sections.

No-Control Test

One of those other restrictions is that the fund or the special purpose entity (“SPE”) held by the fund which holds the Specified Securities in the private company must not have “control” over that private company. “Control” is defined as, in relation to a corporation, the power of a person to secure “that the affairs of the corporation are conducted in accordance with the wishes of the person” either (i) “by means of the holding of shares or the possession of voting power in or in relation to the corporation or any other corporation”, or (ii) “by virtue of any powers conferred by the articles of association or other document regulating the corporation or any other corporation”.

It is unclear what extent of control is required in order for a person to be regarded as being able to secure that the affairs of the corporation are conducted in accordance with his wishes. For example, in the private equity context, it is not uncommon for shareholders to enter into a shareholders agreement in which minority investors may reserve the power to approve specific activities. Would a person would be considered as having “control” if that person holds more than 50% of the voting rights of a corporation but cannot undertake certain major matters without the consent of one or more other shareholders. More fundamentally, for example, would a person holding more than 50% but less than 75% of the voting rights in a corporation be considered as being able to ensure the affairs of that corporation are conducted in accordance with his wishes? Although at more than 50% that person can ensure the passage of ordinary resolutions, at below 75% he cannot ensure the passage of special resolutions. In other words, the person cannot secure the most important affairs of the corporation are conducted in accordance with his wishes in every case.

Holding Period Test

As an alternative to the no-control test, provided that the Real Estate Restriction is satisfied, a transaction in the Specified Securities of a private company could qualify for exemptive relief if the fund or SPE of the fund satisfies the “holding period test”, meaning it disposes of, through a transaction, or a series of transactions, the Specified Securities not less than two years after they are acquired.

It is unclear how this test is applied where the fund or SPE of a fund tops-up their investment in a private company, i.e. where there are multiple acquisition dates. It is not uncommon for funds to wish to participate in successive capital rounds if an investment is considered to be successful.

By way of example, assume that a fund acquired a 10% shareholding interest in a private company in 2016 and then subsequently increased its shareholding to 15% in 2018. If it disposes all of its shareholding in 2019, does exemptive relief apply only in respect only of the 10% interest or the entire 15% interest? Similarly, for example, assume a fund acquires a 10% shareholding interest in a private company and the company raises further capital which otherwise would be dilutive to the fund. However, the fund participates in each capital raise with the result that it maintains its 10% interest. Would relief be given in respect of the entire 10% or only in respect of that portion actually held for 2 years?

While we will need to wait for the IRD’s position, it is hoped that, where successive investments are made in a private equity portfolio company, the IRD will take the view that exemptive relief will be available from all gains from all investments so long as the original investment in that company meets the 2 year test.

Real Estate Restriction

The Real Estate Restriction denies tax relief if a fund invests, directly or indirectly, in a private company that holds Hong Kong immovable property that value of which exceeds 10% of the value of the company’s assets. The Bill does not indicate how or when the 10% assessment is to be made, raising the concern that exemptive relief may be lost as a result of fluctuation in the value given to immovable property as well as the value of other assets of the company. The IRD seems to suggest that the assessment should be made at the time of the investment in the company.

Specified Securities

The proposed Private Funds Exemption provides relief for transactions by an SPE in Specified Securities. Ultimately, Specified Securities must be shares, stocks, debentures, bonds or notes (or their derivatives) issued by a private company.

Where a private equity investment is made in such a private company but the company subsequently becomes a public company (possibly as a result of listing on a stock exchange), it is unclear whether the disposal of that investment would constitute a transaction in Specified Securities. It may be possible to distribute the Specified Securities back up to the fund to secure relief but it is hoped that the IRD will take a more pragmatic approach, offering relief so long as the original investment qualified as an investment in Specified Securities, even if that investment subsequently ceases to be an investment in Specified Securities.


The introduction of the Private Funds Exemption is highly anticipated and a welcome development as it levels the playing field by removing distinctions that discriminate against Hong Kong. Though it is unfortunate that no steps are expected to be taken to clarify various provisions of the Bill to provide greater certainty for the asset management industry, initial feedback suggests that the IRD will address uncertainties identified to date in a DIPN. There is every reason to be optimistic that by April this year, funds will be able re-locate their residency to Hong Kong and still qualify for tax relief.


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