A Guide to the Taxation of Hong Kong Sponsored Funds
The past few years have seen a continued emphasis by the Hong Kong Government to develop Hong Kong as an international asset management centre. Whilst this has not resulted in any tax incentives being offered to asset management groups, the government has been diligent in ensuring that funds managed from Hong Kong are tax neutral. In broad terms, the resulting tax net has 2 features. First, regulated funds, unregulated hedge funds and private equity funds as well as Hong Kong’s new open-ended fund companies (“OFCs”) are unlikely to be liable to profits tax. Secondly, exemptive relief available to funds may be lost if fund structures are used to shelter profits from investment activities in Hong Kong real estate or private Hong Kong businesses or to shelter profits from investment activities of Hong Kong residents. In this guide, we provide an overview of the regime for the taxation of funds.
Though Hong Kong does not have a comprehensive income tax system, it does tax profits sourced in Hong Kong. Under the Inland Revenue Ordinance (“IRO”), subject to exemptions, profits tax is chargeable on every person carrying on a trade, business, or profession in Hong Kong in respect of profits arising in or derived from Hong Kong. Liability to tax does not depend upon the residency of the taxpayer.
The rate of profits tax is low relative to many other jurisdictions. For the 2017-18 tax year, the rate is 16.5 per cent. for corporations and 15.0 per cent. for partnerships and other unincorporated businesses. Amendments are currently proposed to introduce a two-tiered profits tax regime commencing from the year of assessment 2018 - 2019 (i.e. on or after April 1, 2018). Under this proposed two-tier system, the first HK$2 million of profits earned by a corporation will be taxed at 8.25 per cent. whilst the balance will be taxed at 16.5 per cent. Similarly, the first HK$2 million of profits earned by an unincorporated business, such as a limited partnership, will be taxed at 7.5 per cent. whilst the balance will be taxed at 15.0 per cent.
Liability of Funds
A fund may be considered to be carrying on a business in Hong Kong (and thus, within the Hong Kong profits tax net) where the Hong Kong office of the management group carries on the fund’s business in Hong Kong. This may arise because, for example, the directors of the fund are based in that Hong Kong office and thus, the central management and control of the fund is in Hong Kong. Equally, for example, the fund may be regarded as carrying on a business in Hong Kong because the Hong Kong office of the management group exercises a general authority to conclude trades on behalf of the fund as agent for the fund.
However, even if a fund were to be regarded as carrying on a business in Hong Kong, profits tax only applies to profits sourced in Hong Kong (i.e. arising in or derived from Hong Kong). Thus, a fund trading stocks on the New York Stock Exchange would likely not be liable for profits tax on any profits from such trading on the basis that those profits are not Hong Kong sourced.
Given the potential tax liability that funds face, as noted above, the Hong Kong government has taken a number of steps to ensure the tax neutrality of funds. In particular, it has included in the IRO multiple exemptions from profits tax for funds. Given the existence of both exemptive relief and a tax enforcement policy consistent with this commitment, in practice, it is unlikely that a genuine fund (other than a private equity fund investing in Hong Kong real estate or private businesses) would be subject to profits tax.
SFC Authorized Funds
The IRO exempts a fund authorized by the Securities and Futures Commission (“SFC”) from profits tax on any profits of the fund where:
the fund is a unit trust, mutual fund or “similar investment scheme”,
the fund is carried on for the purposes set out in its constitutive documents and in accordance with the SFC’s regulatory requirements, and
those constitutive documents have been approved by the SFC.
The IRO does not define what qualifies as a “similar investment scheme” but the Inland Revenue Department (“IRD”) has suggested that in such a scheme, investors should have no control over the management of the scheme other than being able to appoint a manager of the scheme. SFC authorized funds are funds that have been authorized by the SFC for offer to the public. Such funds are normally authorized and operated in accordance with the SFC Handbook for Units Trusts and Mutual Funds, Investment-Linked Assurance Schemes and Unlisted Structured Investment Products. Authorization is generally regarded by the asset management industry as a rigorous process and hedge funds and private equity funds generally do not apply for authorization. Indeed, the latter could not qualify for authorization under the established regulatory process.
Overseas Regulated funds
The IRO gives the Commissioner of Inland Revenue the discretion to exempt the profits of a fund where it determines that the fund (i) is bona fide widely held, and (ii) complies with the requirements of a supervisory authority within an acceptable regulatory regime. As with SFC authorized funds, the exemption applies where the fund is carried on for the purposes set out in its constitutive documents and in accordance with the requirements of that supervisory authority and those constitutive documents have been approved by that supervisory authority.
The IRO does not define the term “bona fide widely held” but the IRD has indicated that it would assume a fund to be bona fide widely held if during any year of assessment it had no fewer than 50 investors and no fewer than 21 investors were entitled, directly or indirectly, to 75 per cent. or more of the income or property of the fund. In so saying, the IRD did not preclude the possibility that a fund might be bona fide widely held without meeting these threshold figures if it is clear that the fund was established with a view to wide public participation and genuine efforts are being taken to achieve that objective.
Equally, the IRO does not define the term “acceptable regulatory regime”. However, the IRD has indicated that the term would indicate any fund regulated in a jurisdiction identified by the SFC in the Code of Unit Trusts and Mutual Funds as a “Recognized Jurisdiction Scheme”.
Amendments are currently proposed to exempt OFCs from profits tax. OFCs are new to Hong Kong. Enabling legislation was only enacted in 2016 and this legislation has not yet been brought into effect pending the finalization of regulations to govern them. It is expected that the OFC regime will become operational in 2018.
Nature of OFCs
OFCs are open-ended collective investment schemes incorporated as Hong Kong companies. OFCs enjoy a number of benefits, including:
Redeemable Share Capital - Unlike traditional companies incorporated under the Companies Ordinance, shares of OFCs are redeemable free from capital maintenance restrictions.
Segregated Portfolio Cells - The assets and liabilities of each sub-fund of an OFC are segregated so that the assets of one sub-fund cannot be used to discharge the liabilities of another sub-fund.
Basis for Exemption
OFCs may or may not be authorized by the SFC. If authorized by the SFC, they will be exempt from profits tax pursuant to the existing exemption for SFC authorized funds. If not authorized, under the latest proposed amendments (which are subject to change as the legislative process continues), OFCs will be exempt from profits tax if 4 conditions are satisfied:
Resident in Hong Kong - The OFC must be resident in Hong Kong (i.e. its central management and control must be in Hong Kong).
Not Closely Held - The OFC must not be closely held. To meet this criteria, no investor (other than an initial or other qualifying investors) may hold more than 50 per cent. of the share capital of the OFC and the originators of the OFC and their associates may hold no more than 30 per cent. of the share capital of the OFC. In addition, the OFC must satisfy one of the following tests. The first test is that (i) the OFC has at least 10 investors, and (ii) at least 10 investors have subscribed for at least HK$20 million. The second alternative test is that (i) the OFC has at least 1 institutional or qualifying investor meeting prescribed qualification criteria who has invested at least HK$200 million into the OFC, (ii) it has at least 5 investors, and (iii) at least 4 investors, not being the qualified institutional or other qualifying investor, has subscribed for at least HK$20 million. Even where relief is available and the fund is therefore not closely held, if a person resident in Hong Kong holds an interest, directly or indirectly, of 30 per cent. or more in the OFC, that person (rather than the OFC) will be deemed to have derived the profits of the OFC and will subject to profits tax assessed on the share of the profits of the OFC.
Investments Restricted to Prescribed Classes - The OFC must predominantly invest in prescribed asset classes. These will include securities, futures contracts, deposits, foreign exchange contracts and OTC derivatives. Investments outside these permissible classes are capped at 10 per cent. of the gross asset value of the fund. Profits from investments in nonpermissible asset classes in excess of 5 per cent. of the gross value of the fund will be subject to profits tax. A breach of the 10 per cent. cap may result in a total loss of exemption.
SFC Licensed Manager - The OFC must carry out transactions through or arranged by a manager licensed by the SFC for Type 9 (asset management) regulated activity.
One concern is that the profits tax exemption will be retrospectively revoked if the OFC ceases to be non-closely held (e.g. through the exit of investors) within 24 months after it became non-closely held. However, the Commissioner of Inland Revenue has the discretion to regard the OFC as being non-closely held if (i) the failure to do so is due to circumstances not reasonably foreseeable by the company and is temporary, and (ii) after taking into account all relevant factors, it is fair and reasonably to regard the failure as not having occurred (taking into account remedial actions taken to address the failure and the speed of taking such actions).
Where an OFC has multiple sub-funds, under the legislative proposals, each sub-fund will be assessed separately. As a result, the availability of exemption is determined on a sub-fund basis.
Private Offshore Funds
Historically, hedge funds and private equity funds sponsored from Hong Kong have been structured using vehicles incorporated outside of Hong Kong (i.e. offshore). The use of such offshore vehicles reflects not only the fact that investors in this region are generally familiar with such vehicles but also the fact that Hong Kong legislation has (until the introduction of OFCs) failed to provide the flexibility needed to accommodate these types of funds. For example, hedge funds have been unable to form as Hong Kong companies because Hong Kong companies do not allow for the easy redemption of shares.
Recognizing the need to provide certainty to the industry as to the Hong Kong tax status of such funds, the IRO exempts (i) funds which are not resident in Hong Kong from profits tax in respect of profits from prescribed qualifying transactions and transactions incidental thereto, and (ii) prescribed special purpose vehicles used by such funds to hold prescribed qualifying private equity investments from profits tax arising from exits from these investments.
Not Resident in Hong Kong
A fund will be not resident in Hong Kong if its central management and control is exercised outside of Hong Kong. For this purpose, “central management and control” refers to the highest level of control rather than day-to-day management. As the IRD itself notes, the “exercise of central management and control does not necessarily require any active involvement” and “the place where the central management and control is exercised is not necessarily the place where the main operations of the business are to be found”. Thus, for example, in the case of a hedge fund, the fact that a manager based in Hong Kong exercises day-to-day investment discretion will not by itself necessarily result in the central management and control of the fund being exercised in Hong Kong.
It is a question of fact where central management and control is exercised and the courts will look at the totality of the circumstances. Though caselaw has suggested that, in the case of a company, the courts may take into account factors such as the place of residence of the shareholders and directors and the place where board meetings are held, these factors are not (as the IRD itself recognizes) necessarily conclusive.
A qualifying transaction is a transaction in a prescribed permissible asset class and where either (i) the transaction is carried out through or arranged by specified persons, or (ii) the fund carrying out the transaction is a qualifying fund.
Permissible Asset Classes
The prescribed permissible asset classes include:
foreign exchange contracts (defined to mean contracts where the parties contract to exchange currencies at a future time),
foreign currencies (which would thus result in the inclusion of spot FX transactions),
exchange-traded commodities (which only includes gold and silver traded on the Chinese Gold and Silver Exchange Society), and
The prescribed permissible asset classes are generally broad enough to cover investments by hedge funds. Notably, the term “futures contracts” includes contracts for differences which are regulated by or carried out in compliance with the SFO. Equally, the term “securities” includes rights, options or interests in respect of shares and debentures. As a result, many derivatives will fall within the scope of the permissible asset classes.
Private Equity Funds
For private equity funds, the term “securities” includes shares and debentures issued by a special purpose vehicle or an excepted private company. In broad terms, an “excepted private company” is a private equity portfolio company and a “special purpose vehicle” is a holding company for one or more such portfolio companies. As a result, exemptive relief is generally available for private equity funds on the exit by a fund through the direct disposal of an investment in the form of an excepted private company as well as through the indirect disposal of that investment through the disposal of a special purpose vehicle used to hold that investment.
However, private equity portfolio companies are restricted both from operating businesses in Hong Kong and owning real estate in Hong Kong. Under the IRO, an “excepted private company” must be incorporated outside of Hong Kong, must not be allowed to issue shares or debentures to the public and must meet the following criteria in the 3 years prior to the transaction for which exemptive relief is claimed (i.e. the disposal of the private equity investment):
No Direct Business in Hong Kong - The company did not carry on any business through a permanent establishment in Hong Kong. A company will be regarded as having a permanent establishment in Hong Kong if it has a fixed place of business through which activities are carried on or if the company has an agent carrying on activities in Hong Kong who habitually exercises general authority to negotiate and conclude contracts or hold a stock of merchandise from which the agent regularly fills orders..
No or Minimal Indirect Business in Hong Kong - The company either did not hold any shares of any private company carrying on any business in Hong Kong or, if it held such shares, the aggregate value of such holdings was capped at 10 per cent. of the value of its assets.
No Hong Kong Real Estate – The company either (i) held no immovable property in Hong Kong and no shares, directly or indirectly, of any private company with a direct or indirect holding of immovable property in Hong Kong, or (ii) if it held such property or shares, the aggregate value of such holdings was capped at 10 per cent. of the value of its assets.
Under the IRO, a “special purpose vehicle” is a corporation, partnership or other vehicle established and operated solely for the purpose of holding, directly or indirectly, and administering one or more excepted private companies. The vehicle may be incorporated or registered in or outside Hong Kong. It is important to note that a company cannot transition from an operational role to an investment holding role and still qualify as a special purpose vehicle.
A loan of money is unlikely to qualify as a permissible investment class.
The IRD does not regard the earning of interest from the holding of bonds as a transaction in securities as there is no purchase and sale between transacting parties and thus, takes the position that such interest does not arise from a qualifying transaction. Nevertheless, it regards the earning of such income interest as a transaction incidental to a qualifying transaction.
Specified Persons and Qualifying Funds
A “specified person” is either a corporation licensed by the SFC or an authorized financial institution registered by the SFC under the SFO to carry on a business in any regulated activity. Equivalent financial intermediaries regulated outside of Hong Kong do not qualify as specified persons.
Managers of hedge funds will, if based in Hong Kong, generally hold a license for Type 9 (asset management) and advisers to private equity funds may, if based in Hong Kong, hold a license for Type 1 (dealing in securities), Type 4 (advising on securities) or Type 9 (asset management). However, some advisers to private equity funds will not be licensed and in this case, those funds must meet the requirements for being “qualifying funds” to be eligible for exemptive relief.
A “qualifying fund” is a fund that meets 3 criteria:
it has at least 4 investors (other than the originator of the fund and its associates),
the capital commitments of those investors exceeds 90 per cent. of the aggregate capital commitments, and
under the agreement governing the operation of the fund, the originator and its associates are not entitled to more than 30 per cent. of the net proceeds arising out of transactions of the fund (after deducting their capital contributions).
This final requirement effectively caps the sponsor’s carried interest at a generous 30 per cent. but may inhibit the sponsor from participating as an investor in the fund.
For these purposes, an “originator” has the power, directly or indirectly, to make investment decisions on behalf of the fund. In a private equity fund structured as a limited partnership, the general partner would normally be regarded as the originator.
Funds structured through parallel vehicles and master-feeder vehicles may face particular difficulties in meeting the requirements of a qualifying fund. The IRD has signalled a more pragmatic approach to aggregating investors of parallel funds but has declined to do so in the case of master-feeder structures.
A fund which carries on any business in Hong Kong involving any transactions other than qualifying transactions and transactions incidental thereto in any tax year will not be eligible for exemptive relief that year.
The IRO does not define what is meant by an “incidental” transaction but the IRD accepts that the term would include the receipt of interest or dividend income that is not otherwise exempt from profits tax. Incidental transactions are capped at 5 per cent. of the profits of a fund in any tax year, otherwise the exemption will be lost in respect of all the fund’s profits for that tax year (not just those exceeding the cap).
As with the proposed amendments to the IRO to exempt OFCs, the IRO prevents round-tripping, where a person resident in Hong Kong uses the exemptive relief available for offshore private funds to shelter otherwise taxable profits through a fund that is not bona fide widely held:
Major Shareholder of a Fund Resident in Hong Kong - Where a person resident in Hong Kong has a direct or indirect beneficial interest of 30 per cent. or more of an offshore fund exempt from profits tax, the profits of the fund are to be regarded as the profits of that person and that person will be subject to profits tax on those profits based on the extent and duration of his interest in the fund unless the IRD determines that the fund is bona fide widely held. As a corollary, where a person resident in Hong Kong has a direct or indirect beneficial interest of 30 per cent. or more in an offshore fund exempt from profits tax that has a beneficial interest in a special purpose vehicle and the special purpose vehicle is exempt from profits tax, the profits of that special purpose vehicle are to be regarded as the profits of that person and that person will be subject to profits tax on those profits based on the extent and duration of his interest in the fund and the fund’s interest in the special purpose vehicle.
Associates of Fund Resident in Hong Kong - Where a person resident in Hong Kong has a direct or indirect beneficial interest in an offshore fund exempt from profits tax and that person is an associate of the fund, the profits of the fund are to be regarded as the profits of that person and that person will be subject to profits tax on those profits based on the extent and duration of his interest in the fund unless the IRD determines that the fund is bona fide widely held. As a corollory, where a person resident in Hong Kong is an associate of the fund, has a direct or indirect beneficial interest in an offshore fund exempt from profits tax that has a beneficial interest in a special purpose vehicle of the fund and the special purpose vehicle is exempt from profits tax, the profits of that special purpose vehicle are to be regarded as the profits of that person and that person will be subject to profits tax on those profits based on the extent and duration of his interest in the fund and the fund’s interest in the special purpose vehicle.
The result is that where an offshore private fund is not bona fide widely held, although the fund itself may be exempted, investors in the fund who are resident in Hong Kong may be subject to profits tax in Hong Kong calculated on the profits of the fund, whether or not the profits of the fund are in fact distributed to that Hong Kong resident.
Given these round tripping provisions, investors in funds who are resident in Hong Kong would be prudent to ensure that they are entitled to receive information as to the tax status and profits of the fund.
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