Hong Kong: Hedge Fund Structures

Based on data from the Securities and Futures Commission (SFC), at the end of 2022, Hong Kong’s regulated asset management and fund advisory business managed just under US$3 trillion of assets, representing an increase of over 36% compared to 2018. The increase evidences the structural advantages of Hong Kong as an asset management hub, as it comes despite political headwinds and negative publicity arising from COVID restrictions and the 2019 protests.

These structural advantages include a strategic location to manage assets within Greater China and the wider Asia-Pacific region, a highly developed infrastructure allowing for global connectivity, a sophisticated regulatory environment familiar with international financial standards and practices, a deep pool of financial services talent, and a robust and tested legal system based on the common law.

The introduction of the OFC and LPF regimes builds on these structural advantages, allowing asset managers as well as investors to locate all key infrastructure within Hong Kong and enabling them to benefit from a single unified legal regime to govern and regulate the fund manager and the fund itself, as well as trading and clearing activities, and operating with a single set of service providers in the same time zone.

The OFC and LPF regimes offer a timely alternative to Cayman and other offshore hedge fund structures which are facing increasing OECD driven challenges in the form of stricter transfer pricing and economic substance rules. The challenges have resulted in these Hong Kong structures becoming an increasingly attractive option for fund managers. Based on SFC data, as at the end of March 2023, 69 OFCs have been registered with 126 sub-funds, and based on our own analysis of public filing records, 527 LPFs had been registered at the end of September 2022.

The choice between the two structures when considering their use for a hedge fund will ultimately depend on several factors which are explored in more detail below. However, in broad terms, as far as a hedge fund is concerned, an LPF is subject to fewer regulatory constraints, whereas an OFC can enjoy a more favourable tax position if structured correctly.

OFC: A Corporate Structure with Redeemable Shares

An OFC is a Hong Kong domiciled corporate fund structure that is perfect for hedge funds, as it allows for redemptions and can be privately offered in Hong Kong subject to permitted exemptions. Fund managers with existing offshore corporate hedge funds will find the OFC structure very familiar, being a corporate vehicle with a separate legal personality where shareholders’ liabilities are limited to any amounts unpaid on their shares.

Guaranteed Segregation of Assets & Liabilities

Where an OFC is established as an umbrella structure with one or more sub-funds (similar to a Cayman Islands SPC), the assets and liabilities of each sub-fund are segregated by law and can then be managed in accordance with their own separate and specific investment strategies. The important difference is that the segregation of the assets and liabilities in an umbrella OFC is guaranteed by law to work in Hong Kong, whereas the segregation between different portfolios of a Cayman Islands SPC under Hong Kong law is untested. This is important given that the liabilities of a hedge fund are more likely to arise in a genuine financial centre such as Hong Kong. The guaranteed legal segregation offered by an OFC will also be important for managers employing investment strategies with potential unlimited liability.

A Wide Investment Scope & Preferential Tax Treatment

OFCs have very wide flexibility in their investment choices and perhaps most importantly, enhanced eligibility for exemptive relief from Hong Kong profits tax on that wider scope of investments.

Where an offshore corporate vehicle meets the various requirements under the Inland Revenue Ordinance (IRO) and earns profits from certain qualifying transactions (including transactions in securities, futures contracts, foreign currencies, OTC derivative products and deposits), it may enjoy a tax exemption in respect of such profits.

However, an OFC is entitled to more favourable tax treatment since it may be exempt from tax on profits earned from both qualifying transactions and non-qualifying transactions, provided it meets the definition of a “fund” under the IRO and does not carry on direct trading, or a direct business, the assets which constitute non-qualifying transactions or hold such assets to generate income.

Approval & Regulation

Whilst the formation of an OFC requires approval from the SFC, this is a relatively simple process. The OFC must also be managed by an investment manager licenced or registered for Type 9 (asset management) regulated activity in Hong Kong, who must be, and remain, fit and proper at the OFC’s registration and thereafter.

Directors

The directors of the OFC are not required to be licenced individuals, but the SFC must be satisfied that they have the expertise to carry out the business of the OFC and are of good repute.

Limited Partnership Structures (LPFs)

The LPF structure is completely flexible in terms of capital contributions, profit distributions and its other contractual terms, with no minimum capital requirement for partners. How an LPF operates and the structure of its documents will be familiar to both hedge fund managers and hedge fund investors who have previously used offshore limited partnership structures.

An LPF needs to have at least one limited partner and at least one general partner. Each LPF structure is governed by a limited partnership agreement subject to certain very basic statutory requirements, with the result that the limited partners and the general partner have almost complete freedom to negotiate the terms of the limited partnership agreement and therefore the LPF itself.

Approval & Regulation

The general partner has ultimate responsibility for the management and control of the LPF and has several duties including appointing an investment manager (which can be the general partner itself or another entity), an auditor, and a responsible person to carry out anti money laundering processes. Unlike an OFC, the LPF itself is not required to seek approval from the SFC or to automatically appoint a Type 9 licenced investment manager.

In respect of the latter issue, the SFC has suggested that a general partner of an LPF should be Type 9 licenced or registered “if it conducts fund management business in Hong Kong”. Whether a general partner of an LPF does in fact conduct asset management business in Hong Kong would be a question of fact and law. For example, if the general partner has wholly delegated all investment management functions to an investment manager, then the general partner should not require a Type 9 licence, although the investment manager would require such a licence if it carried on an asset management business in Hong Kong.

A Wide Investment Scope

There are no restrictions on the investment scope or investment strategy of an LPF and as a result it may be used to invest in shares, bonds, notes, and other securities issued by private or listed companies, virtual assets, alt coins, tokens, real estate, and other investments. There is also no requirement that the LPF disclose its assets under management to the Companies Registry or the identity of its limited partners.

No Separate Legal Personality

Unlike an OFC, an LPF has no separate legal personality or built-in segregation, so the use of an LPF would not be appropriate for multiple investment strategies with potential unlimited liability, unless each such strategy is placed within a separate SPV held by the LPF.

Notwithstanding the lack of segregation between different investment strategies, limited partners themselves are not liable beyond their agreed contribution amounts if they do not participate in the management of the LPF. The general partner, on the other hand, has unlimited liability for all the debts and obligations of the LPF.

Tax Position

As a result of Hong Kong being one of the most tax-friendly jurisdictions, fund managers of, and investors in, an LPF can enjoy taxation benefits.

In respect of profit, an LPF that satisfies the IRO's definition of “fund” and meets certain specified exemption conditions is eligible for a profits tax exemption in respect of qualifying transactions covering a wide range of specified classes of assets, and profits derived from incidental transactions not exceeding five per cent of the total of the LPF’s trading receipts from both qualifying transactions and incidental transaction are also exempt from profits tax.

In respect of the LPF’s management fee, assuming the fund manager carries on a trade or business in Hong Kong, such management fees would generally be taxable. However, transnational fund managers receiving management fees sourced outside Hong Kong may be exempt from taxation in Hong Kong.

Whilst a tax exemption is also available in respect of carried interest, this is available in respect of qualifying carried interest which is broadly carried interest received from gains on investments in private companies. As a result, this tax advantage is unlikely to be of use for a hedge fund strategy.

Lastly, as interests in LPFs are not Hong Kong stock under the Stamp Duty Ordinance, their transfer or assignment is not chargeable to Hong Kong stamp duty. All of the above places LPFs on an equal tax footing with traditional offshore vehicles, but with LPFs also benefitting from an extensive double taxation treaty network.

Gavin Cumming
Mr. Cumming joined the firm in 2005 and has day-to-day responsibility for the firm’s non-contentious financial services practice. He is recognized by AsiaLaw Leading Lawyers as a leading lawyer in financial services regulation. Mr. Cumming has broad and deep experience in corporate, commercial and tax matters with a particular focus on strategic and operational initiatives of asset managers, investment banks, private banks and other wealth managers, insurance companies, broker-dealers and market infrastructure operators. He has a wealth of experience in electronic trading and clearing systems, the formation of private funds, including hedge funds and private equity funds, capital raising for funds, the authorization of public funds for sale to the retail public, private equity portfolio transactions, change of control transactions involving regulated financial institutions, and ongoing compliance issues for regulated financial institutions.