Asia continues to be the destination for a significant proportion of the world’s capital.
The most recent annual report on foreign direct investment (FDI) issued by the United Nations Conference on Trade and Development (UNCTAD) showed that Asia had retained its place as the continental grouping with the most FDI, with its US$426 billion inflows making it worth almost 30 per cent of worldwide investment. Of this, China accounted for US$221 billion, ahead of every other country worldwide apart from the United States. East and South East Asia have showed consistent year-on-year growth in FDI.
UNCTAD treats Hong Kong, which saw its FDI inflows rising slightly to US$77 billion, as separate from China (Hong Kong has, in particular, been very successful in attracting multinationals to establish regional headquarters there), but much of the investment in Hong Kong is (either directly or indirectly) China-related.
The use of Hong Kong as a pivot for investments into China is popular for a myriad of reasons. Among them is the fact that, where an investment requires the relocation of personnel, Hong Kong is a very ‘liveable’ city. It also has a well-regarded, stable legal system, the rule of law, and human capital that combines diligence with Chinese language skills, all in close proximity to China.
Capital flows into Asia generally, and China in particular, can take a number of forms, including direct investments, such as those undertaken by private equity investors, investing through the Hong Kong Stock Exchange, or by buying units in mutual funds.
A good deal of private equity investment into China is structured through Hong Kong companies. There are a number of reasons for this. For Western investors, the Chinese legal system is often unfathomable, whereas the legal system in Hong Kong has a rather more familiar common law basis.
Secondly, if an investment is made directly into a PRC entity, changes in shareholdings are more laborious than for companies incorporated outside China. There are also advantages from a tax perspective. The DTA between Hong Kong and China provides qualifying Hong Kong companies with a number of advantages, including allowing dividends received by a Hong Kong holding company from a mainland subsidiary to be subject to a withholding tax rate of five per cent, rather than the usual 10 per cent.
Hong Kong’s tax regime is very investor-friendly: corporate tax is low by international standards, and it is territorial in nature, only accruing on profits generated in Hong Kong. However, transfers of shares in a Hong Kong company are subject to stamp duty at a rate of 0.2 per cent of the value of the transferred shares. Where the value of investments is significant, this can lead to a substantial transaction cost on an exit. Accordingly, it is not uncommon to see a further vehicle, incorporated in one of the ‘traditional’ offshore centres, in addition to the Hong Kong company (usually a Cayman or BVI company). The various investment interests in such a company can then be transferred without incurring a charge to stamp duty. The use of a dual Hong Kong and ‘offshore’ structure can therefore be advantageous to investors if implemented prior to an exit.
Investing in Listed Companies
Another sphere in which Hong Kong and ‘offshore’ centres work hand in hand is in relation to listings on the Hong Kong Stock Exchange. The Hong Kong Stock Exchange is Asia’s second largest by market capitalisation after Tokyo, and dwarfs its regional competitors. While the underlying businesses of companies listed on the Exchange are predominantly mainland Chinese, the listed company itself is often incorporation in an offshore jurisdiction, particularly Cayman or Bermuda. In January 2015, more than 70 per cent of the companies listed on the Hong Kong Stock Exchange were incorporated in the Cayman Islands and Bermuda.
The Listing Rules allow companies incorporated in certain jurisdictions (other than Hong Kong) to list on the Hong Kong Stock Exchange. In the late 1990s, the list of approved jurisdictions was limited, including only the PRC, Bermuda, Cayman and, unusually, the Cook Islands. Now the list has been extended to cover many more of the traditional ‘offshore’ jurisdictions such as the BVI, the Isle of Man, Jersey and Guernsey, although Cayman is still the most popular by some margin. The Exchange will allow any companies incorporated in any jurisdiction to list if they are satisfied that a minimum level of shareholder protection can be achieved: Prada, for instance, is an Italian company listed on the HKSE. The Exchange is understandably interested in ensuring that shareholders in these companies are afforded the same level of protection as they would have if they invested in a Hong Kong company, and requires amendments to their constitutive documents in order to achieve this.
Recently, Asia’s richest tycoon, Li Ka-Shing, hit the headlines by announcing that he intended to shift the place of incorporation of his two flagship companies, Hutchison Whampoa and Cheung Kong Holdings, from Hong Kong to the Cayman Islands. Mr Li’s stock exchange documentation referred to the greater flexibility for making distributions afforded by Cayman Islands company law (Cayman companies can, subject to a solvency test, make distributions out of their share premium account). The document added that Cayman is one of the jurisdictions accepted by the Hong Kong stock exchange for issuers seeking a listing and both Cayman entities would be listed there.
The market’s comfort with and confidence in Cayman and Bermuda as jurisdictions of choice for listed companies stems from a number of reasons. Among them are pedigree – these jurisdictions have been approved and used for so long that investors are confident that no unforeseen jurisdiction-related problems will occur; the English common law foundation of each jurisdiction, is familiar to those accustomed to a similar system in Hong Kong and the fact that English precedents are highly persuasive in their courts means that a large body of judicial authority is available when any legal issues arise; and, of course, it does not hurt that there is no corporation tax, inheritance tax or stamp duty in either jurisdiction.
In November 2014, Shanghai-Hong Kong Stock Connect was officially launched. This allows foreign investors to invest in ‘A Shares’ through the Hong Kong Stock Exchange. Previously, such investments were only available to mainland investors. The scheme also makes it possible for mainland investors to acquire many of the larger Hong Kong listed stocks, thus enabling intra-regional capital flows.
Investing via Mutual Funds
Another way in which capital flows into Asia is through the use of mutual funds. Baring Asia recently announced that it had raised almost US$4 billion for its sixth Asia fund. This represented the second-largest private equity funding ever for investments into the region, reflecting investor appetite for the growth story in Asia.
Hong Kong’s history as a leading international financial centre has left it well-positioned as a hub for fund management, and it is now widely recognised as a leading fund management centre in Asia with a large concentration of international fund managers. As at the end of 2013, Hong Kong’s combined fund management business amounted to US$2.05 trillion (up 27 per cent from 2012)
Again, the human capital element of this success is hard to overstate: Hong Kong brims with Chinese-speaking, financially literate professionals, perfect for fund managers with a focus on mainland China. There are, however, a number of other reasons behind its success. Hong Kong’s fund industry is well-regulated, and its tax regime for mutual funds is relatively benign.
Notwithstanding the above, many mutual funds, even if they are managed in Hong Kong, are established in other jurisdictions (the Cayman Islands is the most popular alternative jurisdiction), again demonstrating a neat dovetail between Hong Kong and the offshore industry. Cayman exempt companies are the most straightforward structure, while limited partnerships are popular with US investors for tax reasons, and segregated portfolio companies being used for umbrella structures.
Shanghai Free Trade Zone
The Shanghai free-trade zone was launched in September 2013, and was considered to symbolise China's commitment to reform. There were hopes that it would mirror the success of the Shenzhen Special Economic Zone. The Prime Minister, Li Keqiang, was keen for the zone to attract investment by slashing red tape and opening up some areas for investment by foreign capital, such as health care. Foreign businesses setting up in the SFTZ were not required to obtain central government approval in advance, unless their activities were on a ‘negative list’ of regulated sectors.
Businesses generally, however, have been reported as considering the first year of the SFTZ as something of a damp squib. Initial hopes that foreign investment banks and brokerage firms might obtain full access to the China’s domestic capital markets have not materialised. Commentators observe that officials are ultra-cautious about how activities within the SFTZ might affect attitudes and behaviour outside it.
It is worth noting, of course, that the SFTZ has only been in existence for just over a year. China Daily announced, in the run-up to the zone’s anniversary that more than 12,000 firms had registered there (including 600 foreign enterprises). It recently launched an international gold exchange, and trading in other commodities is promised for the future. SFTZ-watchers acknowledge that useful advances have been made in cutting bureaucracy, and Mr Li’s enthusiasm for the project is likely to give it further impetus. The SFTZ represents such a radical departure in China’s approach towards FDI that it was never likely to achieve results overnight.
It is likely, then, that Hong Kong will continue to play a significant role in attracting investment into Asia, particularly when the funds are destined for China.
John Melia is a partner and Group Head of the Corporate department in Appleby Hong Kong office, with extensive experience dealing with mergers and acquisitions, listings, private equity transactions, banking and finance matters, and general corporate/commercial matters.
Bermuda, British Virgin Islands, Cayman Islands, Guernsey, Hong Kong, Isle of Man, Jersey, Mauritius, Seychelles and Shanghai.