The Hong Kong Government recently introduced a number of legislative changes to encourage the formation of private equity funds in Hong Kong. These changes include the introduction of a new private equity fund structure in the form of limited partnership funds under the Limited Partnership Funds Ordinance (LPFO) as well as tax relief both in respect of private equity funds operated from Hong Kong and in respect of carried interest earned from such funds.
Traditionally, Hong Kong private equity sponsors have opted for Cayman Islands exempted limited partnership structures, partly because Hong Kong limited partnerships under the Limited Partnership Ordinance were poorly adapted for private equity and partly because the Cayman Islands offered an efficient alternative that was well understood by investors.
However, changes in the Cayman Islands to comply with global base erosion, and profit shifting and money laundering and terrorist counter-financing initiatives have made the Cayman Islands less attractive. For example, private equity funds are now required to register with the Cayman Islands Monetary Authority (CIMA), to file their offering document with CIMA and to comply with certain ongoing operational requirements. These changes, together with the new Hong Kong structure, may start a shift towards Hong Kong. In the two months since the introduction of the limited partnership fund structure, 29 funds have registered under the LPFO.
Under the LPFO, a partnership can qualify as a limited partnership fund if, amongst other matters, it (i) has at least one general partner (GP) and one limited partner (LP); (ii) has a registered office in Hong Kong to which communications can be sent; (iii) not all of its partners are corporations in the same group of companies; and (iv) appoints an investment manager, whether that is its GP or another company (either a Hong Kong company or a non-Hong Kong incorporated company registered in Hong Kong).
Formation And Filings
A limited partnership fund is registered by filing an application to the Registrar of Companies, but there is no requirement to file a copy of the limited partnership agreement or any private placement memorandum. The application must be submitted by a Hong Kong law firm or solicitor.
There is no requirement to make any filings with the Registrar of Companies in respect of the identity of the LPs, but for anti-money laundering control purposes, a responsible officer of the GP must maintain a register of LPs and make that register available to prescribed government authorities.
Whilst the Registrar of Companies must make available to the public for inspection a register of limited partnership funds, there is no public access to the annual returns or to the register of LPs to which the Registrar of Companies has access.
Terms And Conditions
Under the LPFO, the rules of equity and common law applicable to partnerships apply to limited partnership funds to the extent they are not inconsistent with the LPFO and the LPFO implies into limited partnership funds a number of default partnership provisions of the Partnership Ordinance. Otherwise, the LPFO has few restrictions on the terms of the partnership agreement, meaning that partners are generally free to agree upon the terms and conditions of the fund.
Subject to a two year grace period from the issuance of a fund’s certificate of registration to enable the completion of capital raising, the LPFO prohibits the partners of the fund from all being corporations in the same group of companies.
Responsible Officer For Money Laundering Control
The GP of every limited partnership fund must appoint a person as a responsible officer for money laundering control purposes including conducting due diligence on LPs.
Participation Of Limited Partners In Management
The LPFO provides that an LP is not liable for the debts and obligations of the limited partnership fund beyond the amount of the partner’s agreed contribution, provided that the LP does not have day-to-day management rights or control over the assets held by the limited partnership fund and does not take part in the management of the limited partnership fund and, in this regard, the LPFO sets out certain specified activities in which an LP may engage.
Similar to other jurisdictions, the limited liability afforded to LPs under the LPFO may offer no protection in jurisdictions outside of Hong Kong.
Although there are no requirements to maintain capital contributed to the limited partnership fund, withdrawals of capital contributions and distributions of profits and assets are only permitted if the limited partnership fund remains solvent following such withdrawal or distribution.
Traditionally, in a limited partnership private equity fund, the GP exercises investment discretion and retains an investment manager to advise it.
A key question is whether a GP in Hong Kong needs to be licensed for Type 9 (asset management) regulated activity, particularly if it exercises investment discretion. This is a difficult question for which there is no clear authority. Conversely, it is likely that the investment manager will need to be Securities and Futures Commission (SFC) licensed, although the licence required will depend upon the scope of the investment manager’s activities.
To the extent that a limited partnership fund may be carrying on a business in Hong Kong, profits which arise in or derive from that business in Hong Kong may be subject to profits tax. Whether a limited partnership fund carries on a business in Hong Kong is a question of fact and one significant consideration is whether the GP or investment manager in Hong Kong has general authority to contract on behalf of the fund.
Whilst Hong Kong does exempt profits from the sale of capital assets from profits tax, gains in the value of private equity investments would likely not be regarded as profits from the sale of capital assets because in a typical private equity investment, at the time of the investment there is an intention to sell that investment.
Unified Funds Tax Exemption
Consistent with Hong Kong Government policy to ensure that Hong Kong is a tax neutral fund destination, a new exemption (Unified Funds Exemption) from profits tax for qualifying private equity transactions has been created. The Unified Funds Exemption may provide tax relief for a limited partnership fund engaged in private equity even if the GP is based in Hong Kong.
In broad terms, under the Unified Funds Exemption, the profits of a limited partnership fund may be exempt from Hong Kong profits tax if (a) the profits are derived from qualifying transactions; and (b) either (i) the transactions are carried out or arranged by an SFC licensed corporation or an SFC registered bank; or (ii) the fund is a qualifying investment fund.
Under the Inland Revenue Ordinance (IRO), “qualifying transactions” eligible for relief are transactions in shares, debentures and other prescribed assets of or issued by a private company. There are certain restrictions in respect of investments in a private company, for example, in terms of the holding of Hong Kong real estate by the private company.
If the limited partnership fund is not managed by an SFC licensed corporation or an SFC registered bank, the fund may need to meet qualification criteria in order for its profits to be eligible for exemptive relief from Hong Kong profits tax. These criteria include having a minimum of four external LPs who together account for more than 90 per cent of capital commitments as well as a 30 per cent cap on the carried interest payable to the GP, the investment manager, and their affiliates.
The GP and the investment manager may be subject to profits tax in Hong Kong on the basis that either or both carries on a business in Hong Kong with profits arising in or derived from Hong Kong.
Whilst the traditional approach has been to situate the GP outside of Hong Kong for tax purposes and to situate the investment manager in Hong Kong, thereby minimising tax on the basis that carried interest and management fees earned by the GP are outside the territorial ambit of Hong Kong profits tax, and the investment manager would only receive a portion of the management fees earned by the GP, thereby limiting the extent of management fee subject to Hong Kong profits tax, this approach has come under significant attack around the world and in Hong Kong.
In addition to more aggressive enforcement by the Inland Revenue Department (IRD) and reliance on anti-avoidance provisions, the introduction of base erosion and profit shifting legislation has empowered the IRD to assess tax on the assumption that transactions between affiliated persons are conducted on an arm’s length basis even if, in fact, they are not.
Tax Concession For Carried Interest
To attract more private equity funds to domicile and operate in Hong Kong, the Government recently issued a consultation paper proposing to introduce a tax concession for carried interest distributed by eligible private equity funds. The tax concession will be retroactive and takes effect from April 1, 2020.
Under the proposal, a GP or an investment manager may be eligible to a concessionary rate of tax on carried interest distributed to it by a limited partnership fund if a number of conditions are satisfied, including:
Mr. Loh founded the firm in 2004 and has led it since its inception. He is responsible for the firm’s overall management and direction. He is recognized by independent editorial publications, including Chambers & Partners, the Asia-Pacific Legal 500 and Asialaw Leading Lawyers, as a leading lawyer in financial markets regulation, investment funds and mergers and acquisitions. Since founding this firm, he has advised clients on mergers & acquisitions, the aggregate value of which has exceeded US$3 billion. He has particular expertise in mergers & acquisitions involving regulated financial institutions. At the same time, he has taken lead roles in representing clients in seminal cases defining the ambit of the law governing financial markets and financial services in Hong Kong. He has appeared before the Legislative Council of Hong Kong a number of times to speak on proposed legislative changes to redefine the regulatory framework governing the financial markets in Hong Kong.
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.