Hong Kong Strengthens Its Position As A Private Equity And Hedge Fund Centre

Improvements To The OFC Regime

Whilst the OFC regime was introduced back in 2018, uptake in using the vehicle as a hedge fund has so far been slow. In large part, this was due to the investment restrictions placed on private OFCs and their inability to use prime brokers as custodians. Thankfully, the changes announced by the Securities and Futures Commission (SFC) in September 2020 have removed the previous investment restrictions and now permit brokerage firms, including prime brokers, to act as custodians of private OFCs. Coupled with recent tax changes, a hedge fund structured as an OFC now also has certainty of exemptive relief from Hong Kong profits tax not enjoyed by non-OFC hedge funds.

Relaxation Of Investment Restrictions For Private OFCs

There was previously a requirement for a private OFC to invest at least 90 per cent of its gross asset value (GAV) in securities and futures contracts, cash, bank deposits, certificates of deposit, foreign currencies, foreign exchange contracts, or any combination thereof. This restriction has now been removed, meaning that a hedge fund in the form of an OFC now faces no regulatory restrictions on the types of investments it can make or on the size of the position it may take in any particular investment. However, the manager of an OFC (and the appointed custodian of the OFC) must have sufficient expertise and experience in managing and safekeeping the asset classes in which the OFC invests. In addition, an OFC must clearly disclose in its offering document all material risks specific to the type and nature of assets in which it will invest, particularly where it intends to invest 10 per cent or more of its GAV in non-financial or other less common asset classes.

Prime Brokers Eligible As Custodians Of Private OFCs

It was previously the case that only a Hong Kong bank, an overseas bank, or a trustee of a registered scheme under the Mandatory Provident Fund Schemes Ordinance could be appointed as the custodian of an OFC (whether public or private).

Following the changes, brokerage firms and other corporations which hold a Type 1 licence or registration (dealing in securities) under the Securities and Futures Ordinance (SFO) regulated activity and which are suitably qualified are now eligible to act as the custodian of a private OFC provided that the private OFC is a client of that firm for Type 1 regulated activity, thus enabling a private OFC to appoint its prime broker as its custodian.

The SFC also clarified that a private OFC may appoint multiple custodians and sub custodians, thereby enabling a private OFC to appoint a bank as a cash custodian and a Type 1 licensed prime broker as a custodian for securities and cash.

OFCs Enjoy Wider Tax Exemption Under Unified Funds Tax Exemption

The removal of the previous investment restrictions means that the Unified Funds Tax Exemption (see below for more details) will now generally exempt private OFCs from profits tax on profits earned from transactions in all investment asset classes. Conversely, a non-OFC hedge fund is generally exempt only from profits tax on profits earned in transactions (qualifying transactions) in securities (including shares, and debentures issued by a private company), futures contracts, exchange traded commodities, foreign exchange contracts, deposits and other assets specified in Schedule 16C of the Inland Revenue Ordinance (IRO) (i.e. a much more limited universe of investment asset classes).

Furthermore, in respect of profits earned from transactions (incidental transactions) incidental to qualifying transactions, exemptive relief for non-OFC hedge funds in respect of their profits on such incidental transactions is capped at 5 per cent. This means that profits from incidental transactions which exceed 5 per cent of such a non-OFC hedge fund’s total profits (including both qualifying transactions and incidental transactions) are subject to profits tax and are not exempt. OFCs do not share this disadvantage as they are exempt from profits tax on profits from all transactions in investment assets, whether or not such transactions are qualifying transactions or incidental transactions.

Guidance On Unified Funds Tax Exemption

The Unified Funds Tax Exemption, which applies to years of assessment commencing on or after April 1, 2019,  seeks to exempt hedge funds and private equity funds, including OFCs and LPFs, from Hong Kong profits tax. This exemption may apply regardless of the fund structure, location of the fund’s central management and control, fund size or fund purpose provided that prescribed conditions are satisfied. Unfortunately, there was some concern as to how to interpret those conditions.

In June 2020, the Inland Revenue Department (IRD) issued Departmental Interpretation and Practice Note 61 (DIPN 61) to provide guidance on its interpretation and application of the Unified Funds Tax Exemption.

Non-OFC Funds

DIPN 61 clarifies that when determining whether a transaction is an incidental transaction, the IRD will look to the particular mode of operation of the fund concerned. Incidental transactions may include the custody of securities, and the receipt of interest or dividends on securities acquired through the qualifying transactions.

Private OFC Funds

As noted above, following the removal of the investment restrictions on private OFCs, the Unified Funds Tax Exemption offers profits tax exemption to private OFCs on a far wider range of investments. However, even for a private OFC, there is no exemption available for profits from carrying on a direct trading or direct business undertakings in Hong Kong.

DIPN 61 provides that as a result of the foregoing, a private OFC would not be exempt from profits tax on transactions which “relate to assets which are normally purchased and sold in the normal course of business of a commercial or industrial enterprise”. However, on the basis that hedge funds in the form of a private OFC will normally deal exclusively in financial assets, in the ordinary course profits from all of their investments should remain exempt.

Meaning Of Fund

For the purposes of qualifying for the Unified Funds Tax Exemption, the definition of “fund” mirrors that of “collective investment scheme” under the SFO. As intended, a hedge fund, whether in the form of a Hong Kong OFC or otherwise, and a private equity fund, whether in the form of a Hong Kong LPF or otherwise, should have no difficulty meeting the definition. However, as a result of the language used in the IRO to define a “fund”, a number of interpretation issues arose.

To qualify as a fund, the participating persons in the fund must 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), but the IRO does not define the terms “participating persons” or “day-to-day control”. DIPN 61 clarifies that the IRD takes the position that “participating persons” refers to investors, including shareholders in an OFC and limited partners in an LPF. It further clarifies that the IRD takes the position that “control” refers to the control by way of rights as an investor and that even if one investor does not have day-to-day control, the arrangement could still be a fund. 

A second condition to qualify as a “fund” is that the capital contributions of the participating persons and the profits or income from which payment is made to them are pooled. There was a concern as to whether this pooling condition would be satisfied if there was a single investor in a fund.

Start-up Funds Under Unified Funds Tax Exemption

DIPN 61 clarifies that the IRD takes the position that under special circumstances (e.g. where the fund is in its start-up period or winding-down period), an arrangement may be accepted as a fund even if it has only one investor at a certain point in time within a year of assessment. However, a fund that intends to have a single investor only is unlikely to satisfy the “pooling” requirement.

Umbrella Funds Under Unified Funds Tax Exemption

DIPN 61 also explains that the IRD takes the position that where there are separate pools of assets, including an OFC umbrella fund with multiple sub-funds, it will consider each asset pool separately for determining whether each pool should constitute a fund. Thus, the fact that a sub-fund of an OFC does not fulfil this condition will not result in non-satisfaction of this condition for the OFC umbrella fund as a whole.

Similarly, if an asset pool has different classes of interests, DIPN 61 clarifies that the IRD takes the position that it is possible that each class may be regarded as a separate fund. If the assets and liabilities of a class are segregated from the assets and liabilities of another class, the IRD may consider the different classes as different funds.

Exclusion From Fund

Under the IRO, certain arrangements are excluded from the meaning of a fund, including arrangements in which investors are related to the fund manager. DIPN 61 clarifies the IRD’s position is that a fund will not cease to qualify for relief under the Unified Funds Tax Exemption merely because a fund begins a year of assessment with a single seed investment by an affiliate of the investment manager.

Carried Interest Tax Concession

Following its proposal to introduce a concessionary tax rate for carried interest earned from Hong Kong private equity funds, on January 4, 2021, the Hong Kong Government announced that eligible carried interest will be charged at a profits tax rate of 0 per cent and that 100 per cent of eligible carried interest will be excluded from employment income for the calculation of salaries tax. On January 29, 2021, the Inland Revenue (Amendment) (Tax Concessions for Carried Interest) Bill 2021 (Carried Interest Tax Concession Bill) was published in the government Gazette.

Once the Carried Interest Tax Concession Bill is enacted, the concessionary tax rate will have retrospective effect, meaning that eligible carried interest received by or accrued to qualifying carried interest recipients on or after April 1, 2020 will, in essence, be exempt from Hong Kong profits tax. The concession will not apply to carried interest accrued before April 1, 2020, even if it is actually received after that date.

The tax concession will apply to eligible carried interest arising from qualifying transactions in private equity distributed by an eligible private equity fund (that is a private equity fund which the HKMA has certified meets the requirements under the Carried Interest Tax Concession Bill) to a qualifying carried interest recipient.

Carried Interest Eligible For Tax Concession

The term “eligible carried interest” is defined as a sum received by or accrued to a person by way of profit-related return subject to a hurdle rate. A “profit-related return” has three conditions:

• Firstly, the eligible carried interest must arise only if there are profits for a period on the investments, or on particular investments, made for the purposes of the certified investment fund, or there are profits arising from a disposal of investments of the fund;

 

• Secondly, the eligible carried interest paid must vary by reference to the profits; and

 

• Thirdly, the returns to external investors must be determined by reference to the same profits.

Separately, to the extent that there is no significant risk that the amount would not be received or accrued, such amount will not be regarded as eligible carried interest.

Transactions Qualifying For Carried Interest Tax Concession

Qualifying transactions include transactions in shares, stocks, debentures, loan stocks, funds, bonds or notes of, or issued by, a private company specified under Schedule 16C to the IRO; in shares or comparable interests of a special purpose entity (SPE) or interposed SPE which is solely holding (whether directly or indirectly) and administering one or more investee private companies; in shares, stocks, debentures, loan stocks, funds, bonds or notes of, or issued by an investee private company held by a SPE or interposed SPE; or incidental to the carrying out of the foregoing qualifying transactions.

Funds Eligible For Carried Interest Tax Concession

A private equity fund that falls within the meaning of  “fund” under the IRO (see above) will be an eligible private equity fund. However, for the recipients of the carried interest to be eligible for the tax concession, the fund must be certified by the Hong Kong Monetary Authority.

Eligible Recipients Of Carried Interest For Tax Concession

Qualifying carried interest recipients include corporations licensed under the SFO; firms providing investment management services in Hong Kong to a certified investment fund that is also a qualified investment fund eligible for relief under the Unified Funds Tax Exemption but which is not managed or advised by an SFC licensed or registered firm; and individuals deriving assessable income from employment with the foregoing firms by providing investment management services in Hong Kong to certified investment funds on behalf of such firms.

Investment Management Activities Eligible For Carried Interest Tax Concession

Firms will only qualify for the concession if they carry out investment management services, or arrange for such services to be carried out, in Hong Kong from the day they start providing such services to the private equity fund to the day that they receive the carried interest (Carried Interest Tax Rate Period). In addition, the investment management services must be carried on through a permanent establishment in Hong Kong and no other jurisdiction.

Individuals will only qualify for the concession if they are employed by a qualified firm which carries on a business in Hong Kong and if the employee is also providing investment management services in Hong Kong. The concession will only apply to the extent that the amount received by the employee is paid out of eligible carried interest that is exempt from profits tax under the concession. Firms and employees wishing to utilise the tax concession must therefore take care to ensure that the terms of employment are appropriately drafted to demonstrate the connection.

Substantial Activities In Hong Kong Required For Carried Interest Tax Concession

Lastly, to be eligible, a qualifying carried interest recipient that is a firm must, for each year of assessment in the Carried Interest Tax Rate Period, have on average two full time employees in Hong Kong who carry out investment management services and incur expenditure of at least HK$2 million in Hong Kong in providing the investment management services.