Hong Kong plans to provide tax concession for eligible family-owned investment holding vehicles (FIHVs) managed by single family offices (SFOs) with central control and management in the locality, subject to amendments of the tax law.
To qualify as an eligible FIHV, the vehicle or structure must set out in the articles of association or constitutive documents that all issued shares or interest shall be exclusively and beneficially owned directly or indirectly by one or more individuals who are “connected persons” of the same family (the Single Family).
Such a FIHV would enjoy profits tax exemption in respect of transactions in specified assets and transactions incidental to the carrying out of the qualifying transactions subject to a 5 per cent threshold. Specified assets include securities, Hong Kong or foreign private company shares and debts, futures contract, foreign exchange contracts, deposits, exchange traded commodities, foreign currencies, and over-the-counter (OTC) derivative products.
Who Is Family? And Who Is Not?
Who are considered “connected persons” of the same family? The paper to brief members of the legislative council for discussion of the proposed tax concession in April 2022 (the paper) stated that “connected persons” will, broadly speaking, include specified classes of persons in connection with the individual such as the individual’s spouse, lineal descendants, parents, grandparents, and siblings, as well as the child of the individual’s siblings.
Interestingly, the term “child”, which was not defined in the paper, was separately described in a footnote of the government’s consultation proposal regarding the tax concession released in March 2022. A “child” means (a) a child of the individual or of the individual’s spouse or former spouse, whether or not the child was born in wedlock; and (b) includes the adopted or step child of either or both of: (i) the individual; and/or (ii) the individual’s spouse or former spouse. The paper has not made explicit whether the same definition of “child” is going to be adopted.
Though child with a former spouse is included, neither the former spouse nor a co-habiting partner is a “connected person”. This forms a contrast with the position in the United States under the Investment Advisers Act of 1940. Family offices with no clients other than family clients are not considered an investment adviser, and therefore the definition of family clients is key. While only the current spouse is a “connected person” in Hong Kong, the United States has included as family client former family member who is a spouse, spousal equivalent, or stepchild that was a family member but is no longer a family member due to a divorce or other similar event. A category not seen in the Hong Kong regime is the “spousal equivalent” who is defined as “a cohabitant occupying a relationship generally equivalent to that of a spouse.” A question frequently asked by family office clients has to do with the mistress and second family. Would the partner under that special situation acquire the status of a “spousal equivalent”? Is the concept only applicable if both cohabitants are legally unmarried?
Often, in the ultra-high-net-worth world, a wealthy person is in or has had multiple relationships with children in or outside wedlock. Multiple, separate structures (often mirrored to show “fairness”) would be created to provide for the first and second families. In Hong Kong, a mistress cannot be considered a “connected person” but her child would be so considered as the child of the relevant individual does not have to be born within wedlock. From the current language of the proposed regime, it seems that the structure with the legitimate spouse would be the only one that can benefit from the tax concession.
The former spouse will have to set up his or her own SFO and the person he or she was married to would not be a “connected person” of the Single Family. Their children can be “connected person” under both structures. But once the former spouse is remarried, his or her current spouse will be classified as a “connected person” and, if such current spouse has children from previous relationships, so will such children.
How Do The Tax And Regulatory Regimes Come Together?
The assets of the FIHV must be managed by an SFO in Hong Kong. The SFO must be exclusively and beneficially owned directly or indirectly by the Single Family holding the FIHV. In many family office structures, the manager of the family asset could be holder of management shares of the family asset holding vehicle if the family opts to issue different class of shares in such vehicle to clearly segregate the management function and economic interest. In the proposed regime, there are no details as to how exactly the management is implemented, which could be achieved by issuance of management shares and/or entering into investment management agreement. Another question that is not addressed is whether the SFO can engage another entity as sub-manager of the FIHV or an advisory company from which the SFO receives investment advisory. External asset managers are popular so this is a valid question.
The language of the proposed regimes has restricted the ownership of the SFO, implying it has to be the same as that of the FIHV. In other words, there might not be flexibility for family members who shoulder the responsibility of running the SFO to be sole owners of the SFO and there is no room for compensated by way of equity interest. Share incentive scheme would also be not possible.
The requirement on the ownership of the SFO in the proposal should be considered together with the regulatory framework under which the SFO operates. With no legal definition for “family office”, the Hong Kong financial services regulator does not take into account family relationship but the fulfillment of intra-group company exemption to waive licensing requirements for a SFO acting as discretionary investment manager. To qualify for the exemption, provision of investment advice or asset management services that constitutes regulated activities in Hong Kong can only be provided by a company to its wholly owned subsidiaries, a holding company which holds all its issued shares, or other wholly owned subsidiaries of that holding company.
In other words, if the SFO, owned directly or indirectly by the Single Family holding the FIHV, does not fulfill the group company exemption, then licensing requirement would still be triggered, despite the probable intention for the family office to be a streamlined entity without the burden and costs incurred for being licensed.
How Much Does It Involve?
The minimum assets under management (AUM) required is HK$240 million, measured by the aggregate average value of specified assets (which are securities, Hong Kong or foreign private company shares and debts, futures contract, foreign exchange contracts, deposits, exchange traded commodities, foreign currencies, and OTC derivative products) during the relevant year or a three-year period.
The AUM can be held by a single FIHV which is managed by an SFO in Hong Kong or up to 50 FIHVs exclusively and beneficially owned by the Single Family directly or indirectly and managed by the same SFO in Hong Kong. Family-owned special purpose entities in the form of company, partnership, trustee of a trust estate to hold and administer the specified assets are allowed.
The substantial activities requirement can be met by employing at least two full-time, qualified employees in Hong Kong to carry out the activities and spending at least HK$2 million on operating expenditure in Hong Kong for carrying out such activities. Given the minimum AUM of HK$240million, a reasonable team size and expected expenditure will well exceed the required threshold.
Same Tests As Fund Exemptions
To reduce the risk of tax evasion, it was proposed that the various tests currently applicable to fund profit tax exemption shall apply to SFOs and FIHVs. No specific details have been provided so far as to how the tests are adapted for the SFO environment but the general principles are set out below.
To prevent conversion of taxable profits derived from property investment into non-taxable income, the immovable property test imposes a 10 per cent threshold in the direct or indirect holding of real properties in Hong Kong.
The aim of the holding period test is to encourage long-term investment. Profits arising from the transaction in assets held for at least two years will not be taxed. (One might want to note that income from sale of investment assets held for three years or long is less likely to be considered trading receipt and capital gains are not taxed in Hong Kong anyways.) However, if the holding period is less than two years, the control test and the short-term asset test will apply. These tests specify that profits tax exemption would only be provided if either the entity does not have a controlling stake in the investee company or even if the entity has a controlling stake, the holding of the investee company’s short term asset is 50 per cent or below.
Further details will be available when the regime is implemented and when the tax authority releases the interpretation and practice notes.
Patricia Woo is Partner of Squire, Patton Boggs, and co-head of the Firm’s Family Office cross-practice team. She is a fund, trust and tax lawyer noted for her practice in helping global ultra-high-net-worth families set up, restructure and operate family offices. Patricia publishes widely, and is a frequent speaker and press interviewee on the topic of “family office”. She is recognized in Who’s Who Legal: Thought Leaders – Private Client (1st Edition) 2020 and is a recipient of the 2021 Global Law Experts Annual Awards (Private Client Lawyer of the Year in Hong Kong 2021, Trust Lawyer of the Year in Hong Kong 2021 and Tax Lawyer of the Year in Hong Kong 2021), the Corporate INTL Magazine 2021 Global Awards (Private Client Lawyer of the Year in Hong Kong and Trust Lawyer of the Year in Hong Kong) and the High Net Worth Award Winner in Hong Kong of the 2020 International Advisory Experts Award. She is listed in the Euromoney Women in Business Law Expert Guide 2020, CityWealth Leaders List Top 10 China & Hong Kong 2019, The Legal 500 Asia Pacific 2021, Who’s Who Legal: Private Client Global Leader 2020 and CityWealth Leaders List 2020. She is also ranked in Chambers HNW 2021 and recognized in CityWealth 2019 International Powerwomen Top 100 and CityWealth 2017 IFC Powerwomen Top 200. For further information, visit: www.squirepattonboggs.com/en/professionals/w/woo-patricia