Legal update: The New Open-Ended Fund Company Regime in Hong Kong
On 30 July 2018, the new Open-Ended Fund Company (“OFC”) regime came into operation which introduced the OFC as a new form of corporate vehicle in Hong Kong. The legal framework of this new OFC regime consists of the three main pieces of legislation:
- the Securities and Futures (Amendment) 2016 Ordinance (gazetted on 10 June 2016) (“Ordinance”);
- the Securities and Futures (Open-ended Fund Companies) Rules (gazetted on 18 May 2018) (“OFC Rules”); and
- the Code on Open-Ended Fund Companies (a non-statutory code published by the Securities and Futures Commission (“SFC”) in July 2018) (“OFC Code”)
Traditionally, due to the capital protection rules applied in Hong Kong company law, i.e., companies incorporated in Hong Kong are not allowed to reduce its capital or buy back its shares unless specific procedures are followed. An open-ended investment fund which proposes to domicile in Hong Kong is usually established in the form of a unit trust, rather than a company limited by shares.
With the new OFC regime, fund managers are now able to form a Hong Kong limited liability company with a variable share capital structure to be subscribed and redeemed by the investors and pay distributions out of net assets/capital, subject to the solvency test and disclosure requirements.
Key Features of the OFC Framework
An OFC is established by registration with the SFC rather than the Companies Registry (“CR”). A one-stop approach is adopted by the SFC in processing the registration, the incorporation and the business registration of an OFC. Upon incorporation, a certificate of incorporation will also be issued by the CR.
A summary of the key features of an OFC are as follows:
- Instrument of Incorporation
The instrument of incorporation is a constitutive document of the OFC prescribing the regulations for the OFC, and is binding on the OFC’s officers, custodian, and shareholders. The Ordinance, the OFC Rules, and the OFC Code specify that certain mandatory provisions must be included in the instrument of incorporation, including:
- the name and object of the OFC, and kinds of property to invest;
- a statement that the registered office of the company is situated in Hong Kong;
- a statement that the company is an open-ended fund company with variable share capital;
- a statement that the amount of the paid-up share capital of the company is at all times equal to the net asset value of the company;
- a statement that the company’s shareholders are not liable for the debts of the company;
- a statement that the company’s scheme property is entrusted to a custodian of the company for safe keeping in compliance with the law;
- (if the OFC has sub-funds) a statement that the assets of a sub-fund of the OFC belong exclusively to the sub-fund and are not to be used to discharge the liabilities of, or the claims against, any other person, including the OFC and any other sub-fund; and
- a statement that the object of the company is the operation of the company as a collective investment scheme;
- circumstances and procedures for the removal and cessation of office of directors;
- certain corporate administrative matters, including the quorum of general meeting (a minimum of 2 shareholders present in person or by proxy) and notice period of annual general meetings (at least 21 days)
- procedures and requirements for appointment and removal of auditors; and
- circumstances and procedures for termination of the OFC and distribution of assets
The instrument of incorporation duly signed by the first directors of the OFC must be registered with the SFC, with a copy to be delivered to the CR upon incorporation.
An OFC must have at least two individual directors, and at least one of them must be an independent director who is neither a director nor an employee of the custodian (see below). Pursuant to the consultation conclusions published in May 2018 (“Consultation Conclusions”), the independent director is required to be independent of the custodian, but not of the investment manager (see below).
The first directors of the OFC should be appointed subject to the approval of SFC, and any subsequent directors will be appointed either by ordinary resolution or pursuant to the instrument of incorporation (see below) of the OFC. The directors are not required to be SFC licensed persons or Hong Kong residents.
According to the OFC Code, the directors must be of good repute, appropriately qualified, experienced and proper for the purpose of carrying out the business of the OFC. An OFC director also owes fiduciary duties and the duty to take reasonable care, skill and diligence to the OFC, and should be responsible for overseeing the activities of the OFC and the investment manager, and ensuring regulatory compliance.
- Investment Manager
An OFC must have one investment manager licensed by or registered with the SFC to carry out Type 9 regulated activity (asset management), whose appointment is subject to the approval of SFC. All responsibilities for the investment management of the OFC, including the valuation and pricing of fund assets, must be delegated to the investment manager.
An OFC must have one custodian, whose initial appointment needs to be approved by the SFC and any subsequent appointment is made by the directors.
The responsibility of the custodian includes: (i) holding in its custody all eligible assets of the OFC; (ii) maintaining proper and up-to-date records of all OFC assets, including frequent reconciliations; (iii) putting in place appropriate measures to verify the ownership of OFC assets; (iv) segregating OFC assets from assets of other entities; (v) not reusing OFC assets without prior consent of the OFC, and (vi) putting in place adequate risk management measures.
The OFC Code requires the custodian to be subject to the same eligibility requirements as set out in the Code on Unit Trusts and Mutual Funds (“UT Code”) for SFC-authorized funds. SFC further clarified that the prime brokers providing custodial services to the fund are equally subject to the eligibility requirements of custodians.
An OFC must appoint an auditor for each financial year, who must be independent of the investment manager, the custodian and the directors. Annual financial reports of the OFC must be prepared, and then published and filed with the SFC within four months of the end of the financial year. The interim financial reports, if prepared, must be published and filed with the SFC within two months of the end of the period they cover.
- Process Agent
If any director or the custodian of the OFC is not a resident of Hong Kong/registered in Hong Kong, a process agent must also be appointed.
- Termination and Winding-up
If any OFC is to be voluntarily terminated and de-registered, applications will have to be made to the SFC for termination and cancellation of the registration of the OFC. A solvency statement approved by the board of directors must be submitted to the SFC together with the application for termination, and a reasonable notice should also be delivered to shareholders containing particulars and procedures of the termination and impact on shareholders. With effect from the date of such notice, the OFC must neither be marketed to nor accept subscription from new investors, and the powers of the OFC and its directors may continue solely for carrying on business operation essential for closing down. Once all OFC’s assets and liabilities have been settled, and proceeds have been distributed, a further written notice needs to be given to the investors before an application can be made to cancel the registration of the OFC.
As for the winding-up of the OFC, currently OFCs will be subject to the disqualification and court winding-up process as an “unregistered company” under the Companies (Winding Up and Miscellaneous Provisions) Ordinance (“CWUMPO”). At a later stage, the SFO and/or the CWUMPO will be amended to enable the winding-up of OFCs as ordinary companies.
Public and Private OFCs
For all OFCs proposed to be offered to the public, unless any exemption applies they must obtain the authorisation from SFC pursuant to Part IV of the Securities and Futures Ordinance, and observe the ongoing requirements in the SFC Handbook for Unit Trusts and Mutual Funds, Investment-Linked Assurance Schemes and Unlisted Structured Investment Products. The intention is that they should be subject to SFC supervision similar to that of existing SFC-authorized funds.
For other privately offered OFCs, though they are not subject to the compliance regime applicable to the public OFCs, additional requirements are imposed in Section II of the OFC Rules, including:
- at least 90% of the gross asset value of a private OFC must consist of (i) asset types the management of which would constitute a Type 9 regulated activity, and/or (ii) cash, bank deposits, certificates of deposit, foreign currencies and foreign exchange contracts, and only a maximum of 10% of the gross asset value of the OFC can be invested in other asset classes (i.e.“10% de minimis limit”).
- a private OFC must not be a business undertaking for general commercial or industrial purpose;
- The investment scope and investment strategies adopted by the investment manager, including the restriction of the 10% de minimis limit, must be clearly disclosed in the offering documents;
- For any material change to the instrument of incorporation (e.g., material changes to the investment objectives and policy, or changes materially prejudicial to the shareholders), the majority shareholders’ approval will be required; if the change is immaterial, the directors will only need to provide certification that the change is immaterial and the custodian having no objection to the change;
- Reasonable prior notice should be provided for any material changes affecting investor’s investment decisions or materially impact on their rights, and notification of scheme changes should be provided to shareholders according to offering documents and/or the instrument of incorporation;
- the investment of incorporation and/or offering documents should clearly set out the fund operations procedures and comply with the principles listed in the OFC Rules. The offering documents must be filed with the SFC as soon as practicable (for initial issuance) or within seven days after the issuance (for revised offering document).
For public OFCs, profits tax exemption will be applicable similar to other SFC authorised collective investment schemes.
For private OFCs, the government has gazetted the Inland Revenue (Amendment) (No. 2) Ordinance 2018 (“IRAO”) on 29 March 2018 to extend the existing preferential tax treatment to private OFCs. According to the IRAO, the income of private OFCs generated from qualifying transactions will be exempted from profit tax if
- the central management and control of the OFC are exercised in Hong Kong;
- the OFC is not closely held, i.e., by a single group pretending to be an OFC to take advantage of the tax exemption;
- the transaction must be “qualifying” and falls into asset classes specified in Schedule 16A of IRAO (except for incidental transaction not exceeding 5% of trading receipt form both qualifying and incidental transactions); and
- the transactions are carried out through or arranged by persons licensed under Type 9 regulated activities.
Gain from transaction in assets outside Schedule 16A of IRAO may also qualify for tax exemption if it comprises no more than 10% of an OFC’s total assets in the relevant year.
However, the following transactions will NOT be exempted from profit tax:
- transactions in shares or debenture of a private company directly or indirectly holding real estate in Hong Kong with an aggregate value exceeding 10% of the value of the OFC’s total assets;
- transactions in shares or debenture of a private company over which the OFC controls and holds “short term assets” (i.e., assets which are neither Schedule 16A assets nor real estate, and has been held for less than 3 consecutive years prior to disposal), and the aggregate value of such short term assets exceeds 50% of the value of the total assets of the OFC; or
- transactions in assets outside Schedule 16A and (i) held pursuant to a direct trading or business undertaking in Hong Kong, or (ii) used to generate income.
Conclusion & Observations
The adoption of the OFC structure is expected to reduce the costs of appointing additional offshore layers and the complexities of dealing with multiple overseas regulators. However it remains to be seen whether this new regime will lead to the booming of the Hong Kong-domiciled investment fund market. Firstly, there is keen competition from a number of other jurisdictions which have launched or is going to launch similar fund-friendly corporate vehicles, including Singapore, the UK, Luxembourg, and Australia. Secondly, it is submitted that the new OFC regime is still more burdensome than many existing private fund vehicles in offshore jurisdictions, especially the exempted company in the Cayman Islands which has long been preferred by the fund manager based in Hong Kong and the rest of Asia.
Russell Bennett / Peter Tang
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Disclaimer: This publication is general in nature and is not intended to constitute legal advice. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.