Legal update: The New Profit Tax Exemption Regime for Funds in Hong Kong291月2019
The Inland Revenue (Profits Tax Exemption for Funds) (Amendment) Bill 2018 (“Bill”) which introduces a new set of preferential profit tax treatment for both eligible onshore funds and offshore funds, was published in the Government Gazette on 7 December 2018. The Bill, if made effective, will create an alternative to the existing fund tax exemption regime which was criticised by the asset management industry in Hong Kong for being too narrow and too difficult to qualify for.
The Existing Tax Exemption Regime
Presently, profit tax is exempted in Hong Kong for (i) public funds authorised by the Securities and Futures Commission (“SFC”) or (ii) “bona fide widely held” investment schemes which comply with the requirements of a supervisory authority acceptable to the SFC. This exemption also covers an open-ended fund company (“OFC”) offered to the public.
For private funds, profit tax relief was previously available to (i) offshore investment vehicles with no central management and control in Hong Kong; and (ii) investment vehicles incorporated in Hong Kong as private OFCs. Both exemptions are with many restrictions and can be difficult to qualify for, since one of the main concerns behind those exemptions is to avoid the risk of misuse of preferential tax treatment by the local business in Hong Kong through the establishment of artificial offshore fund structures.
The New Exemption
The Bill, if implemented, will repeal and replace the existing tax relief in relation to OFCs. The proposed new exemption will also apply to certain funds which are investing in prescribed types of transactions.
In the Bill a “fund” is, unless expressly excluded, defined as an arrangement in respect of any property for a year of assessment if, at all times during such period:
- either (i) the property is managed as a whole by, or on behalf of, the person operating the arrangement, or (ii) the contributions of the participating persons, and the profits or income from which payment is made to them, are pooled under the arrangement, or both;
- under the arrangement, the participating persons do 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); and
- the actual or pretended purpose or effect of the arrangement is to enable the participating persons, whether by acquiring any right, interest, title or benefit in the property or any part of the property or otherwise, to participate in or receive profits, incomes, payments or other returns.
The following arraignments are expressly excluded from the definition of a “fund” thus not covered under the new exemption:
- Public funds authorised by the SFC;
- Business undertakings for general commercial or industrial purposes, including activities involving sale/supply and purchase of gods or services, property development, property holding, insurance and finance (unless through eligible private equity investments); or
- intra-group arrangements, in which all the participants in the arrangement are corporations in the same group of companies as the operator of the arrangement or arrangements in which all the participants in the arrangement are employees (or close relatives of such employees) of the same corporate group as the operator of the arrangement.
It is mentioned in the explanatory memorandum of the Bill that this definition is similar to that of collective investment schemes set out in the Securities and Futures Ordinance (Cap.571 of the Laws of Hong Kong) (“SFO”). As such, the scope of such definition is wide enough to cover both pooled investment vehicles and sovereign wealth funds, regardless of their place of central management and control (e.g., onshore or offshore), structures (e.g., limited company, partnership or OFC) or investment objectives.
Pursuant to the Bill and subject to anti-avoidance provisions, the new exemption will exempt a fund from profit tax when conducting one of the following prescribed types of transactions:
- Qualifying transaction: a transaction in the assets prescribed in Schedule 16C of the Bill and either:
- the transaction is carried out or arranged in Hong Kong by or through a person licensed by or registered with the SFC, or
- the fund is a “qualified investment fund”. A “qualified investment fund” is a fund which:
- (a) at all times after the final closing of sale of interests, the number of independent investors exceeds 4 and the capital commitments made by investors exceed 90% of the aggregated capital commitments; and
- (b) the persons that originate, sponsor and control the fund are, pursuant to the fund agreement, entitled to no more than 30% of the net proceeds arising out of the transactions of the fund.
- Incidental transaction: a transaction incidental to a qualifying transaction above, unless trading receipts from such incidental transaction exceeds 5% of the total receipts of qualifying transactions and incidental transactions in the basis period.
- OFC qualifying transaction: a transaction by an OFC which is not within the assets prescribed in Schedule 16C of the Bill.
The assets prescribed in Schedule 16C of the proposed Bill include the following: (i) securities; (ii) shares, debentures, bonds, etc. issued by a private company; (iii) future contracts; (iv) foreign currency exchange contracts; (v) deposits; (vi) certificates of deposits; (vii) exchange-traded commodities; (viii) foreign currencies; (ix) OTC derivative products; and (x) an investee company’s shares co-invested under the Innovation and Technology Venture Fund Scheme.
The Scope for OFCs
It is worth noting that compared to the previous tax relief for the OFCs (which is only applicable to certain types of transactions), the wording in the proposed Bill has a much wider scope since an OFC may apply for the profit tax relief based on any transactions other than those listed in Schedule 16C. However, the Bill goes on to provide that the “direct trading or direct business undertaking in Hong Kong” carried on by an OFC will not be exempt from the profit tax. It is unclear at this stage as to the meaning and the scope of a “direct trading or direct business undertaking”, and whether an OFC conducting, for example, cryptocurrency tokens, will be caught by this definition.
It is also worth noting that for privately offered OFCs, the Securities and Futures (Open-ended Fund Companies) Rules provides that at least 90% of the gross asset value of the OFC must consist of (i) asset types the management of which would constitute a Type 9 regulated activity, and/or (ii) foreign currencies, certificates of deposit, bank deposits, cash, and foreign exchange contracts.
Special Purpose Entities (“SPEs”) under the Fund
In addition to a fund fulfilling the conditions above, the Bill also extends tax relief to profits obtained from transactions of SPEs set up by a fund for the sole purpose of holding and administering any of the following eligible private equity investments:
- transactions in bonds, stocks, debentures, shares or notes (“Specified Securities”) issued by private companies or interposed special purpose entities between the fund and such companies;
- transactions in options, rights or interest in or in respect of the Specified Securities; and
- transactions in temporary or interim certificates, receipts or warrants, or certificates of interest in relation to the Specified Securities.
The extent of tax exemption applicable to any eligible SPE is the percentage of shares or interests in that SPE owed by the relevant qualifying fund.
Similar to the existing tax exemption regime, the Bill is drafted with the intention to minimise the risk of illegal tax evasion activities through the establishment of artificial fund structures.
For funds and/or SPEs carrying out transactions in Specified Securities of a private company which does not directly or indirectly hold any immovable property in Hong Kong, their profit tax is exempted if the relevant investments comply with at least one of the following restrictions:
- if the fund and/or the SPE disposes of Specified Securities not less than 2 years after acquiring the same; or
- if the fund and/or the SPE disposes of Specified Securities less than 2 years after acquiring the same –
- it has no control over the private company; or
- it has control over the private company and holds short-term assets (i.e., non-Schedule 16C assets held for not less than 3 consecutive years before disposal, excluding immovable property) not exceeding 50% of the value of assets in the private company.
For funds and/or SPEs carrying out transactions in Specified Securities of a private company which directly or indirectly holds immovable property in Hong Kong, their profit tax is exempted only if:
- any of the condition above for transactions in private company (holding no immovable property in Hong Kong) is fulfilled; and
- the aggregate value of the immovable property does not exceed 10% of the value of its assets;
The Bill also maintains the provisions against round tripping from the existing regime. The Bill requires any person resident in Hong Kong who are associates of the fund to bear tax liability of the fund, which would have been required to pay profit tax but for the new exemption in proportion to his or her beneficial interest in such fund, provided that he or she holds or is interested in not less than 30% of the interest in the fund.
Conclusion & Looking Forward
The Bill was introduced to the Legislative Council on 12 December 2018. If passed in its current form, it is intended to come into operation on 1 April 2019.
The introduction of this new set of preferential profit tax treatment is an ambitious move by the government to reinforce the position of Hong Kong as an asset management centre in Asia, and it has since then received positive feedback from the industry. The broad scope of those rules means that asset management firms are no longer required to artificially transfer their central management and control function outside Hong Kong, at least not for profit tax purposes. With a carefully designed structure, fund managers may be able to dispense with offshore vehicles and significantly reduce their overall on-going operation and compliance costs for the fund. The Bill also expands the existing preferential tax treatment of OFCs, which is another attempt by the government to increase the popularity of this newly-created business vehicle in Hong Kong.
Russell Bennett / Peter Tang
The above is not intended to be relied on as legal advice and specific legal advice should be sought at all times in relation to the above.
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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.