On 10 July 2015 the Hong Kong Legislative Council agreed to extend the existing profits tax exemption for offshore funds to PE funds. The new exemptions, set out in the Inland Revenue (Amendment) Bill 2015 (the "Bill"), will come into effect shortly when the Bill is gazetted and will apply to transactions carried out after 1 April 2015.

The amendments, designed to address the concerns of offshore PE funds and promote Hong Kong's status as an asset management hub, broaden the existing exemption to cover transactions in securities of certain private companies incorporated outside Hong Kong, to remove the requirement to transact through SFO licensed entities for 'qualifying funds' and to extend coverage to include special purpose vehicles.

Hurdles for PE funds in the existing exemption

Hong Kong's Inland Revenue Ordinance generally taxes profits arising from the disposal of securities carried out in Hong Kong where that disposal is part of carrying on a trade, profession or business in Hong Kong. This potentially makes offshore funds operating in Hong Kong subject to profits tax.

Prior to the amendments introduced by the Bill, the legislation offered tax exemption to offshore funds if:

  • the fund is a non-resident fund which is determined by whether the central management and control of the fund is exercised outside of Hong Kong;
  • the fund's profits are derived from "specified transactions" which include the six categories of transactions which offshore funds typically perform being securities, futures contracts, foreign exchange contracts, foreign currencies and exchange-traded commodities transactions as well as deposit-making other than by way of a money-lending business; and
  • the transactions are carried out through, or arranged by, "specified persons" which includes corporations and authorised financial institutions licensed or registered in Hong Kong under the Securities and Futures Ordinance (Cap. 571) (the "SFO").

However, the qualifying requirements for this current exemption pose two major hurdles for offshore private equity funds. Firstly, the investments of offshore private equity funds are often arranged by entities that do not necessarily require SFO licensing in Hong Kong. Secondly, the "specified transactions" requirement does not currently include transactions in securities of a non-Hong Kong private company. Accordingly, even if an offshore private equity fund arranges its relevant transactions through an SFO licensed person, if (as would often be the case) the transactions are in securities of non-Hong Kong private companies, it could still be subject to Hong Kong profits tax.

The new broadened exemption aimed at PE funds

The amendments address these hurdles through three major reforms specifically aimed to address the needs of offshore PE funds.

  1. Widening the scope of "securities" to cover eligible non-Hong Kong private companies

Under the new amendments, the definition of "securities" (relevant to determining whether a transaction is a "specified transaction") has been broadened to include most non-Hong Kong private companies ("Excepted Private Companies"). However, a non-Hong Kong private company will not be an 'Excepted Private Company' if, at any time in the 3 years before the relevant transaction, the company:

  • carried on business through a permanent establishment in Hong Kong;
  • held (directly or indirectly) equity capital or interests in one or more private companies carrying on business through a permanent establishment in Hong Kong and the aggregate value of such capital and interests exceeded 10% of the portfolio company's own assets; or
  • held immoveable property in Hong Kong or held (directly or indirectly) equity capital or interests in one or more private companies which held immovable property in Hong Kong where the aggregate value of the portfolio company's holdings of immovable property and the equity capital or interests in private companies holding immovable property in Hong Kong exceeded 10% of the portfolio company's own assets.
  1. Waiving the requirement for transactions carried out by "specified person" where the offshore private equity fund is a "qualifying fund"

Currently many offshore private equity funds potentially subject to Hong Kong profits tax are managed by entities which do not require licensing under the SFO. This means they fall outside the current exemption. The amendments address this by exempting certain "qualifying funds", designed to capture bona fide offshore private equity funds while preventing possible abuse by local private equity funds disguised as offshore funds, from the requirement to transact through an SFO licensed person.

To be a 'qualifying fund' a fund must have at least five investors (not including the originator of the fund) who, in aggregate, commit more than 90% of the capital of the fund. In addition, the originator and its associates must not be entitled to receive more than 30% of the net proceeds arising from the transactions of the fund.

  1. Extending the exemption to include special purpose vehicles ("SPVs")

The use of single or multi-tiered SPVs to hold or transact investments is a common practice for private equity funds. In recognition of this, the amendments provide that SPVs (whether resident or non-resident) may be exempt from profits tax arising from transactions involving Excepted Private Companies or the securities of an interposed SPV. In addition, the definition of "securities" (again relevant to determining whether a transaction is a "specified transaction") has been amended to include securities of SPVs.

What this means for you

These changes are designed to attract more offshore private equity fund managers to set up or expand their business in Hong Kong and generate demand for local asset management, investment, advisory and other professional services.

Offshore private equity funds should assess whether the new expanded exemption applies to them, and whether they can streamline or improve their operations in Hong Kong in light of these changes. For example:

  • funds may be able to do away with existing complicated and administratively burdensome offshore meetings protocol and have investment management meetings in Hong Kong without the risk of tax leakage in Hong Kong;
  • if arrangements are made to have substantial management presence in Hong Kong, investment entities may be structured to take advantage of the Hong Kong double taxation treaty network; or
  • unlicensed Hong Kong fund managers may consider restructuring their fund and management structures to take advantage of the "qualifying fund" exemption, while fund managers who are not yet based in Hong Kong may consider moving their operations to Hong Kong to take advantage of this tax exemption and Hong Kong's tax treaty network.

Speak to us if you have any questions or would like any assistance on any restructuring of your management company or funds in light of these amendments.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.