Hong Kong Introduces Tax Exemption to Onshore Privately Offered Open-ended Fund Companies
The Hong Kong Government has proposed legislation (the Inland Revenue (Amendment) (No. 4) Bill 2017) (the Bill) to offer profits tax exemption to onshore privately offered Open-ended Fund Companies (Subject OFCs).1
The implementation of the Bill is intended to coincide with the commencement of the OFC regime which was created in June 2016 by the Securities and Futures (Amendment) Ordinance and is expected to become operational in 2018. The changes are expected to attract more funds to domicile and originate in Hong Kong, and bolster Hong Kong's appeal as an international funds centre.
What is the scope of the tax exemption?
Only Subject OFCs that meet the qualifying criteria (as discussed further below) are exempt from Hong Kong profits tax, but only in respect of profits that they derive from:
- qualifying transactions; and
- transactions incidental to the carrying out of qualifying transactions (subject to the 5% de minimis rule).
A qualifying transaction is a transaction in a permissible asset class carried out through or arranged by a person that holds a Type 9 licence under the Securities and Futures Ordinance. Permissible asset classes are defined to encompass debt or equity securities (but exclude those issued by private companies), futures contracts, foreign exchange contracts, deposits made with a bank, foreign currencies, certificates of deposit and cash.
A Subject OFC will be taxed on profits from non-qualifying transactions (at the corporate tax rate of 16.5%), unless the non-qualifying transactions are incidental to the carrying out of qualifying transactions, in which case, the exemption can apply to profits from such incidental transactions if the trading receipts from the incidental transactions do not exceed 5% of the total trading receipts from both the qualifying transactions and the incidental transactions. If the 5% de minimis rule is breached, the Subject OFC will be taxed on all profits arising from such incidental transactions. The current view of the Inland Revenue Department (IRD) is that interest income from debt securities should be regarded as profits derived from incidental transactions.
Investment funds should take note of this feature in applying the 5% de minimis rule.
How does a Subject OFC qualify for the tax exemption?
To be eligible for profits tax exemption, a Subject OFC must satisfy all of the following conditions:
- Not closely held: The Subject OFC must not be owned by only a few individuals or corporate investors. This feature ensures that investors cannot abuse the tax exemption by setting up their private investment vehicles as a Subject OFC. A Subject OFC that is not closely held must meet all of the not closely held Conditions (the NCH Conditions) (as discussed below)
- Be a Hong Kong resident company: No residency test has been prescribed but it is anticipated that the IRD will adopt an approach consistent with that applied for offshore funds exemption (details of which are provided in Departmental Interpretation and Practice Note 43 Profits Tax – Profits Tax Exemption for Offshore Funds) in determining the residency of a Subject OFC. One key criteria for residency is that the company must be onshore, with its central management and control located in Hong Kong
- Mainly investing in permissible asset classes: The Subject OFC must invest at least 90% of its assets in the permissible asset classes and no more than 10% in non-permissible asset classes. If the 10% de minimis threshold is exceeded, the exemption will be lost and all assessable profits of the Subject OFC (including those derived from qualifying transactions) will be chargeable to profits tax at the corporate tax rate
What are the NCH Conditions?
A Subject OFC must meet the following NCH Conditions to be regarded as not closely held:
- The Subject OFC must have a minimum number of investors, not including the originators or their associates. A Subject OFC with at least one qualified investor which has a participation interest of more than HKD 200 million must have at least five investors (including the qualified investor). A Subject OFC with no such qualified investors is required to have at least ten investors. A qualified investor means certain specified types of institutional investors, including pension funds, publicly offered funds, governmental entities and organisations established for non-profit making purposes;
- For at least 10 investors of a Subject OFC with no qualified investor, or 4 investors of a Subject OFC with one or more qualified investors, the participation interest of each of them (other than a qualified investor) must exceed HKD 20 million;
- The interest of each investor (other than a qualified investor) must not exceed 50% of the Subject OFC's issued share capital; and
- The participating interest of the originators and their associates must not exceed 30% of the Subject OFC's issued share capital.
If a Subject OFC has multiple sub-funds (where investors of one sub-fund will only have rights to assets in, and income generated from, that sub-fund), each sub-fund is treated as a separate Subject OFC for the purposes of the tax exemption. A sub-fund must meet all of the qualifying conditions above before it can qualify for the tax exemption. Note that a breach of the NCH Conditions by a sub-fund cannot taint other sub-funds of the same Subject OFC.
As a Subject OFC is expected to take time to establish a stable consortium of investors to support the NCH Conditions, all Subject OFCs are deemed to satisfy the NCH Conditions in the first 24 months from the date it accepts its first investor. If the Subject OFC fails to actually meet the NCH Conditions at the expiry of the 24 months period, the tax exemption will be treated as if it had never been granted to the Subject OFC.
Failure to meet the NCH Conditions and the safe harbour rules
To prevent the operators of a Subject OFC from potentially abusing the tax exempt start-up period (e.g., by repeatedly opening and closing a Subject OFC every 24 months), the tax exemption may also be retrospectively revoked if the NCH Conditions are not met for a further period of 24 months after first meeting the NCH Conditions.
Notwithstanding the above, the IRD has discretion to permit a Subject OFC to continue to qualify for the tax exemption even if it fails to meet the NCH Conditions in certain situations (for example, if the breach is temporary).
Is the tax exemption as good as it sounds?
The tax exemption aims to incentivise fund managers to consider Hong Kong as a jurisdiction for setting up investment funds through the use of a Subject OFC structure, without compromising investors' protection. With this in mind, there are a few key issues that fund managers and investors should be aware of:
- As OFCs cannot invest in private companies (subject to the 10% de minimis rule), OFCs cannot operate as private equity funds. For private equity investments, the preference would remain with using an offshore investment vehicle to take advantage of the offshore fund exemption where applicable.
- While dividend distributions from a Subject OFC to its shareholders should ordinarily be exempt from tax, the Government in rolling out the tax provisions for Subject OFCs took an unprecedented step to include a specific anti-avoidance rule that expressly provides that performance fees and carried interest paid out in the form of dividends to investment managers of a Subject OFC will not be exempt from tax. The proposed legislation offers no guidance as to how to determine whether a performance fee or carried interest has been paid out in the form of a dividend. As such, a degree of uncertainty is anticipated around the operation of this rule. Investment mangers of OFC should take note of this rule when designing their remuneration plan to avoid any surprises.
- Given that a tax exemption for the initial 24-month period can be retrospectively dis-applied due to the subsequent non-compliance of the NCH Conditions by a Subject OFC, the fund documents may need to provide for situations where such dis-application occurs and the implications on any exiting and remaining investors. Legal advice should be sought to avoid any unexpected tax consequences for exiting and remaining investors.
- The application of the safe-harbour rules is not automatic and can only be granted at the IRD’s discretion. In particular, certain important terms such as "temporary" have not been defined in the Bill. Therefore, it remains to be seen how the IRD will interpret these rules and exercise its power in this regard.
- As an additional measure to prevent investors from using a Subject OFC as their private vehicle, where a Hong Kong resident person: (1) either alone or jointly with his associates, holds a direct or indirect beneficial interest of 30% or more in a Subject OFC; or (2) holds any direct or indirect beneficiary interest in a Subject OFC that is an associate of the resident, the resident will be deemed to have derived assessable profits in respect of the resident's entitlement to the profits earned by the Subject OFC. This is similar to the anti-avoidance rule applicable to the offshore fund regime that also offers similar tax exemption.
The tax exemption proposed for Subject OFCs has been welcomed by the industry and represents a significant step in promoting Hong Kong's managed funds sector. One may argue that investors can achieve the same tax-free treatment by setting up funds in tax free jurisdictions, such as Cayman Islands, without the need to observe the requirements that a Hong Kong OFC will need to meet to achieve the same tax position. We believe that given the investors' protection and transparency that Hong Kong offers, there are certain appeals to establishing investment funds in Hong Kong.
1 Subject OFCs refer only to OFCs that are established onshore and are privately offered and should be distinguished from publicly offered OFCs.