Introduction

With a view to promoting Hong Kong’s position as “a premier international asset and wealth management centre”, the Hong Kong Government introduced a limited partnership fund (“LPF”) regime and relaxed the requirements for open-ended fund companies (“OFCs”) in 2020. A tax exemption regime for funds and tax concessions on carried interest (performance fee) have also been introduced to support the development of the fund industry. Together with the tax concession for family offices, these tax incentives will provide tremendous support to Hong Kong fund managers and will attract global asset managers to relocate their Asian centres to Hong Kong.

The Inland Revenue (Profits Tax Exemption for Funds) (Amendment) Ordinance 2019, which came into effect on 1 April 2019, seeks to exempt most type of funds from Hong Kong profits tax. The unified funds exemption (“UFE”) regime provides a unified tax treatment for all funds operating in Hong Kong. In addition, investment managers of private equity funds can enjoy a 0% tax rate on qualified carried interest for both Hong Kong profits tax and salaries tax, when the fund is certified by the Hong Kong Monetary Authority (“HKMA”).

This article will give an outline of the basic features of an LPF and an OFC, and how the fund managers and funds can take advantage of the above tax relief.

Common fund structures in Hong Kong

The following table shows the major differences between an LPF and an OFC:

	LPF	OFC
Investment vehicle	Close-end More suitable for a private equity fund	Open-ended More suitable for a hedge fund or a listed securities fund
Fund set-up costs	Lower	Higher, but a government subsidy is available
Establishment of subfunds	Not allowed	Allowed Liability is separated between independent subfunds
Separate legal liability	No General partners have unlimited liability while limited partners have limited liability	Yes
Requirement for an investment manager licensed or registered with the SFC for carrying on Type 9 (asset management) regulated activity	No	Yes
Custodian	Not mandatory	Legal required
Time required for processing an application	Shorter (approximately 2-3 weeks)	Longer (approximately 1.5-2 months)
Appointment of external auditor	Yes	Yes
Qualified for UFE	Yes	Yes

LPFs

The LPF regime was implemented in August 2020 to attract private investment funds to set up and register in Hong Kong, and ultimately facilitating the channelling of capital into the Greater Bay Area. LPFs are structured in the form of a limited partnership to manage investments for the benefit of its investors. A fund qualified for registration under the LPF regime constitute one general partner (with unlimited liability in respect of the debts and liabilities of the fund) and at least one limited partner (with limited liability).

OFCs

OFCs are open-ended collective investment schemes. Structured in corporate form with limited liability and a variable share capital, OFCs mainly serve as an investment fund vehicle and are used to manage investments for the benefit of shareholders. As such, OFCs are not designed to engage in activities such as the commercial trade and business undertaken by conventional companies that are incorporated under the Companies Ordinance (Cap 622).

Government subsidy for OFCs

OFCs have similar features as the segregated portfolio companies as used in the Cayman Islands. In order to enhance the competitiveness of OFCs, an attractive subsidy is now offered to fund managers for setting up OFCs or re-domiciling offshore funds to Hong Kong. The subsidy offers a rebate of 70% on all professional expenses that are paid to Hong Kong-based service providers (for example, legal fees for the preparation of incorporation, including any fees incurred in drafting legal documents or offering documents). The tax rebate is subject to a cap of HK$1 million per OFC. Each investment manager can claim a subsidy for a maximum of three OFCs.

It should be noted that tax advice in relation to setting up an OFC or re-domiciling foreign funds is also eligible for the 70% rebate. Investment managers are encouraged to carefully study the Hong Kong tax implications (including but not limited to the availability of UFE and carried income tax concessions, as well as the traditional capital gains claim). A review of the fund’s private placement memorandum is also often important, as it is a public document providing a significant amount of information on the investment strategy of the fund.

UFE regime

The IRD’s Departmental Interpretation and Practice Note (DIPN) 61 published in June 2020 provided clarifications of its view on the UFE regime for both Hong Kong and non-Hong Kong domiciled funds. For more details, please refer to our article “Highlights of the offshore fund exemption regime for Hong Kong-domiciled funds”.

Hong Kong-domiciled funds are now also eligible to enjoy the UFE, as the non-resident requirement has been abolished in 2019. There is also no requirement for the directors of the fund to carry out business activities outside Hong Kong.

Specified transactions

Specified transactions include, amongst others, transactions in public securities, private company shares, futures contracts and foreign currencies. Further clarification is required on whether transactions in cryptocurrencies and other virtual assets are specified transactions.

For transactions in private companies, it is common practice for a fund to set up one or more special purpose entities (“SPEs”) to hold the investments in the investee private company (“PEs”).

SPEs

An SPE must be established for the sole purpose of holding and administering a private company and is not allowed to carry out any other trade or activity after incorporation.

PEs

While a fund exemption has been extended to private equity funds, additional requirements are imposed on the portfolio company. First and foremost is the 10% threshold imposed on investment in Hong Kong immovable property, whereby the aggregate market value of the holding of immovable properties in Hong Kong must not exceed 10% of the total asset value of the respective company.

In addition to the immovable property test, one of the following additional requirements has to be satisfied:

1.       the holding period test: the fund has to hold the private company for at least two years;

2.       the control test: the fund does not have a controlling shareholding of the private company; or

3.       the short-term asset test: no more than 50% of the market value of the assets of the private companies are short-term assets (that is, the holding period of the relevant assets is less than three years).

Anti-round tripping provisions

Even when a fund is qualified under the UFE, a deemed taxable income will be imposed on Hong Kong investors of the fund on the exempted assessable profits under the following circumstances:

1.       if the Hong Kong investors jointly hold 30% or more of the beneficial interest in the fund; or

2.       if Hong Kong investors who are associated with the fund hold any beneficial interest in the fund.

Carried interest tax concessions

Under the Inland Revenue (Amendment) (Tax Concessions for Carried Interest) Ordinance 2021, which took effect in May 2021, eligible carried interest arising from in-scope transactions received by qualifying recipients for the provision of investment management services to qualifying payers is exempt from tax in Hong Kong. Tax concessions are available for eligible carried interest received or accrued on or after 1 April 2020.

Contrary to annual asset management fees, only profit-related service fees (that is, carried interest) are eligible for tax concession. Generally speaking, only profits above the hurdle rate (benchmark) are expected to generate carried interest for the investment managers. Carried interest distributed by the fund management entity to the individual fund manager is also exempt from Hong Kong salaries tax.

Another essential prerequisite involves “in-scope transactions”, which refer to those of private equity funds that have already been exempt from profits tax under the UFE. The private equity funds have to be certified by the HKMA, and an external auditor report is required to be included in the application of certification to the HKMA.

On 31 August 2022, the HKMA released its guidelines on the auditor’s report for application for certification of funds. To apply for certification, a fund has to engage a certified public accountant (practising) to prepare an agreed-upon procedures report in accordance with HKSRS 4400 (Revised). A detailed review of the structure and investment activities of the fund is expected in the agreed-upon procedures report.

Last but not least, the fund manager is also required to fulfil the adequacy test in every relevant year of assessment, as set out below:

1.       average number of full-time qualified employees in Hong Kong ≥ 2; and

2.       annual operating expenditure incurred in Hong Kong ≥ HK$2 million (US$260,000).

Conclusion

While the Hong Kong government is dedicated to promoting both the asset management industry in Hong Kong and Hong Kong-domiciled funds, the IRD has expressed concerns about the potential abuse of fund exemptions, especially on short-term trading of Hong Kong immovable properties.

It is therefore important for fund administrators to pay close attention to all the above requirements, as failure to comply with any one of the requirements, even for a short period of time during the year, may result in ineligibility of the fund to enjoy the exemption benefits. In order to enjoy the 70% rebate on professional fees, OFCs are encouraged to consult a tax advisor at the initial set-up stage of the fund.

 

For enquiries, please feel free to contact us at:

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Important: The law and procedure on this subject are very specialised and complicated. This article is just a very general outline for reference and cannot be relied upon as legal advice in any individual case. If any advice or assistance is needed, please contact our solicitors.

Published by ONC Lawyers © 2024