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Extension of Profits Tax Exemption to Private Equity Funds

2015-10-31

Background
On 17 July 2015, the Inland Revenue (Amendment) (No.2) Ordinance 2015 (“New IRO”) was gazetted to the effect of exempting specific types of offshore private equity funds (“PE funds”) from profits tax in Hong Kong. Through the amendment, it was hoped that more funds of various types would operate business in Hong Kong and Hong Kong’s competitiveness as an international asset management hub can be strengthened.

Characteristics of PE Funds

The diagram above shows a typical structure of PE funds. Most PE funds profit primarily by acquiring private companies as their portfolio companies to yield long-run returns. Many of them do this in Hong Kong through setting up Hong Kong or offshore special purpose vehicles (“SPVs”) which hold the PE funds’ interests in the portfolio companies. Many of the fund managers that are hired for carrying out these investment transactions are not licensed under the Securities and Futures Ordinance (Cap. 571) (“SFO”).

Before the enactment of the New IRO, tax exemption was only permitted in respect of a non-resident person’s profits from “specified transactions” that are carried out through “specified persons”. Yet, the definition of “specified transactions” did not include transactions in securities of private companies. In addition, a “specified person” referred only to a corporation licensed under the SFO.

As such, typical PE funds benefit very little from the tax regime under the Old IRO because many of them earn profit from transactions in securities of private companies. Furthermore, PE funds may not necessarily be managed by corporations licensed under the SFO.

The New IRO
Under the New IRO, a non-resident person continues to be exempted from profits tax if their profits are from a specified transaction through a specified person pursuant to s.20AC. However, the New IRO has expanded the scope of transaction in “securities” under Schedule 16 to include shares or debentures of an SPV or an “excepted private company”. Also, under the New IRO, profits of a non-resident person which is a “qualifying fund” may now be exempted from Hong Kong profits tax even if the transaction is not carried out through or arranged by a “specified person”.

Specified Transactions (in securities)
Before the enactment of the New IRO, the definition of “specified transactions” included “transaction in securities”. “Securities” was defined as “shares, stocks, debentures, loan stocks, funds, bonds, or notes of, or issued by, a body, whether incorporated or unincorporated… but does not include (the same) of a company that is a private company”. Under the New IRO, the definition of “securities” has been modified to include securities of a private company which is a “special purpose vehicle” or an “excepted private company” as defined therein. Accordingly, an offshore PE fund’s transactions in the shares and debentures of either an “excepted private company” or a “special purpose vehicle” can amount to a “specified transaction (in securities)” and potentially be exempted from Hong Kong profits tax.

Excepted Private Company
A new provision under s.20ACA(2) of the New IRO has introduced the concept of an “excepted private company”, securities transactions of which can qualify as “specified transactions” under Schedule 16. An “excepted private company” means a private company incorporated outside Hong Kong which, at all times within the 3 years before any specified transaction (in securities), that company: (a) did not carry on any business through or from a permanent establishment in Hong Kong; (b) did not hold, directly or indirectly in an amount exceeding 10% of the value of its own assets, share capital in one or more private companies carrying on any business through or from a permanent establishment in Hong Kong; and (c) did not hold, directly or indirectly in an amount exceeding 10% of the value of its own asset, immovable property in Hong Kong or share capital in one or more private companies carrying on any business through or from a permanent establishment in Hong Kong. An offshore PE fund may qualify for profits tax exemption if their profits are generated from a specified transaction in the securities of such an excepted private company.

Special Purpose Vehicles
s.20ACA(2) of the New IRO also defines a “special purpose vehicle”. It is “a corporation, partnership, trustee or any other entity” that is (a) wholly or partially owned by a non-resident person; (b) established solely for the purpose of holding, directly or indirectly, and administering excepted private companies; (c) is incorporated, registered or appointed in or outside Hong Kong; (d) does not carry on any trade or activities except for the purpose of holding, directly or indirectly, and administering one or more excepted private companies; and (e) is not itself an excepted private company.

To contextualize this, SPVs are Hong Kong or offshore incorporated entities owned by an offshore PE fund commonly used for the purpose of investing in or holding the securities of excepted private companies in Hong Kong. Where an SPV is a private company issuing shares or debentures, an offshore PE fund’s investment transaction in such shares or debentures qualifies as a “specified transaction (in securities)” under Schedule 16 of the New IRO. Under s.20ACA(1) of the New IRO, SPVs are exempted from profits tax, to an extent corresponding to the percentage of shares or interests that a non-resident person exempted under section 20AC(1) holds in the vehicle, specified transactions in securities of an excepted private company.

Qualifying Fund
Under s.20AC of the New IRO, there is now an alternative way of exempting offshore PE funds that are not managed by licensed corporations from profits tax. An offshore PE fund making profits from a “specified transaction” may still qualify for exemption as long as that offshore PE fund is a “qualifying fund”. A “qualifying fund” means a fund that (a) constitutes more than 4 investors whose capital commitments exceed 90% of the aggregate capital commitments at all times after the final closing of sale of interests; and (b) the portion of the net proceeds arising out of the transactions of the PE fund to be received by the originator and the originator’s associates, after deducting the portion attributable to their capital contributions (which is proportionate to that attributable to the investors’ capital contributions), is agreed under an agreement governing the operation of the PE fund to be an amount not exceeding 30% of the net proceeds. This new alternative of a “qualifying fund” couches all the special characteristics of PE funds, allowing genuine offshore PE funds to be exempted from profits tax, whether or not their transactions are carried out through a licensed “specified person”.

Implications
The amendments in the New IRO are explicitly targeted at removing the obstacles that offshore PE funds typically face with regard to profits tax exemption for returns from investments in private companies. It is expected that more offshore PE funds will carry on business in Hong Kong to take advantage of the relaxed regime. It is likely that the amendments can create further opportunities for local professional and advisory services, bolstering Hong Kong’s economy as a whole.


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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.


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