The Departmental Interpretation and Practice Note (“DIPN”) 61 of the Inland Revenue Department (“IRD”) was published on 30 June 2020 to clarify the IRD’s view on offshore fund exemptions for Hong Kong-domiciled funds. While offshore fund exemptions initially only applied to non-resident funds, they became applicable to Hong Kong-domiciled funds from 1 April 2019.

Four major areas of exemptions are provided under DIPN 61, namely:

1.       Definition of fund: persons qualified as a “fund” may enjoy offshore fund exemption

2.       Exemption provisions: fund, special purpose entities and private companies

3.       Anti-round tripping provisions: deeming provisions

4.       Incidental transactions

 

This article will give an overview of these areas. The first two areas involve substantial changes in comparison with the previous provisions; whereas only limited changes have been made to the latter two areas.

Definition of a “fund”

The definition of a “fund” is similar to that of “collective investment scheme” under the Securities and Futures Ordinance (“SFO”). The term is defined with a view to preventing abuse of offshore fund exemptions when investors make investment on their own without relying on asset management services from external service providers, as the exemptions are intended to promote the development of the asset management industry in Hong Kong.

The IRD will look at all relevant decisions in determining whether a person is a fund or not (a detailed definition of “fund” is given in Section 20AM of the Inland Revenue Ordinance (“IRO”)). A person has to fulfil the definition of a “fund” at all times during the year of assessment in order to qualify for any profits tax exemption.

First of all, investors must not have day-to-day control over the management of the fund, as a fund should be managed as a whole by a fund operator (for example, a corporation licensed by the Securities and Futures Commission) that has overall responsibility for the management of the fund, including investment advice and operational services. A securities broker, for instance, is unlikely to be considered a fund operator as it does not provide investment advice but merely carries out its clients’ investment decisions.

An arrangement intended to have only one investor would not normally be considered a fund as it is unlikely to fulfil the “pooling” requirement. For complex structures, such as parallel funds or a master-feeder structure, all the relevant facts (including whether such funds constitute separate funds or not) must be considered before determining if the structure falls within the definition of fund under Section 20AM of the IRO.

The IRD also highlighted that group schemes or employee share schemes in which the operations are in the same group of companies would not generally fall within the definition of fund, as the taxability of employee remuneration in Hong Kong cannot be exempted under a fund structure.

Exemption provisions

Four main requirements for a fund to be qualified for an offshore fund exemption were set out under the Inland Revenue (Amendment) (No 2) Ordinance 2015 (“2015 Ordinance”), and further amendments were made to those requirements in the Inland Revenue (Profits Tax Exemption for Funds) (Amendment) Ordinance 2019 (“2019 Ordinance”). We will go through each requirement in turn.

Non-resident in Hong Kong

Under the 2015 Ordinance, a fund must be a non-Hong Kong resident in order to qualify for an offshore fund exemption. After the 2019 Ordinance came into force, Hong Kong-domiciled funds are now eligible for offshore fund exemptions subject to additional requirements (see the section “Specified transactions” below).

Tax residency of a fund generally refers to the location in which the central management and control of the fund are exercised. In determining tax residency, the deciding factor is not the place of incorporation. Instead, the IRD will look at a number of other factors, including the location of directors and where the board of directors’ meetings take place. A Certificate of Resident Status in Hong Kong is good evidence that an entity has been confirmed by the IRD as a Hong Kong tax resident.

Specified transactions

Specified transactions include, amongst others, transactions in public securities, private company shares, futures contracts and foreign currencies. Of these, transactions in private company shares are attracting the most attention in the market, particularly those relating to the private equity industry.

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”). Exemption requirements for SPEs and PEs are set out as follows.

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. In particular, an SPE is only permitted to conduct the following business activities:

1.       reviewing the financial statements of portfolio investment companies;

2.       attending shareholder meetings of the portfolio investment companies;

3.       opening bank accounts to enable the receipt of dividends and investment disposal proceeds; and

4.       appointing a company secretary and auditor.

 

PEs: Under the 2015 Ordinance, offshore fund exemptions were not granted to funds investing in a private company incorporated in Hong Kong. These exemptions were extended in the 2019 Ordinance to include investment in Hong Kong private companies subject to additional requirements.

The limitation on investment in Hong Kong immovable property still applies. In particular, whether considering the private company itself or the companies in which the private company has invested, 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.

Though market value will be applied in calculating the 10% threshold, the IRD will first make reference to the book value in the audited financial statements of the private company. As such, it is recommended to limit both the book value and the market value of any Hong Kong immovable properties to the 10% threshold.

While offshore fund exemption has been extended to Hong Kong private companies, as the intention is to encourage the fund to hold private companies for long-term investment purposes, Hong Kong private companies are subject to one of the following additional requirements:

1.       the fund has to hold the private company for at least two years;

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

3.       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).

 

As long as one of the above three conditions is satisfied, the exemption will apply to private companies in Hong Kong.

Specified persons or qualified investment fund: Exemptions are available to a fund if it is carried out or arranged by a specified person in Hong Kong, or if the fund is a qualified investment fund. The term “specified person” generally refers to a licensed corporation under the SFO. To be classified as a “qualified investment fund”, the following conditions must be met.

1.       the number of investors (excluding the originator and the originator’s associates) exceeds four at all times after the final closing of sale of interests;

2.       over 90% of the aggregate capital commitment is made by investors (excluding the originator and the originator’s associates) at all times after the final closing of sale of interests; and

3.       net proceeds to be received by the originator and the originator’s associates cannot exceed 30% (after deducting the portion that is attributable to them based on their capital contribution).

 

More detailed definitions of some of the specific terms mentioned above are set out in paragraphs 82 to 94 of DIPN 61.

Anti-round tripping provisions

As to anti-round tripping provisions, even when a fund meets all the above exemption requirements, a deemed taxable income will be imposed on Hong Kong investors of the fund in 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.

 

Having said the above, anti-round tripping provisions do not apply under the following situations:

1.       when, at all times during the year, 50 or more persons hold all the units of the fund;

2.       when, at all times during the year, 21 or more persons are entitled to 75% or more of the income or property of the fund; or

3.       by special concession by the IRD’s assessor.

 

Incidental transactions

Incidental transactions are transactions incidental to the carrying out of specified transactions. Typical examples are interest or dividend income on securities and custody of securities.

If the trading receipts from incidental transactions do not exceed 5% of the total trading receipts (both specified transactions and incidental transactions), the incidental transactions could still be exempted; otherwise, the total amount of the trading receipts from incidental transactions is subject to Hong Kong profits tax.

Nevertheless, it should be noted that some of the trading receipts from incidental transactions (for example, dividend income or offshore interest income) are non-taxable in Hong Kong even without the exemption.

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 concern about the potential abuse of offshore fund exemptions, especially on short-term trading of Hong Kong securities, as capital gains from long-term investments (as well as income from overseas securities) are likely to be non-taxable in Hong Kong.

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 to enjoy the exemption benefits.

 

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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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