Tax boosts for Hong Kong funds industry

In recent years, the Hong Kong government has been introducing various initiatives to bolster Hong Kong's position as a regional management hub in Asia. The asset management industry plays a key role in maintaining financial stability in the challenging market and economic environment.

According to the Fund Management Activities Survey 2016, published by the Hong Kong Securities and Futures Commission (SFC) in July 2017, the combined fund management business in Hong Kong represented HK$18,293 billion ($2,343 billion) as at the end of 2016, and achieved an annual growth of 5.2% and a five-year cumulative growth of 45.3%. The SFC survey also showed that a total of more than 2,200 funds were domiciled in Hong Kong, an increase of 12% compared with three years ago, while the number of Hong Kong domiciled SFC-authorised funds had increased by 50% to 735. These figures reflect the Hong Kong government's initiatives in promoting Hong Kong as an international asset management hub.

Hong Kong has also overtaken Singapore, a key regional rival, as the third leading global financial centre according to the 2017 Global Financial Centres Index (GFCI) published in September 2017. London and New York remain the top and second global financial centres, respectively.

In order for Hong Kong to continue to maintain its competitive edge as a global financial centre, the Hong Kong government has introduced various initiatives to reinforce Hong Kong's position as Asia's leading asset management hub. The most significant legislative change affecting the funds industry has been the extension of the offshore fund tax exemption to private equity (PE) funds in July 2015 (offshore PE fund tax exemption) to exempt offshore PE funds from tax in Hong Kong in respect of investments outside of Hong Kong. The key features of the offshore PE fund tax exemption include:

• Extending the offshore fund tax exemption to offshore PE funds by expanding it to cover investments in private companies incorporated offshore as well as both onshore and offshore special purpose vehicles (SPVs) that are established to hold offshore investments; and

• Waiving the original requirement in the offshore fund tax exemption for investments to be arranged by SFC-licensed persons.

While the offshore PE fund tax exemption was initially welcomed by the PE industry, it was noted by the Financial Services Development Council (FSDC) that there has been no noticeable increase in the number of offshore PE funds managed from Hong Kong since the implementation of the tax exemption. This was due to practical limitations of the existing rules on the offshore PE fund tax exemption. The two key constraints are:

• The offshore PE fund tax exemption does not apply to investments in Hong Kong private companies and non-Hong Kong private companies with substantial operations in Hong Kong or which hold substantial real estate in Hong Kong. A single non-qualifying investment could taint the entire fund and disqualify the fund from being exempt; and

• The permitted functions of an SPV are only limited to holding (directly or indirectly) and administering one or more eligible offshore private companies or another SPV – however an SPV is not permitted to undertake any other management activities.

Given the importance of the role that PE funds play in raising capital for businesses, and in order for Hong Kong to maintain its position as Asia's leading asset management hub, the Hong Kong government should enhance its tax initiatives to make it more business-friendly and favourable to the PE and venture capital industry. As a result, further proposals have been made by the FSDC to:

1. Extend the offshore PE funds tax exemption to cover investments in Hong Kong businesses; and

2. Extend the offshore PE fund tax exemption to cover investments in onshore privately offered open-ended fund companies (OFCs).

Hong Kong is facing keen competition from other jurisdictions such as Singapore, Hong Kong's closest competitor in the Asian region, where Singapore's assets under management (AUM) were up 7% to $2.02 trillion in 2016 according to the Monetary Authority of Singapore compared to Hong Kong's AUM of $2.34 trillion in 2016. As Singapore continues to make headway by introducing tax and regulatory incentives to grow and promote its own financial hub, Hong Kong must continue to benchmark itself against fund management centres regionally and globally, to be more competitive and attractive for fund managers to domicile in Hong Kong.

In light of the market environment and to increase Hong Kong's competitiveness as a global asset management hub, the FSDC initiated certain proposals in July 2017 including:

1. The extension of the offshore PE fund tax exemption to cover investments in Hong Kong private companies and non-Hong Kong private companies with substantial operations in Hong Kong, with the exception of those holding substantial Hong Kong residential properties;

2. Remove the tainting legislation. Under the existing legislation, where a qualified PE fund holds multiple investments and one of its investments fails to qualify as an excepted private company, the profits derived by the fund from the disposal of its other investments would not enjoy the tax exemption. This is because one of its investments has 'tainted' the other investments. The FSDC proposes amending the rule such that an offshore PE fund investing in a non-qualifying investment would only be subject to tax, in respect of the investment income derived from such non-qualifying income, to the extent the investment income is Hong Kong sourced revenue gains;

3. Introduce legislation to treat any gains derived from the disposal of a non-qualifying investment mentioned in (b) above as capital in nature if such investment has been held for more than two years; and

4. Expand the scope of the allowable activities of an SPV.

The proposed changes should encourage investments into Hong Kong portfolio companies and place Hong Kong and non-Hong Kong portfolio companies on a level playing field to qualify for the offshore PE fund tax exemption. If the legislative process is implemented and finalised as already proposed, this initiative would make the offshore PE fund tax exemption more attractive and more aligned with the Hong Kong government's policy to promote 'home grown' local new business start-ups so as to increase Hong Kong's competitiveness as Asia's leading asset management hub.

On June 23 2017, the Hong Kong government proposed to extend the offshore fund tax exemption to onshore privately offered OFCs. The proposed OFC regime exempts gains derived by certain Hong Kong based privately offered OFCs from profits tax (onshore private OFCs tax exemption).

This is another important initiative of the Hong Kong government to further promote Hong Kong as a leading investment asset management hub. The objective is to encourage fund managers to domicile their funds in Hong Kong instead of in one of the alternative and more established jurisdictions such as the Cayman Islands. The proposed OFC framework therefore must be commercially attractive and one that is, at the very least, on par with the more established fund jurisdictions so that Hong Kong is considered as a viable alternative jurisdiction in which to domicile.

However, the proposed OFC framework, in its existing drafted form, is generally viewed as not commercially competitive with the more established jurisdictions and therefore is unlikely to be used by fund managers. If the proposals are enacted as drafted, this would likely be a missed opportunity by the Hong Kong government to introduce an OFC regime that would make Hong Kong a competitive alternative, and one that would put Hong Kong ahead of its regional rivals. In particular, the key limitations in the June 2017 bill are:

• Strict ownership requirements – the OFC has to have at least 10 investors, or if it has at least one qualified investor it has to have at least five investors in total. A 'qualifying investor' in relation to an OFC is defined (subject to meeting certain conditions) as: an institutional investor; a collective investment scheme under the Securities and Futures Ordinance; a registered scheme (or its constituent fund) under the Mandatory Provident Fund Schemes Ordinance; an entity established to provide retirement, disability or death benefits to beneficiaries that are existing or former employees; a government entity; or a fund established by a governmental entity, international organisation, central bank or the Hong Kong Monetary Authority to provide disability or death benefits.

  The investor commitment thresholds for an exempt OFC for 10 investors have to be at least HK$20 million each or where the OFC has one or more qualified investors, the participation interest of at least four other investors has to be at least HK$20 million each; and each qualified investor has to exceed HK$200 million. More critically, the OFC must continue to meet the not closely held test for 24 months after the first 24 month period. Otherwise, the OFC will be taxable retrospectively from its start-up date i.e. as if the tax exemption had never been granted – generally funds would not be willing to take on this risk.

• Inclusion of a provision that deems dividends from a non-exempt OFC to be taxable if the dividends are regarded as consideration or remuneration for services rendered in Hong Kong. This is a rather simplistic approach to address the issue of taxation of carried interest and fees in Hong Kong, which has been a complex and fact-specific issue in Hong Kong. There are obvious concerns that this new rule could have wider implications for the asset management industry in Hong Kong.

• Qualifying investment classes are only limited to securities, futures contracts, foreign exchange contracts, deposits made with banks, foreign currencies, certificates of deposits, cash and over-the-counter derivatives. However, some popular classes of alternate investments – e.g. real estate investments and loans are not covered, and a single non-qualifying investment could taint the entire fund and disqualify it from being exempt.

Consistent with the offshore PE fund tax exemption introduced in July 2015, the proposed onshore private OFC initiative announced in the 2017-18 budget was in principle strongly supported by the industry. However, after the release of the June 2017 bill, there is broad consensus within the industry that the proposals as drafted in the bill may be an initiative that would not be widely used by the industry in Hong Kong. In order to bolster Hong Kong's appeal as an international financial centre for funds to use as a domicile, further refinements to the existing limitation in the June 2017 bill would need to be addressed and refined.

Despite the challenges facing the asset management industry, the Hong Kong government is making positive changes in promoting Hong Kong as Asia's leading asset management hub in the coming years.

Proposals from the FSDC for the extension of the offshore PE fund tax exemption to Hong Kong businesses is a positive step. It helps with identifying practical limitations of the existing tax rules, and proposing remedial action to better align the rules with the Hong Kong government's policy. However, it remains to be seen how these measures will eventually translate into legislation.

Draft legislation introducing the onshore private OFCs tax exemption is another supportive step to implement the initiative announced in the government budget to attract more funds to domicile in Hong Kong and build up Hong Kong's fund management capabilities. Legislative procedures are expected to refine the draft tax rules and address their limitations such that the initiative can compete with other global asset management centres.

Until Hong Kong provides better tax benefits/incentives to inspire international investors' confidence to domicile in Hong Kong, fund managers domiciled in other jurisdictions will be resistant to move into Hong Kong.

Darren Bowdern

Partner, Tax KPMG China 8th Floor, Prince's Building 10 Chater Road Central, Hong Kong Tel: +852 2826 7166 darren.bowdern@kpmg.com Darren Bowdern is the head of alternative investments and head of financial services in KPMG's Hong Kong tax practice. For more than 20 years, Darren has been involved in developing appropriate structures for investing into Hong Kong, mainland China and the Asia Pacific region. Darren's extensive experience includes cross-border buy- and sell-side M&A tax services (e.g. tax due diligence and tax vendor due diligence), tax structuring, tax planning and optimisation and international corporate tax issues, restructuring and optimisation. Many of these projects comprise tax effective regional planning including consideration of direct and indirect taxes, capital and stamp duties, withholding taxes and the effective use of double taxation agreements. Darren is also a regular speaker and writer on private equity related tax issues, and advises on establishing direct investment, private equity and other investment funds in Hong Kong and in the Asia Pacific region. He also advises on structuring tax efficient performance and co-investment arrangements for private equity funds, as well as effective remuneration and employment arrangements. Darren is a member of the technical committee of the Hong Kong Venture Capital Association (HKVCA), a member of the tax committee of the Alternative Investment Management Association (AIMA), the chair of the finance, legal and tax committee of the Australian Chamber of Commerce and deputy chair of the Australian Chamber of Commerce in Hong Kong (AustCham).

Matthew Fenwick

Partner, Tax KPMG China 8th Floor, Prince's Building 10 Chater Road, Central, Hong Kong Tel: +852 2143 8761 matthew.fenwick@kpmg.com Matthew Fenwick has provided tax advisory and compliance services to many multinational clients over a number of years, having worked for the KPMG tax practices in New Zealand, the UK and Hong Kong. Matthew's clients include a wide range of organisations operating in Hong Kong and across the Asia Pacific region. He has a focus on both Hong Kong specific and regional tax issues, meaning that he regularly liaises with colleagues in other jurisdictions on the myriad of tax related issues his clients face. Matthew's experience includes advising many funds and fund managers on the establishment and continuing operation of their businesses. Matthew's work covers the full spectrum of tax advisory and compliance services, including the provision of advice in relation to the tax implications of changes or other developments in relevant tax, accounting and regulatory law and practice.

Malcolm Prebble

Partner, Tax KPMG China 8th Floor, Prince's Building 10 Chater Road, Central, Hong Kong Tel: +852 2685 7472 malcolm.j.prebble@kpmg.com Malcolm Prebble has extensive experience in advising on regional merger and acquisitions projects including a number of tax due diligence and structuring projects for acquisitions by fund organisations and other professional investors. Through this work he has developed significant expertise in issues associated with cross border structures and is familiar with specific structuring issues associated with investments into a number of countries within the Asia Pacific. Malcolm has also assisted a number of organisations with the establishment of new funds focused on investments in the Asia Pacific region, or reviewing existing fund structures to recommend improvements to mitigate tax risks for the fund, sponsors and/or carried interest participants. Malcolm has advised clients in a wide range of industries, including manufacturing, infrastructure, real estate and private equity.