Hong Kong PE regulation: The quest for certainty

Bridging the gap in Hong Kong's legal and tax regimes to turn the territory into a fully fledged onshore private equity hub takes more than a single stride. This week the local PE community took the second of what will be numerous small steps in its journey.

In February, Financial Secretary John Tsang announced in his budget statement that Hong Kong would introduce the relevant framework to attract more funds to the territory.

Now the Financial Services Development Council (FSDC) has released proposals as to how these broad goals can become concrete policies - specifically extending the profits tax exemption for offshore funds to include private equity and introducing open-ended investment company (OEIC) structures through which fund managers could raise Hong Kong-domiciled funds.

"It's the first time we have got a group of people who are experts in their fields and tried to fix our shortcomings," says Florence Yip, leader of PricewaterhouseCoopers' PE tax practice in China and Hong Kong and a non-official member of the FSDC's New Business Committee. "In doing this, tax is just the starting point. We are waiting to start the next phase, which involves looking at the limited partnership regime in Hong Kong."

Tax exemptions and OEICs are two of the six topics covered in a series of research papers produced by the FSDC. They also go to the heart of concerns within the local PE community that the territory is losing ground on Singapore, which offers greater certainty on tax treatment and clearer regulation of the asset class.

A simpler plan

By extending the tax exemption, PE firms with funds domiciled offshore would no longer have to set up structures designed to avoid triggering permanent establishment in Hong Kong and becoming liable for local tax. It should also make it easier to access the tax treaty network - funds must meet local substance requirements to qualify for treaty benefits and this could be done without risking local tax liability.

The FSDC recommends offshore funds operated by licensed managers should qualify for the exemption provided they - or offshore special purpose vehicles (SPVs) under their control - don't invest in "land rich" Hong Kong real estate companies or in companies that directly or indirectly rely on Hong Kong real estate for 10% or more of their net asset value.

The exemption also includes Hong Kong-based SPVs controlled by offshore funds. "Allowing the exemption for onshore SPVs would simplify the process and open up the tax treaty network, turning Hong Kong into a hub for investments in the region," says Darren Bowdern, a tax partner at KPMG China.

He is less impressed by the real estate restriction, arguing that PE funds should receive the same treatment as other foreign investors. No one disputes this, but it appears the concession was made for expediency's sake. The Hong Kong authorities are sensitive about real estate and one source notes that the proposals were drafted in the knowledge that the government wanted material that could seamlessly move towards full legislation by the first quarter of next year.

A more substantial sticking point is licensing. The proposal only allows managers licensed by the Securities and Futures Commission (SFC) can take advantage of the tax exemption, although the FSDC expresses a desire for a mechanism that can include unlicensed managers as well. It is estimated that only half the managers operating in Hong Kong are currently licensed.

On one hand, industry groups don't want private equity firms to be discriminated against for not registering with the SFC; on the other, government agencies don't want to hand a tax exemption to managers without retaining the ability to ensure they are who they say they are.

Another type of registration is required but it isn't clear whether this would be under the SFC or the Inland Revenue Department, so nothing is likely to happen in the first wave of reform.

"Our technical view is you would make a disclosure that you are a collective investment scheme with more than 3-5 unconnected investors and a third-party manager," says John Levack, managing director of Electra Partners and chairman of the HKVCA's technical committee.

"You would declare that no more than 30% of your capital comes from Hong Kong sources and agree to appear on a register of collective investment schemes that would be able to benefit from the offshore fund exemption."

After the OEIC

As locally-domiciled vehicles, OEICs would certainly require SFC-licensed managers. They are more flexible than unit trusts and there is the added carrot of potential mutual recognition with the mainland, whereby Hong Kong-domiciled funds could be sold to mainland investors.

While a private OEIC could feasibly be used by a PE firm, they are unlikely to supplant limited partnerships. Rather, industry participants see OEICs as a stalking horse for adjustments to the limited partnership legislation.

"OEICs are not as significant a development for private equity but more relevant for mutual funds and hedge funds," says James Ford, a partner O'Melveny & Myers in Hong Kong. "I would expect that Phase II might be a revamp of the existing Hong Kong limited partnership ordinance to try to encourage people to use that as a fund structure for private equity."

Opinion is divided as to the utility of this structure. For many, the key consideration is certainty on tax treatment, granted under the tax exemption, which allows the manager to be brought onshore. It is unclear whether traditional LPs would be happy using a Hong Kong-domiciled fund instead of Cayman Islands one.

However, an increase in locally-domiciled funds would certainly boost to the financial services industry and Levack's argues that principal source of demand will actually be China.

"If we can get the legal, regulatory and tax structures that make Hong Kong a really good onshore hub for PE there will be a trickle of business from established Western and Asia-based funds but it will be the mainland that will see this as what it has been waiting for," he says.

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• Topics
• Regulation
• Greater China
• GPs
• Hong Kong (China)
• Offshore
• tax
• regulation