Q&A: Hong Kong Monetary Authority's Anson Law

Q: Why is Hong Kong Monetary Authority (HKMA) involved in developing the new structure?

A: If you look at the Exchange Fund ordinance, one function of HKMA is to maintain Hong Kong’s position as an international financial center. I used to be with the investment team looking after the European PE portfolio. We invested in PE funds and real estate projects, so I came across a lot of structures, mainly domiciled in the Cayman Islands. On joining my current team, I was asked to identify a project for Hong Kong. Working with industry bodies and associations, tax advisors, auditors, and fund lawyers, we came to a view that Hong Kong lacks a viable limited partnership regime.

Q: What’s behind the timing?

A: We initiated it about three-and-a-half-years ago. We already had a blueprint comprising three building blocks: the fund level tax exemption, the limited partnership vehicle, and carried interest tax treatment. We focused on the fund level tax exemption first. Some players in the market were saying, ‘Don’t touch us; we are using Cayman, we are offshore, we are happy; there is no need for change.’ At the same time, others were saying you should do it if Hong Kong is to become a true hub for PE and VC. While we put in a lot of hard work, there was some luck. A year ago, offshore domiciles including Cayman rolled out a series of tightening measures in terms of substantial activities requirements. It’s possible to structure around this, but in the past 18 months there have been three rounds of tightening, so who knows what happens next. The typical fund life is 8-10 years, so there could be more to watch out for. People are searching for alternative viable options.

Q: If tax exemption and the limited partnership structure are now in place, that leaves carried interest…

A: It’s under industry consultation. We will work on revising the proposal with a view to getting it into Legco [Hong Kong’s Legislative Council] by the end of this year or early next year. The Financial Secretary has said that, subject to legislative approval, this regime will take retrospective effect from April 2020. We are trying to create a simple regime. Whoever you are, so long as you comply with the substantial activities requirement and you provide the qualifying investment management services in Hong Kong, carried interest you earn will be eligible for this regime. It’s important to balance anti-avoidance and being market-friendly.

Q: What can we expect in terms of tax treatment?

A: Any qualifying distribution will be subject to what we call a highly competitive tax rate. We haven’t been specific on that rate, but a highly competitive rate is obviously lower than the prevailing salaries tax rate in Hong Kong. We are not planning to categorize this sort of income as categorically falling under profit, capital gain or salary, because under Hong Kong’s Inland Revenue ordinance (IRO) framework, capital gain is not really a defined term. It would be hard, without major surgery to the IRO, to recognize something as capital gain in nature.

Q: How do you decide what is taxable as Hong Kong-based investment activity?

A: As to the delineation of what is being done in Hong Kong and outside of Hong Kong, there are established rules under the IRO. It would be akin to how many days or working hours someone spends in Hong Kong. We would expect the fund or any employer to keep a record of who is in Hong Kong on which day to carry out what function. This is not a day-to-day account, but an account of important activities for tax reporting purposes. It is normal tax reporting practice for a regular employee who travels from time to time. We are not creating something new.

Q: What about Singapore, where carried interest is not taxed?

A: When we looked at how to build Hong Kong into a PE and VC hub, we considered a lot of factors. You mention Singapore, but there are other hubs we are learning from in the US, Europe, and Australia. In terms of attracting business to Hong Kong, tax is one element. We need to provide a good ecosystem – geographical proximity, access to markets, access to talent. We have a strong legal vehicle that is supported by a large portion of the industry. Service providers and lawyers say we offer good protection of investors’ limited liability and flexibility in terms of freedom of contact. We are trying to enhance the fund level tax exemption and we are trying to work out carried interest. We hope funds will not come to Hong Kong based on one single reason. It depends on their strategy, where their investors are based, where their people are based, where they like to live. There is a basket of considerations and we want to work them out together to make Hong Kong successful.

Q: To what extent is Hong Kong part of a global trend?

A: Decades back, in the US and Europe, we saw a lot of offshore funds. Now a lot of US managers use the state of Delaware as a domicile, while European managers use Luxembourg. According to the BEPS [Base Erosion and Profit Shifting] initiative, fund structure should align with business substance. This has a bearing on how funds do their business. It was common market practice for a manager in Hong Kong to use an offshore structure. However, there is a risk that a few years down the road when this fund is making an exit, the base case financial projection on day one doesn’t work because it cannot claim relevant DTA [double taxation agreement] benefits due to a failure to comply with certain actions under BEPS. If it could happen in the US and Europe, why not in Asia? It’s just a matter of time in our belief.

Q: Who will be the first users?

A: The first wave of users will be from the mainland. Some of the big names have already indicated they will be using the regime. I talked to one that already has a sizeable Cayman fund – we are talking multi-billion-dollar funds. After a couple of meetings, they asked if they could redomicile the existing Cayman structures to Hong Kong the first week the new regime comes in. Unfortunately, this is not explicitly provided for under the ordinance. However, this manager has a number of vehicles for different projects. They are now working with lawyers on setting up Hong Kong limited partnership structures for project funds.

Q: Why large mainland managers in particular?

A: The larger managers in the mainland tend to be government-related or state-owned enterprises (SOEs). They have more incentive to streamline operations. For reputational reasons, they want to avoid using offshore structures. Many offshore jurisdictions have been perceived as tax havens where you can circumvent regulatory oversight. Large institutions don’t want to be associated with anything like that.

Q: Why would global managers want to use Hong Kong as a fund domicile?

A: We were planning to do an international roadshow, including visiting the US to promote our structure, but we haven’t been able to do that because of the COVID-19 outbreak. The managers we can reach out to are the big names. Their funds tend to be at least $1 billion in size, so there are 30-50 investors behind each fund. For them to use a Hong Kong limited partnership, 30-plus investors must get comfortable with the structure. That’s not as easy as a local fund manager with 5-10 investors. Managers investing in the US will stick to onshore vehicles – we aren’t trying to get a cut of that pie. However, in addition to the Delaware vehicle, these managers often have an offshore feeder vehicle for non-US investors. Maybe they no longer want to use Cayman. We will try to let them know what we are offering with a view to having some of them try out our regime. If we can prove this works, we can bridge a gap. We will also talk to managers in Korea and Japan that use Cayman structures for international investors.

Q: Do managers need to be locally licensed to use the limited partnership structure?

A: The regime doesn’t specify anything on regulation. We were thinking about mandating the need for a license, but we want to create a regime that is truly flexible and market embracing. If in the course of management, fund activities fall under the regulated activities, the provision [on licensing] would apply. But we want to allow room for the industry such that different operational models can still find the regime relevant. For example, a fund might be used as a feeder vehicle to channel capital from Asia into a Delaware fund. If we had mandated having a Hong Kong-licensed investment manager for that fund, it would be impossible for it to serve as a feeder vehicle to an overseas-centric fund. 

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• Topics
• Greater China
• Regulation
• Fundraising
• Hong Kong (China)
• Hong Kong Monetary Authority (HKMA)
• Fund formation
• tax