Hong Kong advisory body criticizes ineffective PE tax policy

The exemption, which was extended to include private equity in 2015, means that firms with funds domiciled offshore no longer have to set up structures designed to avoid triggering permanent establishment in Hong Kong and becoming liable for local tax. As a result, more substantive activity should be able to take place locally, rather than ancillary support work.

The Financial Services Development Council (FSDC) argues in a newly released paper that the implementation guidelines relating to the tax exemption are impractical, resulting in limited take-up. This tallies with observations from tax advisors that most GPs still rely on the traditional approach where the fund, special purpose vehicles (SPVs) and fund management entity are located offshore while the Hong Kong sub-advisor undertakes certain limited activities onshore.

Several recommendations made by the FSDC were incorporated into the legislation. However, practice notes released last year by the Inland Revenue Department (IRD) have proved disruptive. Most contentiously, it announced plans to tax carried interest by treating it as income rather than capital gains. But the IRD also limited the utility of the exemption in two ways, and it is with these that the FSDC has taken issue.

First, the exemption does not apply to funds that hold Hong Kong real estate assets or shares in a company with local business operations that exceed 10% of the overall value of the target company. The restriction exists to prevent local companies from using offshore fund structures to convert taxable profits into non-taxable income. But the fact that one deal could taint an entire fund – for example, a minority PE investment in a Chinese company that buys a property in Hong Kong – makes it problematic.

Second, the SPVs that exist beneath a fund only qualify for the exemption if they are established only for holding and administering private investments. This prevents an SPV from doing any of the things typically required to prove substance in a jurisdiction and take advantage of double taxation agreement (DTA) benefits. The IRD’s concern is that Chinese money could be round-tripped into Hong Kong and back into China to take advantage of these benefits, but the measure limits the economic rationale for any investor to establish an SPV in Hong Kong.

“In order for Hong Kong to reinforce its role as Asia’s leading asset management center, the FSDC recommends that the offshore PE fund tax exemption should be enhanced to make it more business-friendly and conducive to the PE and venture capital funds industry. Particularly, it should not discourage investments in Hong Kong portfolio companies and should place Hong Kong and non-Hong Kong investments on a level playing field to qualify for the PE fund tax exemption,” the paper says.

The FSDC makes several recommendations: extend the exemption to cover investments in companies with substantial Hong Kong operations, with the exception of those holding sizeable residential real estate interests; remove the tainting provision so that funds are only taxed on investment income derived from non-qualifying investments; treat the profit arising from non-qualifying investments held for more than two years as capital gains; and expand the scope of permitted SPV activities.

The Hong Kong Venture Capital & Private Equity Association (HKVCA) endorsed this proposal. Eric Mason, the organization's chairman, said it would help "cement Hong Kong's leadership role as the largest cross-border private equity center in Asia, whilst allowing capital to be invested in Hong Kong businesses."

The FSDC paper also stresses that a failure to act could see Hong Kong lose more ground to rival financial centers, notably Singapore. Funds managed or advised by a Singapore-based fund management company can obtain tax exempt status under one of three tax incentive schemes. The country also has a robust regulatory framework, a large collection of DTAs, and a deep professional services industry.

“In light of the developments in Singapore there is an urgent need for Hong Kong to improve its taxation framework for the PE industry, something which is recognized by the asset management industry of Hong Kong,” the FSDC says. It adds that a greater PE presence in Hong Kong would boost demand for financial services professionals, and the government would, in turn, benefit from increased tax revenue from the resultant economic activity.

In addition, there is the longer-term goal of bringing PE fund structures to Hong Kong, which would enable managers to bring their entire structure onshore. The government started a process to introduce open-ended fund company (OFC) structures for mutual fund and hedge fund managers to raise Hong Kong-domiciled vehicles. It was hoped this could be the precursor to a revised local limited partnership ordinance, and the FSDC drew up a proposed legal and regulatory framework in 2015.

However, tax advisors warn that the stance taken by the IRD on the offshore exemption does not inspire confidence within the industry for a user-friendly onshore regime. If there is a risk of local taxation, private equity firms will just go elsewhere.

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• Topics
• Greater China
• Regulation
• GPs
• Advisory
• Hong Kong (China)
• tax