Hong Kong to amend unpopular PE tax exemption

The exemption means that PE 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 can take place locally, rather than ancillary support work.

However, practice notes issued in 2017 created two problems. First, 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 would not qualify for the exemption. Second, special purpose vehicles (SPVs) that exist beneath a fund are only exempt if their role is limited to holding and administering investments – effectively excluding what is required to prove local substance.

As a result, most GPs don't apply for the exemption, according to tax advisors. They simply rely on the traditional approach where the fund, SPVs and fund management entity are located offshore while the Hong Kong sub-advisor undertakes certain limited activities onshore.

Draft legislation released on December 7 indicates that the exemption will be extended to apply to all income and capital gains generated by the sale of shares in private companies, no matter where those companies are established. Should an investment breach the 10% local real estate threshold, the fund will only be taxed on profits arising from that investment. Similarly, tax must be paid on profits from controlling investments in companies that are held for less than two years, but the fund as a whole would not be tainted.

The changes are intended to remove ring-fencing at the SPV level and the fund level, whereby onshore and offshore investors are treated differently. These discrepancies were identified by the EU under the BEPS initiative, which is intended to stop investors exploiting gaps in the tax system to artificially shift profits to low or no-tax locations. Specifically, it was uncomfortable with the tax exemption applying to offshore, but not onshore, funds and with investments by offshore funds only qualifying for the exemption if portfolio companies are incorporated overseas, not locally.

Hong Kong duly promised to modify the tax regime for offshore funds and introduce amended legislation by the end of 2018. "Failure to honor the aforementioned commitment may lead to the EU revisiting Hong Kong's status when reviewing the list of non-cooperative jurisdiction for tax purposes," the Legislative Council brief states. That could result in the imposition of defensive measures such as reinforced monitoring of certain transactions and withholding tax measures.

Last year, the Financial Services Development Council (FSDC) warned that a failure to improve the exemption regime could see Hong Kong lose more ground to rival financial centers, notably Singapore. Its specific recommendations have been broadly included in the legislation.

"Hong Kong's fund managers can look forward to having clearer and workable rules to rely on when managing private equity funds, regardless of whether these are managed onshore or offshore," Paul Ho, head of EY's financial services tax practice, in a statement. "Taken in conjunction with the government's potential introduction of an onshore limited partnership regime in the future, we believe Hong Kong will have a highly competitive regime to rival regional competitors in attracting fund managers to establish and grow their presence in Hong Kong."

The Inland Revenue Department's practice notes from 2017 also included plans to tax carried interest by treating it as income rather than capital gains.

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