PE industry cautiously optimistic on Hong Kong tax reforms

“In the past, the government didn’t want you to invest. [Now] we want you to invest here in Hong Kong, we want you to have fewer restrictions on how you invest in private companies and benefit from tax concessions,” said Chris Sun, a deputy secretary with the Financial Services and the Treasury Bureau (FSTB), which is responsible for executing government policy on financial services issues, told the Hong Kong Private Equity & Venture Capital Association’s (HKVCA) Asia Forum.

The passing of legislation to amend the tax exemption for private equity is a formality, Sun added, and it will come into force on April 1. The move follows a critical report last year 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. The EU was uncomfortable with the tax exemption applying to offshore but not onshore funds, and Hong Kong promised action to implement a unified regime by the end of 2018.

The exemption was extended to include PE in 2015 so that funds domiciled offshore don’t have to set up structures designed to avoid triggering permanent establishment in Hong Kong and become liable for local tax. However, practice notes issued in 2017 made it unworkable, prompting most firms to 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.

The headline change is a new definition of what constitutes a fund, so that all relevant vehicles qualify for the exemption, regardless of structure, the location of central management and control, size, or purpose. Regarding the PE industry's specific concerns, the legislation removes the tainting provision that prevents funds with exposure to Hong Kong real estate assets that exceed 10% of the overall value of a portfolio company from taking advantage of the exemption. Now, if an investment breaches the 10% threshold, the fund will only be taxed on profits arising from that investment.

In the same way, individual investments – rather than the whole fund – will not qualify for the exemption if they include Hong Kong business operations and the holding period is less than two years. Exceptions will be made in cases where the fund does not have a controlling stake in the portfolio company or it does have a controlling stake but at least half of the company’s assets have been held for three years or more.

Furthermore, the legislation offers clarity regarding the treatment of special purpose vehicles (SPVs) that exist beneath a fund. They will also be exempt from local tax, although their role is limited to holding and administering investments – a remit some industry participants see as too restrictive.

Sun stressed that “this time around we will do something that makes Hong Kong attractive,” and the desire to accommodate the private equity industry – as part of broader efforts to secure Hong Kong’s future as a financial services hub – does not stop with the tax exemption. The next step is to revise the territory’s limited partnership ordinance, so that entire structures can be brought onshore.

However, approaches to regulation must evolve as more functions come onshore. If the advisor and the general partner entity are both in Hong Kong, what will the Securities & Futures Commission (SFC) do? This is especially relevant to smaller managers that will have to apply for licenses to operate locally. The matter not only concerns policy but also time and resources.

“Unlike some other regimes, Hong Kong requires you to file an application and be licensed. There is an approval process of 5-6 months, rising to 9-10 months for difficult situations,” said Lorna Chen, a partner at Shearman & Sterling. “Will the SFC be able to handle the increased number of license applications mounting up at its door?”

Three kinds of license – dealing in securities (type one), advising on securities (type four), and asset management (type nine) – could potentially cover private equity activity in Hong Kong. One of the options for managers wary of infringing local licensing laws has traditionally been to ensure asset management activity takes place outside of Hong Kong. Macau is often the destination of choice.

“Let’s see if we can fully utilize four and nine without needing to go to Macau,” Chen added. “We can still educate the industry about the importance of getting a license … but make the system less burdensome.”

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• Topics
• Greater China
• Regulation
• GPs
• Advisory
• Hong Kong (China)
• tax
• HKVCA
• Offshore
• Fund formation