Hong Kong tax: Still no certainty

Having spent years lobbying for a local tax exemption to be extended to offshore private equity funds, Hong Kong’s PE industry might end up spending just as long calling for it to be implemented in a sensible way. It isn’t right now, and the territory’s broader financial services community will end up paying the price if investors place people and resources in other jurisdictions.

The exemption is important because it means that private equity 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. The exemption also makes it easier for firms to access double tax treaty (DTA) network, offering smooth passage between jurisdictions as well as tax breaks on dividend payments generated by investments. Local substance is a pre-condition for DTA coverage, and under the exemption, this can be done without risking local tax liability.

Guidance issued by the Inland Revenue Department (IRD) last year has rendered the exemption unworkable, the Financial Services Development Council (FSDC) argued last week. 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. Local service providers are not seeing more business.

The IRD’s actions are not mendacious, rather they illustrate an agency that – perhaps through no fault of its own – sees the world through the prism of local politics. The need for Hong Kong to remain internationally competitive as a private equity hub, and what considerations may drive or destroy this ambition, appear to have been awarded secondary importance.

First, according to last year’s guidance notes, 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. It makes sense from one perspective: the IRD doesn’t want companies using offshore fund structures to convert taxable profits into non-taxable income. But the tainting provision – if one portfolio company buys a property in Hong Kong, this could invalidate the exemption claim of the entire fund – is an obvious turn-off for private equity.

Second, the SPVs that exist beneath a fund only qualify for the exemption if they are established only for holding and administering private investments. Again, there is a genuine concern that Chinese money could be routed into Hong Kong and then back to China purely to take advantage of DTA benefits. But the restriction essentially means that an SPV can do none of the things typically required to prove substance, obtain a tax residency certificate, and take advantage of those same DTA benefits.

The FSDC has made several proposals. It wants the exemption to cover investments in companies with substantial Hong Kong operations, with the exception of those holding sizeable residential real estate interests. The tainting provision should be removed and profit arising from non-qualifying investments, if held for more than two years, should be treated as capital gains, which means they wouldn’t be taxed. Finally, SPVs should be allowed to do more without forfeiting the exemption.

These are reasonable requests and it is to be hoped that regulators pay attention. Failure to do so would leave Hong Kong trailing its peers at a time when it has arguably never been more important to be up to speed on international tax policy. Initiatives like BEPS, which is intended to stop investors exploiting gaps in the tax system to artificially shift profits to low or no-tax locations, could redraw the onshore-offshore map for structuring private equity vehicles. DTA benefits might not come so easily, to the point that investors want to establish even more substance in particular jurisdictions.

Hong Kong is not set up for this – unlike Singapore, for example, it doesn’t have a modern limited partnership law that would allow PE firms to raise locally domiciled funds. Moreover, the difficulties surrounding the tax exemption hardly inspire confidence that government even has the political will to get there.

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