Hunting the lion city

Given the upheaval in the regulation of offshore financial services in recent years, it is not beyond the realms of possibility that Cayman might one day be toppled. But a more immediate competitive threat to Hong Kong that must be reeled in is Singapore.

Allowing private equity investors to qualify for the profits tax exemption extended to offshore funds in Hong Kong is helpful in this respect. In practical terms, the change should offer greater certainty on tax treatment.

Cayman-incorporated funds will no longer incur the costs of setting up complicated structures designed to avoid triggering permanent establishment in Hong Kong and thereby becoming liable for local tax.

It should, in theory, also make it easier for private equity firms to take full advantage of Hong Kong's tax treaty network - funds must meet certain local substance requirements to qualify for treaty benefits and this can now be done without risking local tax liability.

However, there are others areas in which Singapore still maintains an edge, perhaps because its regulators are willing to intervene in the market while their Hong Kong counterparts have traditionally operated on a less-is-more basis

Firstly, tax uncertainty remains in certain areas. Neither Hong Kong nor Singapore taxes capital gains, but while the latter offers reasonably clear guidance on how the system works, the former has no legal definition of capital gains. Concerns have come to the fore in the last couple of years in response to the inland revenue department launching a crackdown on private equity and hedge fund managers. Firms are being audited and in some cases income that was previously classified as a capital gain has been reclassified as business income.

It is unlikely Hong Kong would torpedo the entire funds industry by taking a hard line on this issue, but investors are less likely to remain in a jurisdiction with inconsistent enforcement when a more transparent system is available elsewhere.

Secondly, Hong Kong offers no meaningful regulation to those who request it. The Securities & Futures Commission's (SFC) response to private equity firms registering with it has so far been passive. Public markets remain top priority and there is little interest in PE funds that are domiciled in Cayman with nothing more than an advisory presence in Hong Kong. Private equity firms managing these funds only fall within the regulatory remit if they are selling to local investors or if they offer certain other financial products. Many smaller players don't qualify.

This has become a pressing issue amidst uncertainty as to just how far the EU's Alternative Investment Fund Managers Directive (AIFMD) will go. Will Asia-focused managers that want to raise capital from LPs within the EU have to create costly onshore structures to do so? Or will offshore managers receive a passport to operate in the EU based on the credibility of their local regulators?

The worry is that European regulators might examine Hong Kong's setup and decide that it is insufficient and that mainland Chinese PE firms that want to raise US dollar-denominated capital might look to use Hong Kong as a fundraising hub and apply for local licenses, but ultimately opt for Singapore because the environment is more suitable.

Few people lie awake at night fretting about these issues and if Hong Kong fails to redress the balance with Singapore there wouldn't be a mass exodus.But it would chip away at funds' supporting infrastructure and, as people and functions are shifted out for strategic reasons, the broader financial services sector would suffer. And this sector employs 6% of Hong Kong's workforce and contributes 16% of its GDP.

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• Topics
• Regulation
• GPs
• Greater China
• Southeast Asia
• regulation
• Hong Kong (China)
• Singapore