A new profits tax exemption ordinance (Bill) became effective on 1 April 2019. The Bill introduces a Private Funds Exemption, which has significant implications for the private funds industry. Benefits include: fund managers no longer will need to artificially locate central management and control of the fund outside of Hong Kong; covered funds can enjoy the profits tax exemption when investing in Hong Kong private companies (not only non-Hong Kong private companies); and a fund will not lose its tax-exempt status but will be taxable only in respect of profits from non-qualifying transactions that are onshore-sourced and revenue in nature.
Under the current Hong Kong profits tax regime, the tax is charged on profits arising in or derived from a trade, profession or business carried out in Hong Kong. If a private fund is regarded as carrying out a business in Hong Kong, either by itself or through the activities of another person on its behalf in Hong Kong, the fund will be liable for profits tax on its Hong Kong-sourced profits arising from that trade or business, unless the fund qualifies for the Offshore Funds Profits Tax Exemption.
The Offshore Funds Profits Tax Exemption is available only to non-resident private funds. Historically, this has excluded Hong Kong-resident private funds (other than open-ended fund companies) from enjoying the profits tax exemption and discouraged investment in local private companies. This requirement raised concerns by the EU and exposed Hong Kong to the risk of being included on the EU list of non-cooperative tax jurisdictions and sanctioned by EU Member States with coordinated defensive measures.
The new tax regime removes the ring-fencing features by introducing an additional exemption – namely, the Private Funds Exemption. An investment vehicle will qualify for profits tax relief under the Private Funds Exemption whether or not the vehicle is resident in Hong Kong. A fund will be exempt from Hong Kong profits tax if: (a) the investment vehicle is within scope of the new definition of “fund”; (b) it has engaged a “specified person” to arrange or carry out its transaction, or has a “qualified investment fund” status; and (3) the income arising from transactions incidental to the carrying out of “qualifying transactions” does not exceed 5 percent of the fund's total trading receipts. The new definition of “fund” is similar to “collective investment scheme” under the SFO.
Where a fund establishes a special purpose entity (SPE) and the fund qualifies for the Private Funds Exemption, the SPE would also be eligible to qualify for an exemption in respect of its profits derived from the disposal of an “interposed SPE” or “investee private company,” to the extent that corresponds to the percentage of shares or interests held by the exempt fund. Note, however, that in such a case, the SPE may not carry out any trade or activities other than for the purpose of holding and administering one or more investee private companies.
In addition to the above, the fund or the SPE must satisfy the following tests to qualify for the Private Funds Exemption:
- (a) “Immovable property” test: the fund or the SPE may hold, itself or through shares in a private company, no more than 10 percent of the value of its assets in immovable property (including interest in land but excluding infrastructure) in Hong Kong; and
- (b) Holding period test: the fund or the SPE must have held the private company for at least two years, whether or not it has control over the private company.
Failing test (b), alternative test (c) would apply:
- (c) Short-term assets test: Either (a) the fund or the SPE does not have a controlling stake in the private company; or (b) if the fund or the SPE has a controlling stake in the private company, the fund or the SPE may hold no more than 50 percent of the value of its assets in short-term assets (i.e., assets held for less than three consecutive years before the date of disposal).
The existing Offshore Funds Profits Tax Exemption remains unchanged for non-resident investment vehicles that do not qualify as “funds.” Offshore funds that do not come within the definition of “fund” under the Private Funds Exemption may continue to rely on the Offshore Funds Profits Tax Exemption for relief.