Hong Kong is increasingly a popular jurisdiction for fund distribution, given its nexus with the People’s Republic of China. Historically, investment funds usually have been established in the form of offshore mutual funds, segregated portfolio companies or limited liability partnerships. To further develop Hong Kong into a full-service asset management hub, the Hong Kong government introduced an open-ended fund company (OFC) structure, which became effective on 30 July 2018.1 The OFC regime aims to compete with other major asset management jurisdictions by facilitating market development, while affording a high level of market integrity and investor protection.
The introduction of the OFC structure follows the Hong Kong Securities and Futures Commission (SFC) consultation conclusions (Conclusions) on the Securities and Futures (Open-ended Fund Companies) Rules (Rules) and Code on Open-Ended Fund Companies (Code).
The OFC is a corporate vehicle newly created by statute and, unlike conventional Hong Kong incorporated companies, it is not subject to restrictions on capital reduction or distributions from capital under the Companies Ordinance.2 The OFC structure is comparable to corporate collective investment scheme vehicles currently available in major international fund centers such as Luxembourg, Ireland and the Cayman Islands.
The OFC operates in a manner similar to a conventional company, but is formed solely for the purpose of collective investment. The decision-making processes of an OFC may be conducted pursuant to meetings of the board or shareholders, or by written resolutions where applicable. Management and control are reserved to the board and the shareholders, who are usually under the same controlling party. The constitution of an OFC is its instrument of incorporation (comparable to the articles of association of a conventional company).
Publicly offered and privately offered sub-funds may be formed under an umbrella OFC. The individual sub-funds do not have a separate legal personality apart from the umbrella OFC, and each exists as a separate part of the property of an OFC. However, each sub-fund may sue, be sued or be subject to court orders as if it were a separate legal person. Assets and liabilities of each sub-fund are segregated – assets of a sub-fund belong exclusively to that sub-fund and may not be used to discharge the liabilities of, or claims against, any other person (including the umbrella OFC and any other sub-fund), with the exception that the umbrella OFC may allocate between its sub-funds the assets and liabilities that are not attributable to a particular sub-fund, subject to certain regulatory requirements and the general principle of fair treatment of shareholders.3
The OFC structure offers lower legal and regulatory costs, which is an attractive feature for fund managers with a presence, or seeking to establish a presence, in Hong Kong.
Amendments to an OFC’s constitution, as well as changes to the commercial terms of each of the sub-funds, are relatively easy to implement under the “one-stop” approach (discussed below).
There are further advantages to using an OFC over other offshore vehicles (in particular, the Cayman corporate structure) in the context of privately offered funds. Fund managers wishing to offer their fund products in Hong Kong will be dealing with a single jurisdiction. Formation of an OFC and licensing of the management entity involves dealing solely with the SFC (rather than both the SFC and the Cayman regulators) and complying with one regulatory regime, administered by the SFC. Also, fund managers need engage only with onshore Hong Kong lawyers (who might be able to assist with company secretarial matters), without having to liaise with many different professional advisers. Similarly, fund managers targeting retail investors for an OFC would deal only with the SFC in relation to formation and authorization of the products, instead of dealing with Hong Kong as well as the “home jurisdiction” (which often has different requirements than Hong Kong). Onshore Hong Kong lawyers may assist with the initial authorization, drafting of fund documents, and ongoing compliance with applicable Hong Kong laws and regulations.
Similar to an offshore fund, a privately offered OFC would also be eligible for exemption from Hong Kong profits tax for certain transactions provided that certain requirements are met.
A privately offered OFC is exempt from Hong Kong profits tax in respect of profits from qualifying transactions where the following conditions are satisfied:
- The OFC is a Hong Kong resident;
- The OFC is non-closely held;
- The OFC carries out transactions in permissible asset classes (there is a de minimis exception – the OFC may invest in non-permissible asset classes up to a maximum of 10% of the total gross asset value of the fund); and
- The transactions are carried out through or arranged by a “specified person” (which means a company licensed by the SFC) or an authorized financial institution.
Under the applicable Tax Ordinance,4 a person is regarded a “resident person” in the context of a corporation (that is not a trustee of a trust estate) where the central management and control of the corporation is exercised in Hong Kong in the year of the assessment.
The Tax Ordinance sets out conditions – which must be met in good faith – for an OFC to be deemed non-closely held. There are different sets of conditions to be met (e.g., with respect to number of investors, investment amount, concentration level of external investors) depending upon whether or not the OFC has any qualified investors. Further, the Tax Ordinance requires certain provisions to be set forth in the OFC’s instrument of incorporation and offering documents.
The Tax Ordinance defines “qualified investors” as any of the following:
- An exclusively charitable entity that is exempt from income tax in its jurisdiction of organization, and which has no shareholders or members with proprietary or beneficial interests in the entity’s income or assets.
- A collective investment scheme authorized for public offering in Hong Kong or other jurisdictions.
- A Mandatory Provident Fund (MPF) scheme or key operators of the MPF scheme (i.e., its trustee(s) or investment manager).
- Certain entities established to provide retirement, disability or death benefits to current or former employees.
- A governmental entity.
- A fund established by a governmental entity, international organization, central bank or the Hong Kong Monetary Authority, to provide retirement, disability or death benefits to beneficiaries or participants (subject to certain conditions).
- A sovereign wealth fund established and funded by a state or government (or political subdivision thereof) for the purpose of carrying out financial activities and holding and managing a pool of assets for the benefit of the state or government (or political subdivision).
The Tax Ordinance sets forth requirements as to the minimum number of investors and their respective minimum participation interests, as well as maximum participation interests of the originators and their associates, which differ depending upon whether or not the OFC has any qualified investors.
“Qualifying Transactions” and Other Transactions
A “qualifying transaction” is a transaction in assets of a class specified in Schedule 16A of the Tax Ordinance,5 as well as activities carried out or arranged in Hong Kong by or through a Type 9-licensed fund manager in Hong Kong, which produce assessable profits from the transaction. A transaction in assets of a non-Schedule 16A class that are carried out in or arranged in Hong Kong by a licensed fund manager in Hong Kong is classified as an “other transaction” under the Tax Ordinance.
Incidental Transactions (5% Limit)
“Incidental transactions” are exempted only if the percentage of the OFC’s trading receipts in relation to those transactions in the applicable tax assessment period does not exceed 5% of the total of the OFC’s trading receipts from qualifying transactions and incidental transactions during the period.
In addition to the OFC regime, fund managers must comply with the Fund Manager Code of Conduct (FMCC) and the Code of Conduct for persons licensed by or registered with the SFC (Code of Conduct), both with new requirements effective from 18 November 2018. Publicly offered OFCs must also comply with the requirements of the Code on Unit Trusts and Mutual Funds (UT Code).6
The Code sets forth certain requirements and limitations with respect to the name of an OFC, as well as mandatory provisions to be included in an OFC’s instrument of incorporation,7 including (among other things): shareholder approval requirements for material changes to the OFC’s constitutive documents and offering documents; an undertaking that the OFC will not be conducting business for general commercial or industrial purposes; notification obligations to shareholders; appointment and termination of service providers; and certain operational requirements.
Once an offering document is issued by an OFC, the document must be filed with the SFC as soon as practicable. In the case of changes, the revised offering document must be filed within seven days from the date thereof.
Offering documents are not required for the purposes of formation and registration of a privately offered OFC. However, a publicly offered OFC must submit offering documents in its application for authorization by the SFC (i.e., at the formation stage), and any changes to these offering documents may be made only in accordance with the UT Code.
The OFC regime requires that the offering documents of an OFC must disclose (among other matters): whether it is a publicly or privately offered OFC; whether it is an OFC with variable capital with limited liability and/or segregated liability between sub-funds (if applicable); redemption restrictions (if any); operational matters (e.g., fees and charges); investment scope and investment strategies; circumstances and procedures for effecting a change to the terms of any sub-funds; any material changes to the terms of the sub-fund during the prior year; and circumstances justifying, and procedures for, the removal of directors, investment managers and custodians.
The OFC regime sets forth eligibility requirements for directors, investment managers and custodians.
The applicable ordinance (Amendment Ordinance)8 and the Code set forth requirements with respect to the minimum number of directors (and the independence of directors), as well as the experience, expertise and character of directors. The directors have fiduciary duties to the OFC, as well as the duty to take reasonable care, skill and diligence.
All directors of an OFC must be approved by the SFC. In assessing candidates for director, the SFC may consider: the individual’s qualifications and/or experience; any past misconduct (e.g., disciplinary history, disqualifications from professional bodies, and whether the candidate was subject to prosecution relating to any company, securities or financial markets laws and regulations). In the case of an overseas director, the OFC must appoint an eligible process agent to facilitate the service of process in Hong Kong.
The Code requires that an OFC must appoint at least one investment manager licensed or registered for Type 9 regulated activity (asset management). The Code further addresses how the investment manager is to be “fit and proper”. While there is no separate requirement for the SFC’s approval of sub-delegation arrangements by an investment manager, the investment manager must exercise due care in the selection, appointment and ongoing monitoring of the performance of the delegate, and remain fully liable for complying with the applicable regulatory requirements (including the provisions under the FMCC and Code of Conduct).9 Further, investment managers of publicly offered OFCs must comply with UT Code requirements.
The Amendment Ordinance provides that an OFC must have a custodian to whom the property of the OFC is entrusted for safekeeping. The OFC custodian must meet the same eligibility requirements as set out in proposed amendments to the UT Code (pertaining to the custodian’s entity status, capitalization, and regulatory supervision). The Code sets forth obligations of the custodian, including with respect to: the holding of the OFC’s assets; recordkeeping; and verification, segregation and risk management measures.
Each custodian is subject to approval by the SFC, which recognizes the possibility of multiple custodians as well as the appointment of sub-custodians. However, the appointment of a sub-custodian is not subject to the SFC’s approval. A custodian must exercise its due skill, care and diligence in the selection, appointment, and ongoing monitoring of the performance of any delegate and will remain fully liable for complying with the applicable regulatory requirements. Where an overseas custodian is appointed, the OFC must appoint an eligible process agent to facilitate the service of process in Hong Kong.
The OFC regime sets forth ongoing obligations for OFCs, both privately and publicly offered. In addition, privately offered OFCs are subject to the requirements of the FMCC and the Code of Conduct, and publicly offered OFCs are subject to the requirements of the UT Code as well as the FMCC and the Code of Conduct. These obligations include those with respect to: accounting records; appointment of an independent auditor and publication of annual reports; registration renewal and fees; and applications/notifications to be filed with the SFC.10
The following matters require SFC approval: formation of new sub-funds (applicable to umbrella OFCs); change of an OFC’s name; appointment of key operators (both initial and replacement); and termination and winding up.
The following matters require notification to the SFC, but not prior SFC approval: removal of directors; modification of instrument of incorporation; change of registered office address, location of registers, or process agent; resignation/removal of auditors; resignation of directors, investment manager, or custodian; and changes to a privately offered OFC’s offering documents.
Formation of an OFC
The chart below outlines the procedures for OFC formation. Under the “one-stop process” adopted by the SFC, a fund manager wishing to register an OFC deals with a single regulator, interacting directly with the SFC. While privately offered OFC formation is governed by the OFC regime, publicly offered OFC formation will also be subject to the authorization requirements set out in the proposed amended UT Code and the relevant FAQs.
Publicly and Privately Offered OFCs: The application involves the submission of: (i) applicable SFC application form and information checklists; (ii) incorporation form; (iii) notice to the Business Registration Office (BRO); (iv) proposed instrument of incorporation signed by all proposed directors; (v) profile of each key operator; (vi) letters of consent to appointment for each key operator; (vii) profile of process agent (where overseas director/custodian appointed); (viii) statement of compliance by the proposed directors; and (ix) applicable fees.
Publicly Offered OFC: The application for registration and authorization for public offering of the OFC takes place in tandem. Accordingly, the timeline for approval and registration depends on the type of application (i.e., “standard” or “non-standard”), ranging from one to three months after the application has been submitted to and accepted by the SFC.
Privately Offered OFC: The registration will be granted as soon as possible where all required documents confirming compliance with applicable requirements are in order (expected to take less than one month after the application has been submitted to and accepted by the SFC).
Publicly and Privately Offered OFCs: The Rules require delivery of: (i) application documents; (ii) applicable fees; and (iii) notice to the BRO via the Companies Registry (CR). These are regarded as duly delivered when first submitted to the SFC for approval under Step 1. If the registration requirements are met, the SFC is to deliver the documents, fees and levy to the CR as soon as reasonably practicable upon the SFC’s decision to register the proposed OFC. Fund managers will not have to deal with the CR directly for the purpose of registering the OFC.
Publicly and Privately Offered OFCs: The CR generally expects the certificate of incorporation to be issued within three business days after receiving the SFC’s notification of the OFC registration (excluding the date of receipt). In practice, fund managers may first obtain the OFC company number by telephone inquiry to the CR before receiving the certificate. In addition to the certificate of incorporation, the business registration certificate of the OFC will also be issued by the CR on behalf of the BRO.
The introduction of the OFC is a step by the Hong Kong government to attract fund managers to have their funds domiciled in Hong Kong. This new fund structure aims to provide an easy and efficient way for Hong Kong fund managers to set up onshore funds, and become less reliant on offshore structures. In this regard, the OFC would be attractive to Hong Kong fund managers whose investors demand a protected and regulated structure.