On 17 July 2015, the Hong Kong Government published in the Gazette a legislative amendment that extends the profits tax exemption for offshore funds to private equity funds.1
The old offshore funds exemption
Hong Kong’s offshore funds tax exemption that was enacted in 2006 already exempted certain non-resident funds from profits tax. This exemption applies to profits from Specified Transactions done by Specified Persons. The term Specified Transactions includes transactions in securities; futures contracts; foreign exchange contracts; deposits other than by way of a money-lending business; foreign currencies; and exchange-traded commodities. The term Specified Person generally means a corporation licensed by the Securities and Futures Commission (“SFC”) under the Securities and Futures Ordinance.
Until the recent legislative changes, offshore private equity funds fell outside this exemption because the old definition of the term Specified Transactions did not include transaction in securities of a private company. In addition, offshore private equity funds are not necessarily managed by SFC licensees.
New exemption for offshore private equity funds
The new amendment extends the profits tax exemption to include offshore private equity funds by expanding the definition of Specified Transactions to include transactions in securities of private companies that meet the definition of an Excepted Private Company. To qualify as an Excepted Private Company, the private company must be (a) incorporated outside of Hong Kong and (b) for 3 years prior to the relevant disposal of its securities it must not have
- carried on any business through a permanent establishment (i.e., a fixed place of business) in Hong Kong;
- held shares in another private company which carries on business through a permanent establishment in Hong Kong if the total value of these shares exceeds 10 percent of the private company’s assets; and
- neither held immovable property in Hong Kong, nor held shares in another private company with holding of immovable property in Hong Kong, if the total value of these immovable properties and shares exceeds 10 percent of the private company’s assets.
The recent legislative amendment provides that a Qualifying Fund can be eligible for tax exemption in respect of profits from Specified Transaction even if the fund is not managed by an SFC licensee. A Qualifying Fund is defined as a fund that satisfies the following two requirements. The first requirement is that at all times after the sale of an interest, there are more than four investors and the capital commitment made by investors exceeds 90% of the aggregate capital commitments. The second requirement is that the net proceeds of the funds to be given to the originator do not exceed 30% of the net proceeds.
It is important to note that the provisions prohibiting round tripping will continue to apply if a Hong Kong resident holds 30% or more of the interest in a Qualifying Fund. The Hong Kong resident will still be required to report assessable profits for tax assessment, comply with the reporting requirements under the IRO and safe keep the fund’s records and documents.
Private equity funds may use multi-level holding structures to accommodate preferences of fund investors. For example, private equity funds generally set up one or multiple-tier resident or non-resident special purpose vehicles (“SPV”) to hold their portfolio companies. The recent legislative amendment extends the offshore funds tax exemption to an SPV that meets the following requirements: (a) it is wholly or partially owned by a non-resident, (b) it is established solely for the purpose of holding and administering an Excepted Private Company, (c) it is incorporated, (d) it does not carry on any activities except for the purpose of holding, and administering an offshore portfolio company; and (e) it is not itself an eligible offshore portfolio company.2
Implications for Hong Kong
The new changes to Hong Kong’s profits tax exemption regime are critical for Hong Kong’s competitiveness in the field of asset management, investment and advisory services, and other relevant professional services. Previously, when the regime did not cover transactions in securities of private companies, private equity fund managers undertook onerous measures to mitigate the potential exposure of their offshore funds to Hong Kong’s profits tax assessments. This has put Hong Kong in a relatively disadvantaged position for attracting private equity fund managers to Hong Kong.3
The Hong Kong government hopes to provide the private equity industry with tax certainty so as to attract more private equity fund managers to set up and expand their business in Hong Kong and subsequently utilize local asset management, investment and advisory services. Given the rising sophistication of the private equity fund industry and their increasing outbound investment activities, these tax measures will increase Hong Kong’s attractiveness as a place to conduct deals and transactions.