The Hong Kong government has announced in its latest budget a planned extension of the existing offshore funds tax exemption to bring offshore private equity funds investing in or through Hong Kong, within its scope. The scope of the amendment will not only bring private companies within the exemption, but will also include SPVs which may be Hong Kong incorporated provided they are owned by an offshore person. This is a significant and welcome development for private equity funds investing in or through Hong Kong (typically into China) that will put private equity funds on a par with hedge funds when investing in Hong Kong. It is expected that the government will introduce the draft legislation in the first half of 2015.
Existing Tax Exemption
Hong Kong has a territorial system of taxation under which it will only impose profits tax on a person carrying on a business in Hong Kong in respect of profits arising in or derived from Hong Kong from that business. Profits arising from the sale of capital assets are excluded from the charge to profits tax, as Hong Kong does not have a capital gains tax. Before the introduction of the current exemption, a person, whether resident or non-resident, was chargeable to profits tax on trading profits derived from securities transactions carried out in Hong Kong if those transactions amounted to the carrying on of a trade or business. Conversely, profits tax was not chargeable on offshore profits or capital gains, including those arising from securities transactions.
The current form of the exemption which was introduced in 2006, applies only to non-resident persons. Whether a person (not being an individual) is non-resident, is determined by whether the central management and control of that person was exercised in Hong Kong in the year of assessment in question. The Hong Kong Inland Revenue takes the position that the existence of an onshore manager or advisor of the offshore fund with discretion to manage the assets of the fund, is not a conclusive factor in determining the residence of the fund, and that if the central management and control of the fund is not exercised in Hong Kong, the fund can qualify for the exemption.
The exemption relieves non-resident persons (including corporations, and partnerships) from tax on profits that are derived from "specified transactions" carried out in Hong Kong through or arranged by a "specified person". To qualify for the exemption, the non-resident person must not carry on any other business in Hong Kong other than the specified transactions, or transactions incidental to the carrying out of the specified transactions.
Non-resident private equity funds investing into or through Hong Kong, have generally been unable to use the current exemption as: (i) the definition of specified transactions which includes "securities", specifically excludes shares of private companies, which typically would be the target of transactions by private equity funds rather than listed securities; and (ii) the definition of specified person means a person licensed or registered to carry on a business in any "regulated activity" under Hong Kong's licensing regime. The onshore advisors of many offshore private equity funds are not licensed as either their activities fall outside of the scope of the licensing regime, or they are able to claim an exemption from being licensed. These two requirements resulted in private equity funds being unable to take advantage of the exemption, with the result that any transaction in the shares of a private company in Hong Kong from which the offshore fund made profits, could be subject to profits tax.
Extension of the Exemption to Include Securities in Private Companies
The new proposal would amend the definition of "securities" to include the securities of an eligible private company (i.e., a portfolio company). To qualify for the exemption, a portfolio company would be required to meet these conditions: (i) it is a private company incorporated outside of Hong Kong, and (ii) within the three-year period before the transaction in securities in the portfolio company, it did not (a) carry on any business through or from any permanent establishment in Hong Kong, (b) (whether directly or indirectly) hold equity capital or equity interests in one or more private companies carrying on any business through or from any permanent establishment in Hong Kong, where the aggregate value of the capital and interests exceeded 10% of the value of its own assets, and (iii) do any of the following (x) hold immovable property in Hong Kong, or (y) (whether directly or indirectly) hold equity capital or equity interests in one or more private companies with direct or indirect holding of immovable property in Hong Kong, where the aggregate value of the holding of the property in (x) and of the holding of the capital and interests in (y) exceeded 10% of the value of its own assets.
Relaxation of Requirement That the Transaction Be Carried Out Through Specified Person
Additionally, there would be no requirement in the extended exemption that the transaction in the securities of such a company be carried out through or arranged by a licensed person provided that the offshore fund is able to demonstrate that it is a "qualifying fund". This would require the fund to satisfy the following: (i) at all times after the final close of sale of interests, (a) there are five or more investors (who are not associates of the originator of the fund), and (b) the capital commitments made by investors exceed 90% of the aggregate capital commitments; and (ii) the portion of the net proceeds to be received by the originator and the originator's associates (excluding the net proceeds attributable to the capital contribution of the originator and the originator's associates) does not exceed 30% of the net proceeds arising from the transactions of the fund. These provisions are intended to ensure that only bona fide funds will be eligible for the exemption, and to deny the exemption to vehicles that might be established for round-tripping by onshore originators using a vehicle disguised as an offshore fund.
Extension of the Exemption to Include SPVs
Recognising that private equity funds use single or multiple layers of SPVs to hold portfolio companies, the government is also proposing to extend the definition of "securities" to include a transaction in securities of an SPV. An offshore private equity fund would be exempt from tax on profits derived from the transaction in the securities in an eligible portfolio company through disposal of securities in an SPV. The tax exemption would also include profits of an SPV derived from a transaction in securities in an interposed SPV or an eligible offshore portfolio company.
The definition of SPV would include a corporation and a partnership incorporated or registered in or outside of Hong Kong. The SPV could be wholly or partially owned by the non-resident person (i.e., the offshore fund) and should be established solely for the purpose of holding (directly or indirectly) or administering the qualified portfolio company.
This last proposal is especially significant given that the majority of inbound investment into China is made from Hong Kong, encouraged by (i) the existence of the double-tax arrangement between Hong Kong and China and (ii) increasingly, Hong Kong's growing network of double-tax treaties with other jurisdictions. Whilst the full scope of the proposals will only be known once the draft legislation has been published, they will remove the unequal playing field that allowed only hedge funds to take advantage of the exemption. The proposals will also provide onshore advisers and managers of private equity funds with much greater flexibility in how they structured themselves to mitigate the offshore fund's exposure to Hong Kong tax.