The Financial Services and Treasury Bureau (FSTB) has introduced proposals (Proposals) to extend the profits tax exemption currently enjoyed by publicly offered funds and certain offshore funds, to onshore privately offered open-ended fund companies (Subject OFCs).
The regime for Hong Kong's Open-ended Fund Company (OFC) structure, which was created in June 2016 by the Securities and Futures (Amendment) Ordinance, is expected to become operational in 2018. The Proposals aim to remove existing disparity of tax treatment between privately offered OFCs and publicly offered OFCs, as well as against offshore fund vehicles. The Proposals are expected to attract more funds to domicile and originate in Hong Kong.
It is proposed that a Subject OFC will need to satisfy the following conditions in order to enjoy the profits tax exemption:
1. Resident in Hong Kong
A Subject OFC must be an onshore fund, with its central management and control located in Hong Kong.
2. Not closely held
Subject OFC cannot be closely held, that is, owned by only a few individuals or corporate investors. This is intended to prevent abuse of the tax exemption by individual or corporate investors through artificially repackaging their business to take advantage of the exemption.
The "not closely held" (NCH) criteria focuses on ownership, fund document and terms and conditions requirements:
- Ownership: To ensure that a Subject OFC is not a closely held investment vehicle and has a reasonable fund size, it must meet specific ownership requirements:
- All Subject OFCs must have a minimum number of investors, not including the originator or its associates. Those with at least one "qualifying investor" which has a more than HKD 200 million participation interest, must have at least five investors (including the qualifying investor). Subject OFCs with no such "qualifying investors" are required to have at least ten. A "qualifying investor" means certain specified types of institutional investors, including pension funds, publicly offered funds, governmental entities and organisations established for non-profit making purposes
- Investors (other than a "qualifying investor") must have a more than HKD 20 million participating interest in a Subject OFC and such interest must not exceed 50%
- The participating interest of the originator and its associates must not exceed 30%
The above ownership requirements must apply to a Subject OFC at all times upon expiry of the first 24 months after it has accepted its first investor. This timeframe recognises that a Subject OFC may need some lead time to invite subscriptions from investors to meet the NCH conditions. To prevent the operators of a Subject OFC from potentially abusing the tax exempt start-up period (e.g., by repeatedly opening and closing a Subject OFC every 24 months), the FSTB has indicated that it will propose dis-applying the tax exemption for the initial 24 month period if the NCH conditions are not met for a further period of 24 months.
- Fund documents: Specific terms must be included in fund documents stating that shares in the Subject OFC will not be closely held; and specifying the intended categories of investors. Notably, this criteria is specific to Subject OFCs only and does not currently apply to offshore fund vehicles seeking to qualify for tax exemption.
- Terms and conditions: Neither the reference to the intended categories of investors nor any other terms or conditions relating to participation in the Subject OFC should be used to limit investors to specific individuals or corporate investors, or deter other reasonable investors (within the intended categories) from investing in the Subject OFC.
3. Restricted asset classes
Subject OFCs may only invest in “permissible asset classes” to be eligible for the tax exemption. These asset classes will be set out in the new OFC Code currently being drafted by the Securities and Futures Commission, but it is expected that they will largely align with Type 9 (asset management) regulated activity, i.e. securities and futures contracts. A 10% de minimis limit will be allowed for investing in “non-permissible asset classes”, the profits of which will be chargeable to profits tax. If the 10% de minimis threshold is exceeded however, the exemption will be lost and all assessable profits made by the Subject OFC will be chargeable to profits tax.
4. SFO licensed/ registered managers
All transactions generating profits for the Subject OFC must be carried out or arranged by corporations or authorised financial institutions licensed or registered under the Securities and Futures Ordinance (SFO), the intended aim being to encourage Subject OFCs to be active in and contribute to Hong Kong’s economy by hiring local investment managers.
One issue related to this is the tax treatment of certain types of consideration paid to Hong Kong-based investment managers of Subject OFCs. The concern is that management fees and performance fees (including carried interest) may be paid to investment managers in the form of non-taxable dividends or distributions in order to avoid being chargeable to profits or income tax. The FSTB has indicated that it will include an express provision to address this practice; however no details have been provided at this stage. We note that when this point was initially raised in the FSTB's Concept Paper of January 20161, it was indicated that the law would be clarified to confirm that dividends or distributions derived by Hong Kong investment managers from carrying on business in Hong Kong would be assessable as normal assessable income or profits. This issue will no doubt be subject to further examination once the Proposals are open to public consultation.
If a Subject OFC fails to meet any of the three requirements under the NCH condition, proposed safe harbour rules will permit the Subject OFC to apply to the Commissioner of Inland Revenue (CIR) for the tax exemption if:
- the Subject OFC's activities and investments are being wound down and it has notified its members of the decision to wind down its activities and investments; or
- there are temporary and out-of-control circumstances, such as a significant number of investors redeeming their shares and exiting the Subject OFC in a short period of time owing to market fluctuations.
In relation to the "permissible asset classes" condition, a Subject OFC may apply to the CIR if the 10% threshold is exceeded due to circumstances (such as market fluctuations) which significantly reduce the value of the Subject OFC’s assets and were not reasonably foreseeable.
The new Proposals to exempt profits tax for Subject OFCs should attract more fund companies and managers looking to establish a regional distribution centre from which to sell their products to Asian investors, to domicile in Hong Kong. In turn this is expected to create a greater demand for local fund management, investment and advisory services, generate more job opportunities and benefit Hong Kong's asset management industry as a whole. As such, we see the Proposals as a welcome initiative which should help bolster Hong Kong's appeal as an international fund centre, particularly at a time when the demand for Hong Kong domiciled investment vehicles is increasing in light of the recent mutual recognition of funds schemes.
It is encouraging to note that some of the key Proposals, particularly the NCH criteria, have been refined considerably since the FSTB's Concept Paper, to reflect feedback and data received from the industry. However it will be interesting to see if the profits tax exemption will be further expanded to cover other types of Hong Kong resident fund entities, such as limited partnerships and unit trusts, in order to more meaningfully promote Hong Kong as a competitive fund centre.
The FSTB is targeting an amendment bill by the second half of 2017 to coordinate its implementation with the commencement of the OFC regime in 2018, and will consult the industry again before finalising the legislative amendments.