proposals to extend offshore private equity fund tax ... · “amendment ordinance”) to amend...
TRANSCRIPT
Proposals to Extend
Offshore Private Equity Fund
Tax Exemption to Hong Kong Businesses
July 2017
FSDC Paper No. 32
Index
Executive Summary ....................................................................................................... 1
I. Background ............................................................................................................... 4
II. Limitations of the Current Rules on Offshore PE Fund Exemption ......................... 8
Expansion of the offshore fund exemption to non-Hong Kong PE investment ...... 10
Restriction on investment into Hong Kong private companies .............................. 11
Restrictions on SPV functionality ........................................................................... 13
Considerations for expanding the offshore fund exemption to investment in Hong
Kong businesses ...................................................................................................... 14
III. Recommendations / Proposals ............................................................................... 17
Excepted private company (“EPC”) – call for an expanded definition .................. 17
Special purpose vehicle – call for an expanded definition ...................................... 19
Tainting – call for a relaxation ................................................................................ 20
Anti-tax avoidance .................................................................................................. 21
Other comments / considerations ............................................................................ 22
1
Executive Summary
1. The Financial Services Development Council (“FSDC”) published papers
relating to the private equity (“PE”) fund industry, namely: (i) Synopsis Paper
Proposing Tax Exemptions and Anti-avoidance Measures on Private Equity Funds in
the 2013-14 Budget in November 2013; and (ii) A Paper on the Tax Issues on Open-
ended Fund Companies and Profits Tax Exemption for Offshore Private Equity Funds
in December 2015. The Inland Revenue (Amendment) Ordinance 2015 (the
“Amendment Ordinance”) to amend Hong Kong’s tax law to attract more PE funds
to be managed in Hong Kong was enacted in July 2015 (the “Offshore PE Fund Tax
Exemption”) and the Inland Revenue Department (“IRD”)’s Departmental
Interpretation and Practice Notes No. 51 was published in May 2016. While the new
tax exemption was initially welcomed by the PE industry, there has been no
noticeable increase in the number of offshore PE funds managed in Hong Kong.
2. The FSDC reckons that this was due to the practical limitations of the
current rules on the Offshore PE Fund Tax Exemption. Tax harmonisation could
indeed be helpful in boosting the development of the relevant industry. With this in
mind, this paper sets out these limitations, and the FSDC’s recommendations to
extend the Offshore PE Fund Tax Exemption to certain Hong Kong portfolio
companies in order to boost the development of the industry.
3. In July 2015, the offshore funds tax exemption was extended to PE funds.
Specifically, extending the scope to investments by offshore funds into offshore
private companies as well as certain Hong Kong and non-Hong Kong incorporated
special purpose vehicles (“SPVs”) used by PE funds to hold offshore private
companies. The conditions for the offshore funds tax exemption were also amended
so that PE funds managed by fund managers that are not required to obtain a licence
from the Securities and Futures Commission in Hong Kong could also qualify.
4. Despite this, the Offshore PE Fund Tax Exemption has some major
limitations, the key two being:
2
a. Its restriction on investment into Hong Kong private companies – the
Offshore PE Fund Tax Exemption does not apply to investments in
Hong Kong private companies and non-Hong Kong private
companies with substantial operations in Hong Kong, or which hold
substantial Hong Kong real estate. Moreover, a single non-
qualifying investment could taint the entire fund and disqualify the
fund from being exempt. It is the Hong Kong SAR Government’s
policy to develop areas such as innovation and high-tech industries.
It is therefore important to encourage investments and business
especially for our “home grown” local companies and start-ups. To
do this, these businesses should be on a level playing field as non-
Hong Kong private companies, and get funding from offshore PE
funds.
b. Its restriction on SPV functionality – the functions of an SPV are
limited to holding (directly or indirectly) and administering one or
more eligible offshore private companies, or another SPV. However,
SPVs cannot undertake any other management activities except for
the purpose of holding and administering one or more eligible
offshore private company.
5. In order for Hong Kong to reinforce its role as Asia’s leading asset
management centre, the FSDC recommends that the Offshore PE Fund Tax
Exemption should be enhanced to make it more business-friendly and conducive to
the PE and venture capital funds industry. Particularly, it should not discourage
investments in Hong Kong portfolio companies and should place Hong Kong and
non-Hong Kong investments on a level playing field to qualify for the PE fund tax
exemption. In light of the above, the FSDC proposes the following:
a. Extend the Offshore PE Fund Tax Exemption to cover investment in
Hong Kong private companies and non-Hong Kong private
companies with substantial operations in Hong Kong, with the
exception of those holding substantial Hong Kong residential
properties;
3
b. Remove the provision relating to tainting such that an offshore PE
fund investing in a non-qualifying investment would only be subject
to tax in respect of the investment income derived from such non-
qualifying investment, to the extent such investment income are
Hong Kong sourced revenue gains;
c. Introduce a provision to treat any gains derived from the disposal of a
non-qualifying investment mentioned in paragraph 5(b) above as
capital in nature if such an investment has been held for more than 2
years; and
d. Expand the scope of allowable activities of an SPV.
The above proposed changes should make our PE fund tax exemption
regime more attractive and in line with the Government’s policy to promote new
business start-ups in Hong Kong. Therefore this would assist the growth and
development of Hong Kong private companies some of which may function as head
office of the regional business. As a result, the proposed changes would make the
regime more attractive than Singapore and increase the competitiveness of Hong
Kong as an asset management hub.
6. The FSDC considers there are adequate measures in the current tax law to
prevent anti-avoidance and abuse of the recommendations / proposals, providing
sufficient and effective safeguards. The FSDC urges the Government to consider the
recommendations / proposals in light of the international environment. Changes to
and certainty in the Hong Kong’s tax rules are needed in order for Hong Kong to
retain its position as the largest international PE centre in Asia.
4
I. Background
7. Hong Kong is currently the largest international PE centre in Asia.1 The
Government has taken bold and deliberate steps over the past few years to align Hong
Kong’s tax regime against this landscape. Following the 2013-14 Budget
announcement to amend and extend the offshore funds tax exemption to PE funds in
order to attract more PE funds to be managed in Hong Kong, the Inland Revenue
(Amendment) Ordinance 2015 was enacted in July 2015 with retrospective effect
from 1 April 2015. The Amendment Ordinance was, in principle, welcomed by the
PE industry. However, when it comes to implementation in practice, the restrictions
set forth by the IRD2 on the operation of the Amendment Ordinance limit the ability
of offshore funds to fully take advantage of the Offshore PE Fund Tax Exemption,
and hence the exemption is yet to fulfil its intended purpose. After almost two years
since the enactment of the Amendment Ordinance, there has been no meaningful
increase in the number of PE funds managed from Hong Kong.
8. PE is an important sector of the global fund management industry. In
Asia, the total Assets under Management of the PE industry is US$784 billion3 and
Hong Kong is the preferred centre for the majority of the regional investment and
Mainland China US dollar-denominated investment groups. There is some cyclicality
to PE fund raising – over a five year period Hong Kong based PE fund investment
advisors have accounted for 30% of total Asian PE fund raising4. To provide an idea
of the scale of PE fund raising over the last 5 years, it equates to 42% of the capital
raised on the Hong Kong Stock Exchange through the initial public offering over this
period.
1 http://hong-kong-economy-research.hktdc.com/business-news/article/Hong-Kong-Industry-
Profiles/Private-Equity-Industry-in-Hong-Kong/hkip/en/1/1X000000/1X003VKV.htm
Private Equity Industry in Hong Kong, HKTC, accessed 3 April 2017. 2 IRD’s Departmental Interpretation and Practice Notes (“DIPN”) No. 51 – Profits Tax – Profits Tax
Exemption for Offshore Private Equity Funds 3 Asian Venture Capital Journal
4 Private Equity International (“PEI”)
5
9. Tax neutrality in the fund management host jurisdiction is an important
consideration for fund managers when they choose a jurisdiction to undertake fund
management activities. Therefore, attracting PE funds requires a host jurisdiction to
implement tax regulations, whether it be through tax incentives or otherwise, to
ensure such tax neutrality can be achieved in practice with certainty, maximum
flexibility and minimum risk. Tax incentives introduced by the Government in the
past decade for a number of other industry segments have achieved remarkable
success.
10. One representative example was the removal of all duty-related customs
and administrative controls on wine trading in February 2008. Hong Kong’s wine
imports surged 80% in the following year with 850 new wine-related operators set up
between 2008 and 2009, bringing the total number to 3,550. The wine sector
recorded HK$5.5 billion incremental revenue in 2009, representing an increase of
over 30% compared with the previous year, while the number of employees engaged
in wine-related business increased by more than 5,000 to around 40,000 by the end of
2009.5 Such positive development in the sector would not have been possible without
the Government’s attempt to create a favourable operating environment to attract
international and domestic businesses to establish their operations in Hong Kong.
5 Statistics from the Commerce and Economic Development Bureau of the HKSAR Government.
0
5
10
15
20
2012 2013 2014 2015 2016
Asian PE Fund Raising (US$bn)
Hong Kong Mainland China Rest of Asia
Source: PEI
0
10
20
30
40
2012 2013 2014 2015 2016
HKEX IPO v HK PE fundraising (US$bn)
Hong Kong PE HKEx IPO
Source: PEI & HKEX
HKEX IPO
6
11. Another example was the abolition of estate duty in February 2006, with
the objective to further developing Hong Kong as a leading private wealth
management centre in the Asia-Pacific Region. Immediately following the abolition
of estate duty, Hong Kong’s private wealth management business grew 58% in 2006
to reach HK$1,967 billion. Further, the sector grew to a new high of HK$4,775
billion in 2015, representing a growth of 2.8 times since 2006. 6
The abolition of
estate duty was one of the major factors driving the growth of Hong Kong’s private
wealth sector especially from investors in Mainland China and other Asian countries.
12. Apart from addressing the deficiencies of the Amendment Ordinance
(which will be elaborated in greater detail in the next section), the PE industry
continues to evolve. Since the enactment of the Amendment Ordinance, there has
been an increased focus on and interest in venture capital investments around the
world. Such venture capital investments mainly target start-ups and businesses in the
high technology industry. In order for Hong Kong to reinforce its role as the region’s
leading asset management centre, the Amendment Ordinance should be further
refined to reflect such developments including in the venture capital sector, to stay
competitive and remain relevant.
13. With this in mind, the FSDC conducted a study on the current Hong Kong
tax rules / requirements applicable to the PE industry and saw, among others, real
merit to extending the Offshore PE Fund Tax Exemption to certain Hong Kong
portfolio companies. To facilitate the Government and the relevant tax authorities to
consider extending the scope of the Offshore PE Fund Tax Exemption, the FSDC sets
6 Fund Management Activities Surveys 2004 – 2015, published by the Securities and Futures
Commission.
7
out a number of proposals / recommendations, with reference also to the position of
seven overseas jurisdictions. The jurisdictions studied include Australia, India, New
Zealand, Singapore, Sweden, the United Kingdom and the United States.
14. As an overarching theme, achieving tax certainty is crucial for PE fund
sponsors and managers.
8
II. Limitations of the Current Rules on Offshore PE Fund
Exemption
15. PE funds are established investment vehicles for investors to contribute
capital for investing into (typically) a blind pool of designated investments. One of
the principal objectives of a PE fund from a tax perspective, as well as the expectation
of investors, is that the fund itself should be treated as a tax neutral vehicle so that the
investors in the fund are treated in the same manner as if they had invested directly in
the underlying investment.
16. Funds may be subject to tax on gains made in the jurisdictions in which
they invest or on distributions to investors in their home country, but there should be
no further tax on such gains or profits at the fund level itself. Ultimately, if there is no
tax neutrality at the fund level, investors will be dissuaded from investing into the
fund due to the additional frictional tax costs of doing so which would erode their post
tax returns.
17. Many jurisdictions have specific tax rules to ensure that the fund vehicle
is tax neutral, either by treating the fund as tax transparent or by granting tax
exemption to the fund vehicle. For PE fund managers and advisors in Asia, most
funds they serve are domiciled in the Cayman Islands; however, Singapore has
recently established a range of incentives to encourage funds to be managed from or
domiciled in Singapore.7 Hong Kong first introduced a specific tax exemption for
offshore funds in March 2006, which operated to exempt offshore funds that were
managed from Hong Kong from profits tax provided qualifying conditions were
satisfied. The exemption broadly applied to non-resident funds that were managed
through a licensed person in Hong Kong in respect of a wide range of eligible
securities.8
7 In December 2015, the FSDC published a report titled “A Paper on Limited Partnership for Private
Equity Funds”, with a view to developing Hong Kong as an onshore hub for PE funds, amongst
other objectives. 8 The Revenue (Profits Tax Exemption for Offshore Funds) Ordinance 2006, hereafter referred to as
“the 2006 Ordinance”.
9
18. Although the 2006 Ordinance works reasonably well for the hedge fund
industry that typically invests in publicly traded securities,9 it did not work well for
PE funds. For the PE industry, the 2006 Ordinance was deficient in that it did not
apply to investments in private companies or to debt investments issued by such
private companies because the definition of “securities” specifically excluded
securities of a private company. Further, if a fund invested into a non-qualifying
investment such as a private company, the fund would lose its tax exemption on all of
its investments thereby exposing the entire fund to direct taxation in Hong Kong.
This is because the offshore funds tax exemption was drafted in such a way that the
exemption was only available to a fund if the fund did not carry on any other business
in Hong Kong other than “specified transactions” and transactions incidental to the
carrying out of “specified transactions”.
19. As the 2006 Ordinance did not apply to investments in private companies,
many PE funds operating in Hong Kong were unable to make use of that exemption to
ensure that the fund was not exposed to direct taxation. Instead, they operated under a
model whereby the fund management functions were performed outside of Hong
Kong in order to fall outside the general profits tax charging provisions under the
Inland Revenue Ordinance (“IRO”). This effectively reduced the functions, assets
and risks that an offshore fund could localise in Hong Kong and therefore reduced the
scale of investment management services that could be provided from Hong Kong.
20. In contrast, Hong Kong’s closest competitor in the region, Singapore,
recognised the importance of providing a tax exemption for PE funds and introduced
a number of tax and regulatory incentives to attract and facilitate PE funds to
Singapore. Currently, funds that are managed or advised by a fund management
company in Singapore can obtain tax exempt status in Singapore under one of three
9 The FSDC notes, however, the 2006 Ordinance also presents limitations for the hedge fund industry.
In particular, credit funds that invest in debt securities and earn interest income cannot fully benefit
from the offshore funds tax exemption under the 2006 Ordinance given that the IRD in DIPN No.
43 has made it clear their position that interest can only be considered as derived from an
“incidental transaction” and not a “specified transaction”.
10
tax incentive schemes.10
The exemptions apply to allow either an offshore or
Singapore domiciled fund to benefit from a tax exemption.
21. Singapore is fast becoming a popular Asian asset management centre;
Singapore’s tax exemption for funds, robust regulatory framework, availability of
professional services, functionality as a platform to ASEAN countries and its Double
Taxation Agreement network have collectively made Singapore a formidable
competitor to Hong Kong as a leading PE centre in Asia.
22. In light of the developments in Singapore there is an urgent need for Hong
Kong to improve its taxation framework for the PE industry, something which is
recognised by the asset management industry of Hong Kong. Indeed, the PE industry
associations advocated the need for legislative change to extend the 2006 Ordinance
to private companies so as to maintain Hong Kong’s competiveness as a key regional
PE centre.
23. Extending the exemption to private companies would lead to an increase
in the market presence of offshore PE fund managers in Hong Kong, thereby
benefiting Hong Kong through the allocation of capital to Hong Kong businesses,
which would ultimately increase demand for financial services professionals and
related services in Hong Kong. The Hong Kong Government would in turn benefit
from increased tax revenue from the economic activity generated from these
businesses.
Expansion of the offshore fund exemption to non-Hong Kong PE investment
24. In 2013, the Hong Kong Government formally announced that it would
expand the scope of the 2006 Ordinance to the PE industry in the Financial
Secretary’s 2013/14 Budget speech. The following year, the Financial Secretary
reported that industry consultation for extending the tax exemption for offshore funds
to facilitate PE investment into non-Hong Kong incorporated private companies had
10
Sections 13CA (offshore funds), 13R (Singapore funds) and 13X (Singapore or offshore funds) of
the Singapore Income Tax Act.
11
been completed. Draft legislation was introduced on 20 March 2015, which was
subsequently gazetted on 17 July 2015 with retrospective effect from 1 April 2015.11
25. The Offshore PE Fund Tax Exemption covers investments by non-
resident funds into non-Hong Kong incorporated private companies (but critically not
Hong Kong incorporated private companies) as well as certain Hong Kong and non-
Hong Kong incorporated SPVs or “qualifying SPVs” used by PE funds to hold
offshore investments. Further, the conditions to qualify for the exemption were also
helpfully amended so that those PE funds that may not have needed a license from the
Securities and Futures Commission in Hong Kong could also qualify for the Offshore
PE Fund Exemption under an alternative “qualifying fund” test which requires the
non-resident fund, among others, to have a certain minimum number of investors.
26. The Offshore PE Fund Tax Exemption was initially well received by the
industry. It was an important development in the industry that enabled PE funds that
invest predominantly in private companies to potentially make use of the offshore
funds tax exemption to ensure that PE funds were treated as tax neutral vehicles. This
should have cemented Hong Kong’s status as a leading global PE centre. However,
the Offshore PE Fund Tax Exemption has significant limitations, particularly in
respect of its prohibition on investing into Hong Kong private companies and the
narrow scope of activities an SPV could undertake. These limitations severely restrict
the usefulness of the exemption for PE funds.
Restriction on investment into Hong Kong private companies
27. First, the Offshore PE Fund Tax Exemption currently does not allow PE
funds to invest into Hong Kong private companies, except in very limited
circumstances where the indirect investment into a Hong Kong business falls under a
de minimis threshold. Offshore PE funds that invest into non-Hong Kong
incorporated private companies that directly or indirectly hold Hong Kong assets in
excess of a 10% de minimis value threshold will not qualify for the Offshore PE Fund
11
Inland Revenue (Amendment) (No.2) Ordinance 2015; sections 20AC and 20ACA of the IRO.
12
Tax Exemption.12
Moreover, based on the IRD’s interpretation,13
a single non-
qualifying investment could taint the entire fund and disqualify the fund as a whole
from qualifying under the Offshore PE Fund Tax Exemption. This makes the
Offshore PE Fund Tax Exemption unworkable in practice for funds with any sort of
Greater China investment focus.
28. Given the role PE funds play in raising, and deploying, the much needed
capital to businesses, particularly (but not limited to) start-ups and those in the high
technology industry (i.e. the venture capital), the Offshore PE Fund Tax Exemption
needs to be further extended to allow for investing into privately held companies in
Hong Kong except those holding residential properties in Hong Kong. In this regard,
PE funds should be able to invest into private companies regardless of where they are
incorporated and where they undertake business. It is worth noting that investments
into listed Hong Kong companies, which may carry out business activities in Hong
Kong, are eligible for tax exemptions under the 2006 Ordinance, whereas investments
into a privately held business in Hong Kong are not. The FSDC understands the
Government’s concerns over the real estate market in Hong Kong, especially the
residential property market. In order not to conflict with any policy objectives, the
FSDC suggests excluding Hong Kong residential properties from the extension. The
FSDC believes that the extension of the Offshore PE Fund Exemption to cover
investments in any Hong Kong businesses including start-ups in the high technology
industry, infrastructure projects, and commercial properties in Hong Kong should be
sufficient for the regime to regain attractiveness and stay competitive.
12
The private companies invested into by a PE fund must constitute ‘Excepted Private Companies’ as
defined in section 20ACA of the IRO. The legislation broadly defines Excepted Private Companies
as privately held companies incorporated outside of Hong Kong that at all times within 3 years
before a transaction in securities of a SPV, or the Excepted Private Company, does not: carry on
business in Hong Kong through a permanent establishment, or have an indirect / direct investment
in a company that does, or indirect / direct investment in Hong Kong real estate; such investment is
permitted to the extent that it does not exceed 10% of the value of the Excepted Private Company’s
investments (de minimis threshold). 13
Based on the IRD’s application of the rules in DIPN No. 51.
13
Restrictions on SPV functionality
29. Secondly, the current Offshore PE Fund Tax Exemption rules also place
very restrictive conditions on the operations of a qualifying SPV. The functions of an
offshore PE fund’s Hong Kong or non-Hong Kong SPV(s) are limited to holding
(directly or indirectly) and administering one or more eligible qualifying investments,
or another SPV. However, SPVs cannot undertake any other management activities
except for the purpose of holding and administering one or more eligible private
companies.14
30. These restrictions on an SPV’s activities introduce unnecessary risk to an
offshore PE fund that otherwise makes qualifying investments in non-Hong Kong
incorporated private companies; they also impose commercial constraints for SPVs
whose commercial purposes include the active management of its portfolio
investment holdings, as well as functioning as a transferrable investment holding
vehicle for potential acquirers. This in turn introduces additional operational
complexity. Fund managers need to ensure that detailed technical operational
protocols are followed so that an offshore PE fund continues to qualify for the
exemption in respect of its investment in a SPV, inclusive of the SPV’s investment
holdings.
31. The restriction on an SPV's activities also creates a tension with an SPV’s
ability to qualify as a Hong Kong tax resident for purposes of claiming benefits under
a relevant Double Taxation Agreement. One of the main advantages to using Hong
Kong SPVs is access to Hong Kong's growing network of Double Taxation
Agreements. The IRD assesses the level of “substance” that an SPV has in Hong
Kong in deciding whether a certificate of residence status in Hong Kong, often
required to claim benefits under a Double Taxation Agreement, could be issued to an
SPV. An SPV can expect to face challenges meeting this standard if by definition it
can only engage in holding and administering underlying PE investments.
14
Section 20ACA of the IRO.
14
32. The broadening of the functionality of SPVs would make the Offshore PE
Fund Tax Exemption more useful and reflect the ordinary commercial operations of
typical PE funds, whereby SPVs can undertake more than a mere holding company or
administrative function. Further, by easing the conditions for meeting the definition
of an SPV under the Offshore PE Fund Tax Exemption, fund managers would be able
to enjoy a higher degree of certainty and operational efficiency.
Considerations for expanding the offshore fund exemption to investment in Hong
Kong businesses
33. From a tax policy design perspective, funds (including PE funds) should
operate as tax neutral collective investment vehicles for investors. In this regard, non-
resident investors can fall outside the scope of the profits tax charge in Hong Kong on
gains made from Hong Kong investments if they undertake their investment
management activities outside of Hong Kong. Consequently, there should be no tax
distinction between such non-resident direct investors and those that pool their capital
through an offshore PE fund. Offshore funds can structure their transactions offshore
such that they are not directly taxed on investments into Hong Kong private
companies without relying on the Offshore PE Fund Tax Exemption. Clearly, there is
no incidence of tax avoidance in either case because it is reasonable for investors to
make a commercial decision as to where to carry out their investment management
activities and under Hong Kong’s territorial system of taxation, a non-resident person
is not subject to profits tax if such person does not carry on business in Hong Kong.
Moreover, an explicit tax exemption is available under the IRO for dividends paid
from Hong Kong companies.15
Consequently, the extension of the Offshore PE Fund
Tax Exemption to Hong Kong private companies would not result in a loss of tax
revenue, but rather would align the tax treatment of offshore PE funds with those of
non-resident investors, who can already invest directly into both private and listed
Hong Kong companies without being subject to profits tax.
34. Ultimately, the Hong Kong Government should not discriminate against
investment by an offshore PE fund into Hong Kong private companies vis-à-vis an
investment in offshore companies. The current exclusion under the Offshore PE Fund
15
Section 26(a) of the IRO.
15
Tax Exemption for investing into Hong Kong private companies adds unnecessary
complexity and discourages funding for Hong Kong private companies. Regarding
Hong Kong resident investors in an offshore PE fund, the current anti-abuse measures
applicable under the current Offshore PE Fund Tax Exemption can continue to apply
to prevent ‘round-tripping’.16
35. On the basis of the above, the Offshore PE Fund Tax Exemption should
be extended to Hong Kong private companies given it would:
— Provide an additional source of funding to Hong Kong private
companies, and enhance the development of the venture capital
industry – Traditional means of financing can be difficult to obtain
for businesses that do not have constant cash flows, for example,
technology and research and development centric companies, which
would be highly beneficial to the future growth and development of
Hong Kong’s economy. The additional funding would complement
the existing start-up and local business development initiatives driven
by the Hong Kong Government through the various Government
Funding Schemes17
and InvestHK18
.
— Achieve tax neutrality at a fund level without introducing tax
avoidance – Non-resident investors and offshore funds can already
invest into Hong Kong private companies under the current rules
without suffering direct taxation. Any tax avoidance concerns
regarding Hong Kong resident investors can be addressed via the
existing anti abuse rules under the current Offshore PE Fund Tax
Exemption.
— Simplify the operation of offshore PE funds and provide greater
certainty – As the rules are currently drafted, a single non-qualifying
investment into a Hong Kong private company could lead to the
entire offshore PE fund not qualifying for the Offshore PE Fund Tax
16
In the manner set out in sections 20AE and 20AF of the IRO. 17
https://www.gov.hk/en/business/supportenterprises/funding/. 18
http://www.investhk.gov.hk/index.html.
16
Exemption. Consequently, the fund manager has to constantly
manage the risk of tainting the offshore PE fund. The proposed
extension of the Offshore PE Fund Tax Exemption would result in
operational efficiencies for fund managers and increase certainty as
there would be reduced risk of the Offshore PE Fund Tax Exemption
being inapplicable due to an inadvertent non-qualifying investment.
— Not discriminate against investment into Hong Kong private
companies by introducing a tax bias – Offshore funds can already
invest into listed Hong Kong companies under the 2006 Ordinance19
,
regardless of whether they carry on business in Hong Kong. In this
regard, there does not appear to be any sound policy reason for
prohibiting investment into Hong Kong private companies given the
potential economic benefits to Hong Kong’s economy and there being
no facilitation of tax abuse by extending the exemption to Hong Kong
private companies.
19
See footnote 8.
17
III. Recommendations / Proposals
36. In order for Hong Kong to reinforce its role as Asia’s leading asset
management centre, the tax law should be further refined to address the limitations
highlighted above. The Offshore PE Fund Tax Exemption should be enhanced to
make it more business-friendly and conducive to the PE and venture capital funds
industry. Particularly, it should not discourage investments in Hong Kong (or
“onshore”) portfolio companies and should place Hong Kong and non-Hong Kong
investments on a level setting to qualify for the Offshore PE Fund Tax Exemption.
37. With the above in mind, the FSDC recommends the following proposals
to extend the Offshore PE Fund Tax Exemption to Hong Kong portfolio companies,
except those holding residential properties in Hong Kong. These proposals take into
account certain key overarching principles or elements, which the FSDC considers to
be critical in making Hong Kong’s Offshore PE Fund Tax Exemption regime more
competitive and attractive. The tax exemption should have a wider applicability and
be less prescriptive on target investments. It should appeal to a broader investor base,
with no (or few) restrictions or limitations to the investments.
Excepted private company (“EPC”) – call for an expanded definition
38. The tax law, as it currently stands, favours offshore investments, which
inhibits the growth of Hong Kong businesses generally. As it is, Hong Kong already
lags behind our neighbours in its development in areas such as innovation and the
promotion of high-tech industries. It is therefore important to encourage investments
and business in those areas, especially for our “home grown” local companies. To
promote investments in Hong Kong and local businesses, the FSDC proposes that the
definition of “EPC” as set out in the existing tax law20
should be expanded to cover
investment in all Hong Kong companies (including Hong Kong incorporated private
companies), except those that hold substantial residential properties in Hong Kong.
20
Section 20ACA of the IRO.
18
39. The FSDC understands that the original design of the tax exemption is
that to qualify, a portfolio company, subject to a de minimis rule, should not hold any
share capital in Hong Kong private companies, and non-Hong Kong private
companies carrying on business in Hong Kong or hold any immovable property in
Hong Kong. The aim of such restrictions is to prevent abuse of the exemption by
local entities by simply converting their taxable profits or gains in investments in real
estate to non-taxable income via an offshore fund structure. However, the FSDC
considers such restrictions to discourage PE funds’ investments in Hong Kong
businesses, including start-ups and those in the high technology industry,
infrastructure projects and commercial properties that will help create more
employment opportunities in Hong Kong. Investments in Hong Kong residential
properties are excepted as they are currently subject to the Government’s demand-side
management measures to cool down the residential property market in Hong Kong.
The FSDC believes these changes will make the regime more attractive than
Singapore.21
40. When ascertaining whether or not an EPC holds substantial residential
properties in Hong Kong, reference can be made to the 10% de minimis threshold
included in the current tax law. However, such threshold should only apply to
residential properties in Hong Kong, and should be determined in accordance with the
value (of the Hong Kong residential properties) stated in the latest audited financial
statements of the EPC.22
21
The tax exemptions for funds in Singapore cover a list of “designated investments”. Designated
investments do not include, among others, stocks and shares of companies that are in the business
of trading or holding of Singapore immovable properties (other than the business of property
development). 22
The rationale for this is that a portfolio company may account for its Hong Kong residential
properties at historical book value under the Cost Model or at fair value under the Revaluation
Model under the Generally Accepted Accounting Principles. Insisting on computing the 10%
threshold based on market value in such instance would place undue burden on the investment fund
in case the EPC has adopted a Cost Model and would be difficult to comply with in practice. In
accordance with Hong Kong Accounting Standards (HKAS) 16 “Property, Plant and Equipment”,
an entity can choose either the Cost Model or the Revaluation Model as its accounting policy and
shall apply that policy to an entire class of property, plant and equipment. Under the Cost Model,
after recognition as an asset, an item of property, plant and equipment shall be carried at its cost less
any accumulated depreciation and any accumulated impairment losses. Under the Revaluation
Model, after recognition as an asset, an item of property, plant and equipment whose fair value can
be measured reliably shall be carried at a revalued amount, being its fair value at the date of the
revaluation less any subsequent accumulated depreciation and subsequent accumulated impairment
losses.
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41. The FSDC is of the view that widening the investment scope should not
result in any tax leakage or loss of tax revenue to Hong Kong since a Hong Kong
portfolio company would be liable to pay Hong Kong profits tax in respect of its
Hong Kong sourced profits under the provisions of the IRO anyway. Widening the
investment scope would encourage and promote not only investments in local
business but more investment managers to base themselves in Hong Kong.
Special purpose vehicle – call for an expanded definition
42. The definition of “SPV” should be expanded, and the scope of “allowable
activities” should be made as broad as possible (not limited to holding and
administering the EPCs as the IRO currently stands). SPVs should be permitted to
undertake more substantive activities, e.g. providing investment management and
other related services to or in respect of its portfolio investment holdings without
affecting the ability of the offshore PE fund to qualify for the Offshore PE Fund Tax
Exemption. Where the activity of an SPV exceeds mere investment holding and
administration for example, if the SPV derives income other than income from
“specified transactions” and transactions incidental to the “specified transactions”, the
SPV and the offshore fund should not lose their entitlement to profits tax exemption
entirely. Rather, the scope of the profits tax exemption should be limited to the
income derived from “specified transactions” and “incidental transactions” only. Any
other non-qualifying income would then be assessable to profits tax only to the extent
chargeable under the provisions of the IRO.
43. If the definition of “allowable activities” of the SPV is expanded, it would
bring inherent benefits to Hong Kong including employment creation opportunities
within or supporting the SPVs, which would contribute to the Hong Kong economy.
It would also assist the “substance” test that an SPV has, relevant to deciding the
certificate of tax residence status.
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Tainting – call for a relaxation
44. Regarding the issue of “tainting”, the FSDC considers that the current
position should be relaxed such that where a portfolio company fails to meet the
definition of an EPC (for whatever reason), the PE fund that invests in that portfolio
company should be subject to Hong Kong profits tax only on gains derived from the
disposal of that portfolio company to the extent such gains are Hong Kong sourced
trading receipts. The PE fund should continue to enjoy tax exemption on gains
derived from the disposal of other portfolio companies to the extent such other
portfolio companies meet and continue to meet the definition of EPC.
45. As an illustration, in Example 1 below, a PE fund holds three investments.
Private Company (“PC”) (1) and PC(3) qualify as EPCs, while PC(2) does not meet
the definition of EPC because it (as an example) holds residential properties in Hong
Kong the value of which exceeds 10% of the value of its own assets.
46. The FSDC recommends that the IRO be revised to include a non-tainting
rule and clarify that, in Example 1, the gains derived by the PE fund from the direct or
indirect disposal of PC(1) and PC(3) will continue to be eligible for profits tax
exemption. Whether or not gains from the direct or indirect disposal of PC(2) would
be assessable to Hong Kong profits tax would be subject to the ordinary assessment
provisions of the IRO.
Example 1:
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47. To further enhance the regime, the FSDC recommends that the IRO be
further revised to make provision that where a PE fund invests in a non-EPC (i.e.
PC(2) in Example 1) but holds the investment for (say) two years or more, any gains
derived from the disposal of the investment (i.e. PC(2)) can be considered capital in
nature and therefore not subject to Hong Kong profits tax. This provides PE funds
with more certainty on the tax liability of their investment activities in Hong Kong,
which is an important element for developing a successful and competitive PE
environment. The FSDC has noted that Singapore has similar provisions in its tax
law.
48. Regarding the “two year” period stated above, the FSDC suggests that the
“two year” period can be counted from:
a. the date of the first funding or the date of the first capital commitment
to the investment, whichever is later; or
b. the date of each tranche of funding for the investment,
whichever is later.
Anti-tax avoidance
49. The FSDC understands there may be concerns that the above proposals to
extend the Offshore PE Fund Tax Exemption to Hong Kong portfolio companies
might lead to potential abuse. However, the FSDC believes that there already exist
adequate measures in the current IRO to prevent anti-avoidance and abuse of
recommendations / proposals. First, there are “deeming provisions” under sections
20AE and 20AF of the IRO, which were enacted to prevent abuse, or round-tripping,
by resident persons disguised as non-resident persons to take advantage of the tax
exemption. Second, where tax avoidance is involved, the Commissioner can consider
invoking the general anti-avoidance provisions under section 61A of the IRO as
appropriate to counteract the tax benefits obtained. These provisions should already
provide sufficient and effective safeguards against any abuse of the PE fund
exemption regime or tax avoidance.
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Other comments / considerations
50. The FSDC also notes that jurisdictions like Singapore provide investment
funds with certainty of tax incentives as well as of obtaining tax residency certificates.
Such certainties in tax and administration have successfully attracted many offshore
PE and venture capital funds to Singapore in recent years. Hong Kong should take
note of the competitive international environment and strive to continuously improve
its tax rules in order to remain its position as the largest international PE centre in
Asia.
51. When preparing the recommendations / proposals contained in this paper,
the FSDC is also cognisant of the fact that Hong Kong does not wish to be seen
internationally (including by the OECD) as a tax harmful jurisdiction. The FSDC
believes that these recommendations / proposals would help align the inherent
inconsistencies and biases in the current tax position.
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About the Financial Services Development Council
The Hong Kong SAR Government announced in January 2013
the establishment of the Financial Services Development Council
(FSDC) as a high-level and cross-sector platform to engage the
industry and formulate proposals to promote the further
development of Hong Kong’s financial services industry and map
out the strategic direction for development. The FSDC advises
the Government on areas related to diversifying the financial
services industry, enhancing Hong Kong’s position and functions
as an international financial centre of our country and in the
region, and further consolidating our competitiveness through
leveraging the Mainland to become more global.
Contact us
Email: [email protected]
Tel: (852) 2493 1313
Website: www.fsdc.org.hk