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Hot air or winds of change? Hong Kong’s private equity tax proposals

Government advisory council releases six research reports on financial services industry development in Hong Kong

Tasked with the job of promoting the strategic development of Hong Kong’s financial services industry, the Financial Services Development Council (FSDC) was established by the Administration in January 2013 in response to industry calls for more coordination and action to position Hong Kong as a leading international financial centre.

The FSDC’s six research reports are the products of its half-year long consultation with industry. They provide a mix of macro and micro level recommendations to government and regulators across a range of topics and issues.

Tax – the FSDC’s synopsis paper proposing tax exemptions and anti-avoidance measures on private equity funds in the 2013-14 budget

The Administration and the more conservative ranks of Hong Kong’s tax profession hailed the Financial Secretary’s announcement earlier this year of a proposed extension of Hong Kong’s offshore funds tax exemption to offshore “private equity funds” as a giant leap forward. Hong Kong-based fund sponsors and managers were left scratching their heads as to what all the fuss was about.

By way of background, non-Hong Kong fund vehicles1 that are managed and controlled from outside Hong Kong (“non-resident funds”) are exempt from profits tax on their Hong Kong sourced trading profits arising from most transactions arranged by a “specified person” involving seven common types of financial assets.

At issue is the term “securities”, which does not include “shares…of, a company that is a private company within the meaning of section 29 of the Companies Ordinance…” with the result that Hong Kong sourced trading gains on shares in a Hong Kong incorporated private company are outside the scope of the tax exemption. That much is not in dispute.

The difficulty for fund sponsors and managers is that Hong Kong’s tax authority, the Inland Revenue Department (IRD), has “interpreted” the term “securities” to include shares in all private companies, whether incorporated in Hong Kong or not. It is difficult to find much support for the IRD’s view in either the literal words of the statute, or a broadly based purposive interpretation of the same.

The more conservative advisors of the tax profession identified the gulf between the proper scope of the exemption and the IRD’s published (mis)interpretation of the same, as indicating that, generally, there was doubt as to the tax exemption’s utility for non-resident funds in the business of private equity, with the subtext that it’s all too risky, and we better just do what the IRD says. This echo chamber of cumulative error deprived Hong Kong of much private equity management business; and resulted in the implementation of rather cumbersome operating protocols for certain transactions effected by private equity focused non-resident funds.

The FSDC was engaged to give recommendations on how the existing offshore funds tax exemption could be refined, subject to putting appropriate anti-avoidance measures in place.

The FSDC’s proposal will, if passed, give Hong Kong the tax exemption for non-resident funds focused on private equity that it has, as a technical matter, had since year of assessment 1996-972 but which the IRD has to date refused to accept. This is surely welcome news for the industry.

Also welcome are other FSDC suggestions including:

  • to enable non-resident funds to use Hong Kong incorporated private companies as special purpose vehicles to hold portfolio companies;
  • relax the “bona fide widely held” test by reducing from 50 to 5 the number of investors required to provide the non-resident fund with “widely held” status, which will enhance the effectiveness of the profit tax exemption; and
  • expanding the scope of exempted transactions to include loans and credit transactions.

Overall, the FSDC’s work and recommendations in the area of tax represent an important step in the right direction; and should be welcomed by the financial services industry. Key industry players must keep the pressure on the Administration, to make good on the promise of reform both on the statute books and in practice.

1 For example, a limited partnership governed by Cayman Islands law.

2 In March 2006, the Legislative Council passed the Revenue (Profits Tax Exemption for Offshore Funds) Ordinance 2006 to implement the so-called offshore funds tax proposal. This was made retroactive to year of assessment 1996/97

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