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Proposed profits tax exemption for HK private open-ended funds

The Inland Revenue (Amendment) (No. 4) Bill 2017 (Bill) proposes a profits tax exemption for privately offered Hong Kong open-ended fund companies (OFCs) seeking to make them competitive with offshore funds which benefit from the offshore funds profits tax exemption. It should be noted that the Bill will not apply to private equity funds as only transactions in securities, futures, OTC derivatives, cash and foreign exchange can be “qualifying transactions” eligible for the exemption (the amount of income from other incidental transactions must not exceed 5% of total income). Qualifying transactions have to be carried out or arranged in Hong Kong through or by an investment manager licensed by or registered with the Securities and Futures Commission (SFC) to carry out Type 9 (asset management) regulated activity. 

Concerns as to possible misuse of the OFC vehicle, where the OFC might be used for purposes other than a bona fide investment fund, have driven detailed anti-avoidance provisions requiring a private OFC to maintain a significant number of substantial investors to qualify for the exemption (an OFC must not be “closely held”). These concerns may have been given undue weight given the regulatory requirements involved in the set up and ongoing operation of a private OFC. However in response to industry feedback there has been recognition of the fact that it may take time to seed a start-up fund and to broaden the investor base, so a 24-month period is allowed before the fund has to meet the not closely held test (but the OFC must continue to meet the test after the first 24 month period). If this is not achieved, the OFC will be taxed retrospectively from its start-up date. Maintaining a stable investor base may be problematic for open-ended funds where investors can subscribe and redeem on an ongoing basis. 

To not be closely-held an OFC must have a number of significant investors, either including an institutional investor defined as a “qualifying investor” being a charitable organisation, a government entity, a pension fund or other investment fund, where: 

  • the OFC has at least one qualifying investor, and at least five investors in total;
  • the qualifying investor has invested at least HK$200 million, and at least four other investors have each invested at least HK$20 million;
  • no investor (except the qualifying investor) holds more than 50% of issued capital; and
  • the OFC’s originators and associates in aggregate do not hold more than 30% of issued capital. 

Or if there is no qualifying investor, an OFC will be considered not closely held where: 

  • the OFC has at least 10 investors;
  • at least 10 investors have each invested HK$20 million or more;
  • no investor holds more than 50% of the OFC’s issued capital; and
  • the OFC’s originators and associates in aggregate do not hold more than 30% of issued capital. 

The conditions to be satisfied to obtain exemption are onerous compared to the offshore funds exemption regime and the required investment amounts of HK$200 million and HK$20 million are high compared, for example, to the professional investor eligibility level of assets of HK$8 million or the Cayman requirement of a minimum investment of USD100,000 (HK$780,000) in a registered mutual fund. 

Whilst the introduction of a profits tax exemption is welcomed, there are concerns as to the level of certainty the proposed terms of the Bill will provide and as to how many private funds would in practice qualify as not being closely-held.

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