Hong Kong — the major fund domicile of the future?

There have been a number of joint initiatives by the regulators of Hong Kong and mainland China in recent years for the gradual internationalization of the Remminbi (“RMB”). Such milestones continue to support Hong Kong in achieving its aspiration of becoming the international asset management centre and preeminent offshore RMB centre.

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The Hong Kong Securities and Futures Commission (“SFC”) authorized funds to be indirectly sold in mainland China through the Qualifi ed Domestic Institutional Investor (“QDII”) program.

In 2006

In 2002

In December 2011

In April 2012

In November 2012

To further secure Hong Kong’s leading position as an offshore RMB centre and a premier Asian asset management hub, in November 2012, SFC submitted a proposal to mainland China for developing a mutual recognition platform for locally domiciled funds in Hong Kong and mainland China (“Mutual Recognition Platform”). A working group made up of representatives from the SFC and the China Securities Regulatory Commission (“CSRC”) was formed toward the end of 2012 to study the mutual recognition. SFC described this initiative as a substantial breakthrough and the forthcoming Mutual Recognition Platform will be “Asia’s largest and deepest”.

Currently, authorized funds of Hong Kong and of mainland China are not allowed to be sold directly in the other’s market. Under the Mutual Recognition Platform, fund authorized in

The Renminbi Qualifi ed Foreign Institutional Investor (“RQFII”) program, which allows offshore RMB raised by Hong Kong subsidiaries of Chinese domestic fund managers and securities companies to invest directly in mainland China’s domestic securities markets, was launched.

RQFII quota had been increased by RMB50 billion for A share ETFs to be authorized by SFC and listed in Hong Kong.

The State Council approved an additional RMB200billion RQFII investment quota.

either Hong Kong or mainland China can obtain authorization in each other’s jurisdiction. However, the authorization would not be automatic and a foreign fund will still have to seek authorization from the local regulator, but the process will be streamlined.

According to Alexa Lam, Deputy Chief Executive Offi cer of SFC, on 23 Jan 2013, “Under this arrangement, we envisage that qualifi ed SFC-authorized funds domiciled in and operating from Hong Kong would enjoy the status of ‘recognized Hong Kong funds’, and qualifi ed mainland China funds would enjoy the status of ‘recognized Mainland funds’. These recognized funds could then obtain authorization and be sold directly in the other’s market.” 1

1 Hong Kong – the major fund domicile of the future?

1 http://www.sfc.hk/web/EN/fi les/ER/PDF/Alexa_20130123.pdf

The Qualifi ed Foreign Institutional Investor (“QFII”) program was introduced to allow foreign investors approved by the China Securities Regulatory Commission (“CSRC”) to trade “A” shares in the Shanghai and Shenzhen stock exchanges.

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The benefi tsThe Mutual Recognition Platform will dramatically expand the distribution network of the Hong Kong fund industry. The initiative will allow Hong Kong to distribute its products to mainland China and be the platform to offer mainland China products to international investors; promoting Hong Kong’s attractiveness in comparison to other Asian fi nancial centres. Furthermore, as more Hong Kong-domiciled funds are set-up and as more international managers establish their offi ces in Hong Kong, there will be further demand for professional services such as fund management, investment advisory in addition to legal and accounting services.

Needless to say, given the high personal savings rate and the low investment fund market penetration in mainland China, the Mutual Recognition Platform will also be an attractive opportunity for fund managers outside of mainland China to tap into the mainland China market. Whilst on the other hand opening up a wider range of international investment products to the mainland Chinese investors.

To the mainland Chinese fund managers, this initiative will allow them to attract international investors who want direct access to them. These mainland Chinese Fund Managers will have a competitive advantage over their international counter-parts owing to their knowhow and experience of the mainland China markets. Additionally, in distributing their products in Hong Kong, the mainland Chinese fund managers will benefi t from exposure to the best practices and international standards from the international managers and investors.

The initiative would defi nitely switch Hong Kong from a “local fund-raising/marketing hub” to a true “international asset management centre and offshore RMB centre”.

How will it work?It is worth noting that this arrangement will not be a “fund passport” system like UCITS. According to SFC a fund authorized in Hong Kong will not automatically gain entry to China and vice versa, especially given the limitation of RMB convertibility and restriction of RMB capital accounts.

Reputable international managers with a strong track-record in Hong Kong will likely be the fi rst group of managers to be approved by the mainland Chinese authorities to offer funds in mainland China. It is also likely that the fi rst batches of funds to be sold in mainland China may initially be existing Hong Kong-domiciled funds of these managers. Under the current legal framework in Hong Kong, Hong Kong domiciled funds can only be established as unit trusts. This may change. As mentioned in the 2013-14 budgets, Hong Kong is considering legislative amendments to introduce open-ended investment companies in recognition of the popularity of the legal form and in the hope to provide a more fl exible business environment. Open-ended investment companies could potentially be the legal form of choice for new funds being launched on the Mutual Recognition Platform.

In order to maintain existing well-known names and track record of existing funds, more managers may consider to redomicile their existing funds to Hong Kong. Although the Hong Kong Companies Ordinance currently does not allow the re-domicile of overseas companies to Hong Kong, more overseas unit trusts may choose to re-domicile to Hong Kong to fulfi ll the requirement of the Mutual Recognition Platform.

Hong Kong – the major fund domicile of the future?

A parallel or side-by-side fund may also be considered by managers who would like to replicate existing funds for the Mutual Recognition Platform. These parallel or side-by-side funds can be set-up in Hong Kong to invest alongside existing funds, on a pro rata basis in the same group of investments. However, one must consider the additional costs associated with the need to enter into duplicated agreements with counterparties and to split deals and to rebalance trades between the different funds.

Managers may also potentially explore the possibility of using the Unit Portfolio Management Funds structure (“UPMF”) in order to retain the track-record of existing European-domiciled UCITS. According to the current Code on Unit Trusts and Mutual Funds (the “Code”), a scheme may invest in underlying schemes which are either recognized jurisdiction schemes or schemes authorized by the SFC, provided that the UPMF invests in at least 5 underlying schemes and that the value of a scheme’s holding of units or shares in each such underlying scheme does not exceed 30% of the UPMF’s total net asset value, unless approved by SFC and the name and key investment information of the underlying scheme are disclosed in the offering document of the scheme. Hence a Hong Kong-domiciled fund can be a UPMF and acts as a China feeder fund to existing European-domiciled UCITSs.

Currently Hong Kong also has mutual recognition with Taiwan (for EIFS) and with Australia. In practice, mutual recognition arrangements streamline the process for authorization and selling of funds in these jurisdictions. We expect similar arrangement to be in place for the HK-Mainland Mutual Recognition Platform.

TimingAccording to SFC, there is no concrete timeline when the Mutual Recognition Platform can be fi nalized because it involves cross-border RMB fl ow between Hong Kong and mainland China, and fundamental questions on RMB capital means that the initiative will need detailed consideration by different mainland Chinese Authorities. Based on recent understanding from the SFC, it is expected that the roll-out of the Mutual Recognition Platform will be in stages. Stage one, which is underway now, will involve regulators seeking consensus and looking at the regulatory regimes of the two markets. Stage two of the process is expected to involve the setting of the parameters and the thresholds of the platform.

Given the rapid roll-out of the joint initiatives between Hong Kong and mainland China over the past few years, we are optimistic that the platform will be launched throughout the coming year in stages. We should expect that the fi rst batch of quotas for Hong Kong authorized funds to be marketing in the mainland China under this platform may be granted to managers with large establishment in Hong Kong.

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It’s important to address the fund distribution arrangements in both Hong Kong and mainland China as international managers look to distribute their products in both jurisdictions. Currently, the distribution channels in mainland China are limited, as the four largest state-owned banks dominates more than 60% of mutual fund sales in China. Offshore managers will need to establish distribution arrangements with large onshore banks once funds are authorized by the mainland Chinese regulator. Furthermore, the managers will need to be mindful that tailor-made marketing approach for different provinces should be adopted because of the differences in practices and demand/supply dynamics.

As mentioned earlier, Hong Kong already has mutual recognition with Taiwan (for ETFs) and Australia. The Hong Kong-China mutual recognition regime would not only create the deepest and largest fund platform in Asia, as described by Deputy Chief Executive of SFC, Alexa Lam, but it would also promote Hong Kong to be the leading fund hub of the potential Asia-Pacifi c fund platform. Thus it is not diffi cult to imagine that the Hong Kong fund market will become more attractive to investment managers from various regions around the

What shall we startto think about now?

Whilst this is a potential breakthrough for the Hong Kong asset management sector, there are still a few areas for the regulators and market practitioners to consider, such as:

Dual-distribution arrangement in different jurisdictions

Tax implications

Plan for the potential Fund Passport across Asia-Pacifi c

globe. More importantly, it might be a start for more mutual recognition fund platforms across Asia-Pacifi c, like China-Australia, Hong Kong-ASEAN-China etc. Subject to the goals of the governments and the extent of capital fl ow restriction across the region, these would become a wide-ranging network of mutual recognition platforms and would eventually evolve to be a fund passport platform with a unifi ed investment fund authorization across Asia-Pacifi c, like UCITS.

On a fi nal note, it is worth considering the tax implications where mutual recognition regimes are concerned.

There are inherent differences between the tax regimes in Hong Kong and mainland China across key areas of tax such as withholding tax, capital gains tax, tax on individual investors etc. Issues such as the tax implications on the income derived by a Hong Kong investor from a mainland Chinese fund investment (and vice versa) would need to be addressed. Furthermore, the applicability of the double tax agreement and what are the ongoing tax compliance requirements for such cross border investments etc., would need to be considered. Investors should seek professional tax advice where necessary.

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Roy Stockell

Asia-Pacifi c Asset Management Leader

+852 2846 9688

roy.stockell@hk.ey.com

Joyce Xu

Greater China Asset Management Leader

+86 21 2228 2392

joyce.xu@cn.ey.com

Christine Lin

Partner

+852 2846 9663

christine.lin@hk.ey.com

Paul Ho

Partner

+852 2849 9564

paul.ho@hk.ey.com

Julie Kerr

Director

+852 2629 3262

julie.kerr@hk.ey.com

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This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specifi c advice.

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