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: enquiry@fsdc.org.hk

Tel: (852) 2493 1313

Website: www.fsdc.org.hk