Reach of Hong Kong profits tax extended

This article was first published in the May 2016 China edition of Accounting and Business magazine.

In an attempt to attract offshore private equity funds, Hong Kong financial secretary John Tsang proposed to extend the exemption from profits tax for offshore funds to offshore private equity funds in his 2013/14 Budget. The government gazetted and introduced the Inland Revenue (Amendment) Bill 2015 into the Legislative Council in March 2015. This was passed on 17 July 2015 applies to relevant transactions occurring on or after 1 April 2015.

Old regime

Under the old offshore funds exemption provisions, which were enacted in 2006, a non-resident person is exempt from profits tax in Hong Kong for profits derived from ‘specified transactions’ carried out through or arranged by ‘specified persons’ and ‘transactions incidental to the carrying out of the specified transactions’.

The scope of ‘specified transactions’ includes those in securities, futures contracts, foreign exchange contracts, foreign currencies, exchange-traded commodities and those concerning the making of deposits other than by way of money-lending business carried out by offshore funds in Hong Kong. However, transactions in shares in private companies are excluded from ‘specific transaction’. Furthermore, the transactions must be carried out by ‘specified persons’ – normally those licensed by the Securities and Futures Commission (SFC) under the Securities and Future Ordinance.

In view of the above, offshore private equity funds are generally not able to make use of the exemption regime due to limitations imposed under the definitions of ‘specified transactions’. Private equity funds generally invest in non-Hong Kong projects through private company vehicles.

This has resulted in private equity fund managers taking onerous procedures to mitigate their practical exposure to profits tax by limiting operations and activities there. This has put Hong Kong in a relatively disadvantageous position for attracting private equity fund managers. In addition, it was noted that private equity funds may not be managed by persons licensed by the SFC. 

New regime

In order to enhance Hong Kong’s competitiveness, the new law has extended the scope of profits tax exemption for offshore funds with the following three key provisions:

1. extending tax exemption to offshore private equity funds
2. relaxing the requirement for specified transactions to be carried out through or arranged by ‘specified persons’ for ‘qualifying funds’
3. extending tax exemption to ‘special purpose vehicles’ (SPVs).

Extending to offshore private equity funds

The new law amends the definition of ‘securities’ so that a transaction in securities in an eligible private company, ie an excepted private company (EPC), will not be excluded from a ‘specified transaction’. 

EPC criteria

To qualify for tax exemption, an EPC must be a private company incorporated outside Hong Kong and, at all times within three years before a transaction giving rise to the relevant profit is carried out, satisfy the following conditions: 

1. It did not carry on any business through or from a permanent establishment in Hong Kong.
2. It falls within either one of the following descriptions:
   1. it did not hold share capital in one or more private companies carrying on any business through or from a permanent establishment in Hong Kong, or
   2. it held such share capital, but the aggregate value of the holding of the capital is equivalent to not more than 10% of the value of its own assets.
3. It falls within either one of the following descriptions:
   1. it neither held immovable property in Hong Kong nor held share capital in one or more private companies with holding of immovable property in Hong Kong, or
   2. it held such immovable property and/or share capital, but the aggregate value of the holding of the property and capital is equivalent to no more than 10% of the value of its own assets.

Relaxing the ‘specified persons’ for ‘qualifying funds’ requirement

As mentioned above, only specified transactions carried out through a specified person are exempted from profits tax before the new law was enacted. In order to allow offshore private equity funds which are not managed by SFC licensees to also enjoy the tax exemption benefit, the new law amends the exemption such that an offshore private equity fund carrying out a ‘specified transaction’ could be eligible for tax exemption in respect of profits from that transaction if either one of the following conditions is satisfied:

1. the ‘specific transaction’ has been carried out through or arranged by a ‘specified person’ or
2. the offshore private equity fund conducting the specified transaction is a ‘qualifying fund’.

Qualifying fund

In order to be a ‘qualifying fund’, and therefore be eligible for tax exemption, the following conditions must be met:

1. At all times after the final closing of sale of interests:
   1. the number of investors exceeds four
   2. the capital commitments made by investors exceed 90% of the aggregate capital commitments.
2. The portion of the net proceeds arising out of the transactions of the fund to be received by the originator and the originator’s associates, after deducting the portion attributable to their capital contributions, is agreed under an agreement governing the operation of the fund to be an amount not exceeding 30% of the net proceeds.

Extending tax exemption to SPVs

It is common for private equity to use SPVs for structuring, holding their investments and formulation of exit strategies. Accordingly, the new law exempts the offshore private equity fund from tax in respect of profits derived from the transaction in the securities in an EPC through disposal of securities in a SPV and also exempts the SPV from tax in respect of profits derived from the disposal of another SPV (ie an interposed SPV). 

SPV definition

Under the new law, SPV refers to a corporation, partnership, trustee of a trust estate or any other entity that:

1. is wholly or partially owned by a non-resident person
2. is established solely for the purpose of holding, directly or indirectly, and administering one or more EPCs
3. is incorporated, registered or appointed in or outside Hong Kong
4. does not carry on any trade or activities except for the purpose of holding and administering one or more excepted private companies
5. is not itself an EPC.

It is also worth noting that, for SPVs, the new law includes additional exempted investments: ‘rights, options or interest in; and certificates of interest or participation in, temporary or interim certificates for, receipts for, or warrants to subscribe for or purchase, shares, stocks, debentures, loan stocks, funds, bonds or notes of, or issued by an EPC or an interposed SPV’.

In the example in the box, as long as Cayman Partnership qualifies as a ‘qualifying fund’, and the non-Hong Kong company qualifies as an EPC, any transactions involving the shares of the non-Hong Kong company and the shares of the SPV would be exempt from profits tax, even though the transactions are managed and executed by the fund manager company in Hong Kong. This would be the case even if the fund manager company is not a ‘specified’ person. 

Deeming provision

To prevent abuse of tax exemption by onshore private equity funds and other resident persons disguised as offshore funds, the existing deeming provisions will also apply to offshore private equity funds, ie where a resident person, alone or jointly with their associates holding a beneficial interest of 30% or more in a tax-exempt offshore private equity fund, will be deemed to have derived assessable profits in respect of profits earned by the fund from specified transactions and incidental transactions in Hong Kong unless the commissioner is satisfied that beneficial interests in the offshore fund concerned are bona fide widely held. A similar deeming provision applicable to SPV is also added in the new law.

Overall, we welcome the enactment of the new law, which extends the existing safe-harbour rule for offshore funds to private equity funds and relaxes the SFC licences requirement. In view of the above, it will strengthen Hong Kong’s competitiveness in attracting more private equity fund managers to set up or expand their business in the special administrative region and enhance the development of the asset management industry in Hong Kong.

Anthony Tam is tax partner and Pauline Leung is senior tax manager at Mazars CPA Hong Kong