10 December 20182018 Issue No. 17

Hong Kong Tax Alert

Under the proposed unified exemption regime, funds in the form of collective investment schemes will be exempt from profits tax in Hong Kong in respect of their usual investment and securities trading income, provided that the transactions are carried out by a specified person or the fund itself is a qualifying fund.

Profits tax exemption in respect of investment in both overseas and Hong Kong incorporated private companies by a fund or a special purpose entity (SPE) owned by such a fund will only be available subject to satisfying certain additional conditions.

Importantly, the proposed unified exemption regime will not contain any tainting provisions. This means, a fund will not lose its tax exemption status but will only be taxable in respect of profits from non-qualifying transactions that are onshore sourced and revenue in nature.

The Bill also proposes to keep the current exemption regime for non-resident persons intact such that non-resident persons which do not qualify as funds will still enjoy tax exemption when the legislative amendments take effect.

These proposed amendments also address the European Union’s (EU) concerns as regards the ring-fencing features of the current exemption regime for funds being potentially harmful, thereby, mitigating the risk of Hong Kong being blacklisted by the EU as a non-cooperative jurisdiction for tax purposes.

This Hong Kong Tax alert discusses the key provisions of the Bill.

Proposed profits tax exemption for all privately-offered funds in the form of collective investment schemes in Hong Kong regardless of their residence, size and type

2Hong Kong Tax Alert

As regard the second qualifying condition, consistent with the existing exemption for non-resident funds, the Bill specifies that a fund must engage a “specified person” to

arrange or carry out its transactions or be a “qualifying

fund” as defined.

“Specified person” generally refer to persons licensed by

the Securities and Futures Commission or authorized financial institutions.

If this “specified person” requirement is not met, the fund

has to be a “qualified investment fund”. Same as the

existing provision, a fund would be regarded as a “qualified investment fund” if, not including the originator

and its associates, it has more than 4 investors and these investors contribute more than 90% of the capital of the fund. Furthermore, the distribution of the net proceeds of the fund to the originator and its associates cannot exceed 30%.

SPEs are eligible for tax exemptionCertain funds may establish a SPE for holding, directly or indirectly, one or more investee private companies. The Bill specifically provides that if the fund qualifies for exemption under the proposed unified exemption regime, the SPE is also exempt in respect of its profits derived from the disposal of an interposed SPE or investee private companies, to the extent that corresponds to the percentage of shares or interests held by the exempt fund.

However, consistent with the existing exemption for non-resident funds, the Bill imposes restriction on the activity scope of an SPE under which it is not allowed to carry on any trade or activities other than for the purpose of holding, directly or indirectly, and administering one or more investee private companies.

Profits eligible for the proposed tax exemptionThe Bill provides that the otherwise taxable profits derived by a fund from the following transactions will be exempt from tax in Hong Kong:

(i) transactions in qualifying assets as defined in the newly added Schedule 16C (i.e., qualifying transactions); and

(ii) transactions incidental to the carrying out of qualifying transactions, subject to a 5% threshold.

BackgroundUnder the current tax regime, public funds (regardless of whether the funds are residents or non-residents) are exempted from profits tax under section 26(1A) of the Inland Revenue Ordinance (IRO).

In addition, subject to satisfying certain conditions, non-resident privately-offered funds (which includes individuals, corporations, partnerships and trusts) may enjoy profits tax exemption on specified transactions and incidental transactions (subject to a 5% threshold). However, non-resident funds are restricted from investing in private companies incorporated in Hong Kong if they wish to enjoy profits tax exemption1.

The exclusion of resident, privately-offered funds (except those established as Hong Kong resident open-ended fund companies (OFCs) where a separate profits tax exemption scheme may apply) from taking advantage of the current exemption regime, and the prohibition on investing in local private companies, were identified by the EU as ring-fencing and hence a harmful tax practice.

If these ring-fencing features are not removed by the end of this year, there is a risk Hong Kong may be listed as a non-cooperative jurisdiction for tax purposes by the EU, and exposes Hong Kong to defensive measures which may be applied by EU Member States.

The Inland Revenue (Profits Tax Exemption for Funds) (Amendment) Bill 2018 (the Bill) has been introduced on 7 December 2018 to address the ring-fencing concerns by introducing a unified exemption regime for all funds.

The key provisions of the Bill are discussed below.

Qualifying exemption conditions under the proposed unified exemption regimeThe Bill proposes that effective from 1 April 2019, where an entity (i) qualifies as a “fund” as defined; and (ii) has

engaged a “specified person” to arrange or carry out its

transactions or has a “qualifying fund” status, the entity

will be exempt from profits tax in Hong Kong on its assessable profits in relation to certain transactions.

The proposed definition of “fund” is similar to the

definition of “collective investment scheme” contained in

Part 1 of Schedule 1 to the Securities and Futures Ordinance (SFO), with modifications made to cater for the purpose of the proposed tax exemption. In this regard, a business undertaking for general commercial or industrial purposes is not a “fund”. This exclusion is to guard

against the risk of tax abuse by onshore businesses repackaging themselves as funds. However, a fund’s

engagement in transactions in qualifying assets will not be regarded as a business undertaking for general commercial or industrial purpose.

1 Please refer to Appendix 1 for details of the current exemption

regime for non-resident funds and OFCs.

3Hong Kong Tax Alert

No tainting provision under the proposed unified exemption regimeUnder the existing exemption regime for non-resident persons, a single non-specified transaction would cause income derived from specified transactions of a non-resident person to be chargeable to tax in Hong Kong when such income would otherwise be exempt (the “tainting” provision).

The proposed unified exemption regime does not include the “tainting” provision such that the tax-exempt profits of a fund or a SPE will not be tainted even if profits tax has to be paid in respect of transactions not qualifying for the tax exemption.

Non-resident person not qualifying as a “fund” may rely on the current exemption regimeUnder the current exemption regime contained in section 20AC of the IRO, non-resident persons that fulfil the exemption conditions would be eligible for tax exemption, regardless of whether they are established as “funds”.

The proposed definition of “fund” may potentially exclude

certain such non-resident persons from the proposed unified exemption regime.

To avoid the above potential exclusion and hence not impacting those non-fund entities, the Bill proposes to leave section 20AC and the associated sections of the IRO intact to afford profits tax exemption exclusively to non-resident persons not qualify as “funds” when the

legislative amendments take effect. That means, the current tax exemption regime will run in parallel with the proposed unified exemption regime.

However, the current exemption regime is less liberal than the proposed unified exemption regime, as the Bill does not propose to remove the existing provisions as regards restrictions on the investment in Hong Kong incorporated private companies and the tainting provision.

Aligning the tax treatment of OFCs with other fundsThe Bill proposes to repeal the relevant provisions specifically applicable to the exemption of OFCs in order to align the tax treatments of OFCs with other funds. That means, an OFC will no longer be subject to the non-closely held condition, which imposes minimum requirements on the number of investors and the maximum/minimum participating interest of each investor, in order to enjoy profits tax exemption.

In addition, the taxation of consideration or remuneration received by investment managers of OFCs will not be subject to the specific anti-avoidance provision contained in section 20AJ(3). This specific provision provides that if an OFC is not exempt from the payment of profits tax, then despite section 26(a), the consideration or remuneration received by a person in the form of a dividend from the OFC for providing any services in Hong Kong to the OFC will be chargeable to profits tax.

The qualifying assets included in the newly added Schedule 16C broadly cover securities and other kinds of financial products that a fund would commonly find of interest2.

Nonetheless, profits from investments in certain private companies (whether incorporated in overseas or Hong Kong) by a fund or an SPE that do not meet in good faith the tests specified in the Bill will be taxed. Such a restriction on investment in private companies is to safeguard against potential tax abuse of the proposed unified exemption regime by such funds or SPEs.

The legislative intent of the unified exemption regime is that a fund or an SPE will not be eligible for the tax exemption when it directly trades in short-term assets. However, if not for the imposition of the restriction, a fund or an SPE will be eligible for the tax exemption by employing a private company to acquire short-term assets and then subsequently disposing of the private company as a way of effectively trading in the underlying short-term assets, thus circumventing the legislative intent.

Please refer to Appendix 2 for details of the tests and how they would operate in practice.

Exemption scope of OFCs

The exemption scope of OFCs on its face may seem wider than other types of funds. This is because under the relevant provision an OFC will be exempt from tax in respect of profits derived from transactions in non-qualifying assets (i.e., non-qualifying transactions).

However, there is another provision under the Bill which provides that an OFC will not be exempt from tax in Hong Kong in respect of its profits derived from transactions involving the OFC (A) carrying on direct trading or a direct business undertaking in Hong Kong in assets of a non-Schedule 16C class; or (B) holding assets of a non-Schedule 16C class and the assets are being utilized with a view to generating income. Such a limitation may effectively render the exemption scope of OFCs more or less the same as with other types of funds.

2 Classes of qualifying assets specified in Schedule 16C include securities, shares, stocks, debentures, loan stocks, funds, bonds, or notes of, or issued by, a private company, futures contracts, foreign exchange contracts, deposits other than those made by way of a money-lending business, bank deposits, certificates of deposit, exchange-traded commodities, foreign currencies, over-the-counter derivative products and an investee company’s

shares co-invested by a partner fund and Innovation and Technology Venture Fund Corporation (ITVFC) under the Innovation and Technology Venture Scheme (the Scheme).

Under the Scheme, ITVFC would serve as a special-purpose vehicle to co-invest with the partner venture capital funds in local innovation and technology start-ups at an overall matching investment ratio of approximately 1 to 2. ITVFC will be a passive investor, making direct investment in the start-ups concurrently with the partner venture capital funds upon invitation of the latter.

4Hong Kong Tax Alert

The term “met in good faith”, however, is not defined in

the Bill. Apparently, it is added to guard against abuse whereby a fund could acquire and hold a shelf private company for more than 2 years before the fund activates the private company concerned to acquire certain short-term assets. The fund could then dispose of the private company concerned immediately or shortly after the private company acquired the short-term assets. This would effectively enable the fund to deal in the underlying short-term assets owned by the private company without breaching the holding period test.

As the “met in good faith” condition appears to confer

great discretionary power on the Commissioner to determine whether a fund or a SPE would be able to enjoy the proposed exemption, more clarifications on this front is needed to provide certainty.

Interest income derived from the holding of debt securities

should explicitly be regarded as being income derived from

qualifying transactions

It is known that the Inland Revenue Department (IRD) takes the view that the legislative intent of the current exemption regime is to cover “a transaction in securities”

as being one of the six types of “specified transactions”

with the term “transaction” in this definition referring

only to the buying and selling of securities and not to the holding of securities to generate income.

Based on the IRD’s interpretation, interest earned by a

credit fund from the buying and holding of debt securities (before selling the same) can only be regarded as income incidental to a “specified transaction”.

Being regarded as incidental income, the tax exemption of interest under the current exemption regime would be subject to a 5% threshold test. In other words, where interest earned by a credit fund exceeds 5% of the total relevant income of the credit fund for a given year, the interest income, if sourced in Hong Kong, would be wholly taxable in Hong Kong.

Given credit funds may hold debt securities for the primary purposes of earning interest income, they would risk exposure to taxation in Hong Kong if they invest in Hong Kong issued debt securities (interest derived would then likely be Hong Kong sourced income).

This treatment is not conducive to the HKSAR Government’s stated objective of developing Hong Kong’s

debt capital market.

Accordingly, the IRD should relax its position in this regard, or the proposed regime should explicitly spell out that interest income derived from the holding of debt securities will be regarded as being income derived from transactions in eligible asset classes, thereby qualifying for the tax exemption.

Clients who have any views or comments on the Bill can contact their EY tax adviser so that we can convey their thoughts to the HKSAR Government in an appropriate manner.

CommentaryWe welcome the introduction of a unified fund tax regime for Hong Kong, the removal of the perceived ring-fencing effect and the tainting provision of the current exemption regime, which will further the development of Hong Kong as an international financial center for fund and wealth management.

When formulating the Bill, the HKSAR Government has conducted consultation to gauge feedback from industry participants. Whilst it is very pleasing that much of the feedback provided during the consultation has been incorporated into the Bill, there are still a number of issues that need to be clarified.

Definition of fund

Following feedback from the industry, the definition of “fund” now expressly includes sovereign wealth fund.

Furthermore, as currently proposed, the definition of “fund” excludes arrangements under which each investor

is a company in the same group of companies as the manager operating the fund.

Whilst intended to prevent corporate groups abusing the exemption, this exclusion, unless further clarified, could render the exemption ineffective for managers who provide seed capital into the funds they manage or who need to build track records to attract external investors. To address this issue, the HKSAR Government may need to consider providing a grace period or an intention test.

Activities an SPE can undertake may be too restrictive

While the Bill proposes that tax exemption will apply at both the fund and holding company level (in the form of SPE), the permitted scope of activities that an SPE can undertake is more restrictive than that of a fund, as an SPE is limited to holding and administering investee private companies. Given that an SPE would only be exempt from tax to the extent that corresponds to the percentage of ownership held by an exempt fund, the permitted scope of activities that an SPE can undertake should be relaxed and aligned with that of a fund.

The holding period and short-term assets test need to be

met in good faith

As regard the holding period and short-term assets tests that are relevant in determining whether a fund or a SPE will be taxed on its profits from investment in private companies, the Bill proposes that these two tests have to be met in good faith in order to qualify for exemption.

5Hong Kong Tax Alert

Appendix 2Tests on profits tax exemption eligibility for profits generated from transactions in private companies by a fund or an SPEA fund or an SPE will not be taxed on its profits arising from the transaction in a private company (whether incorporated in overseas or Hong Kong) if the following tests are met:-

(a) Immovable property test: the fund or SPE does not invest in a private company (both overseas and Hong Kong incorporated) that holds directly or indirectly (A) immovable property in Hong Kong or (B) share capital in one or more other private companies with direct or indirect holding of immovable property in Hong Kong, and the aggregate value of the holding of (A) and (B) do not exceed 10% of the value of the total assets of the private company concerned.

For this purpose, immovable property does not include infrastructure, which is defined to mean any publicly or privately owned facility providing or distributing services for the benefit of the public, and includes any water, sewage, energy, fuel, transportation or communication facility.

If the above immovable property test is satisfied, the fund or SPE has to further meet in good faith either one of the following two tests:

(b) Holding period test: the investment in the private company has been held by the fund or SPE for at least two years, whether or not the fund or SPE has control over the private company; or

(c) Short-term assets test: if the holding period test is not satisfied (i.e., held for less than 2 years), profits tax exemption would only be provided if (i) the fund or SPE does not have a controlling stake in the private company; or (ii) the fund or SPE has a controlling stake in the private company, but the latter does not hold (directly or indirectly) short-term assets the aggregate value of which exceeds 50% of the value of the total assets of the private company concerned.

For this purpose, a short-term asset means an asset that (A) is of a non-Schedule 16C class; (B) is not immovable property in Hong Kong; and (C) has been held by the private company concerned for less than 3 consecutive years before the fund or SPE disposes of the shares of, or debentures issued by, the private company concerned.

The above tests, however, do not apply to a partner fund that is a party under an agreement to which the ITVFC is also a party.

The following diagram illustrates how the above tests would operate in practice.

Appendix 1Existing profits tax exemption regime for funds in Hong KongAuthorized funds (regardless of whether such funds are

residents or non-residents)

Section 26A(1A) of the IRO exempts from tax profits of a specified investment scheme accrued to (i) a mutual fund, unit trust or similar investment scheme authorized by the Securities and Futures Commission (SFC) under section 104 of the SFO; or (ii) a mutual fund, unit trust or similar investment scheme that is bona fide widely held and which complies with the requirements of a supervisory authority within an acceptable overseas regulatory regime. In general, such authorized funds are retail funds marketed to the public in Hong Kong.

Non-resident unauthorized funds

Section 20AC of the IRO provides that all non-resident persons (including corporations, partnerships and trusts) are exempt from tax in Hong Kong if their activities in Hong Kong are restricted to “specified transactions”,

carried out through or arranged by a “specified person”

and transactions incidental to the carrying out of the “specified transactions”.

A corporation, partnership or trust is a non-resident if its central management and control is exercised outside Hong Kong. The term “specified transactions” is widely

defined to cover transactions typically undertaken by most general investment funds, as well as transactions in shares or securities issued by certain private companies incorporated outside Hong Kong.

“Specified persons” generally refer to persons licensed

by the SFC. For private equity funds (PE funds), the requirement for transactions to be carried out through or arranged by “specified persons” is waived if the relevant

PE fund satisfies certain qualifying conditions as a “qualifying fund”.

Hong Kong resident OFCs

Section 20AH of the IRO provides that where all the following conditions are satisfied, an OFC formed under the relevant provisions of the Securities and Futures Ordinance 2016 as an open-ended investment fund will be exempt from profits tax in Hong Kong in respect of certain specified types of income: (i) the OFC is a Hong Kong resident corporation; (ii) the OFC is non-closely held; and (iii) the relevant transactions must be carried out in Hong Kong by or through a qualified person, or arranged in Hong Kong by a qualified person. For this purpose, a qualified person is a corporation licensed under Part V of the SFO to carry on, or an authorized financial institution registered under that Part for carrying on, a business in Type 9 regulated activity as referred to in Part 1 of Schedule 5 to the SFO.

Does the private company hold ≤10% of its assets in

immovable property in Hong Kong

Has the private company been held by the fund/SPE for

≥ 2 years?

Is the private company controlled by the fund/SPE?

Does the private company hold ≤ 50% value of its assets in

short-term assets?

Yes

No

Yes

No

Yes

No

Yes

No

Not tax-exempted

Tax-exempted

Source:

Appendix B to Legislative Council Brief – Inland Revenue (Profits Tax Exemption for Funds) (Amendment) Bill 2018 issued on 5 December 2018

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