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Hong Kong Implements Profits Tax Exemption for Offshore Private Equity Funds

On 17 July 2015, the Inland Revenue (Amendment) (No.2) Ordinance 2015 (Amendment Ordinance) was published in the Gazette. The Amendment Ordinance, which takes effect retrospectively from 1 April 2015, extends the existing profits tax exemption benefiting non-residents (offshore funds) to effectively allow offshore private equity funds to take advantage of the exemption.

The profits tax exemption for offshore funds was introduced in 2006 to bolster Hong Kong's position as an international financial centre. Generally, however, offshore private equity funds have been unable to readily take advantage of that regime as they could not satisfy the qualifying conditions for exemption. This is principally because they generally invest in private companies (either directly or through one or more special purpose vehicles) and often the fund's Hong Kong manager carrying out the fund's transactions is not SFC licensed or registered. They have therefore until now had to ensure that their operations were carefully structured mainly outside Hong Kong so as not to expose themselves to profits tax.

The Amendment Ordinance extends the exemption by including within the qualifying conditions (i) dealings by offshore funds in certain offshore private companies (defined as ‘excepted private companies’) and (ii) specified transactions (as outlined below) of ‘qualifying funds' which are not carried out through, or arranged by, a SFC-licensed or registered authorised financial institution or corporation. The exemption has also been extended by exempting certain profits of a special purpose vehicle (as defined in the Amendment Ordinance) (SPV) equal to the percentage of shares or interest in the SPV held by the offshore fund. The changes in the Amendment Ordinance are tailored to broaden the profits tax exemption so that qualifying offshore private equity funds can take advantage of it and thus will be able to set up or expand the business of their fund managers in Hong Kong without incurring profits tax. This should generate demand for local asset management and advisory services and other relevant professional services.

Specified transactions broadened to cover certain offshore private companies

The profits tax exemption applies to profits from specified transactions (and related incidental transactions). ’Specified transactions’ include transactions in ‘securities’, which previously excluded securities of private companies. The definition of securities has now been extended to include shares and other securities in (i) an excepted private company and (ii) an SPV.

‘Excepted private company' is broadly a private company incorporated overseas, which does not within three years prior to the relevant transaction (a) carry on business through or from a permanent establishment in Hong Kong; (b) hold Hong Kong immovable property, or a direct or indirect interest in a private company with a direct or indirect holding of Hong Kong immovable property above a threshold of 10% of the company's own assets and (c) hold a direct or indirect interest in a private company carrying on business through a Hong Kong permanent establishment above a threshold of 10% of the company's own assets.

An SPV includes a corporation, partnership or trustee, wherever incorporated, registered or appointed, established to hold and administer one or more excepted private companies (which is not itself an excepted private company). The SPV must be wholly or partially owned by an offshore fund and must not carry on any trade or activities except for the purpose of holding and administering one or more excepted private company.

Tax exemption expanded to offshore qualifying funds

The profits tax exemption previously required transactions to be carried out through or arranged by an SFC-licensed or registered authorised financial institution or corporation. The Amendment Ordinance extends the tax exemption by adding an alternative condition, namely that the transactions are carried out by an offshore ‘qualifying fund'. A qualifying fund is one which: (a) has more than four investors other than the originator (which is broadly defined to mean a person with the power to make investment decisions for the fund) or an associate of the originator with capital commitments by such investors exceeding 90% of the aggregate capital commitments; and (b) there is an agreement governing the operation of the fund capping the portion of net proceeds from the fund's transactions (after deducting the portion attributable to the capital contributions to the fund by the originator (and its associates)) to be received by the originator (and its associates) to an amount not exceeding 30% of the net proceeds. The 30% threshold for permissible payments to the originator or its associates allows for the common practice in the private equity industry of payments of carried interest being made to the originator or its associates.

Exemption for certain profits of an SPV

For any year of assessment commencing on or after 1 April 2015, the profits tax exemption applies to such percentage of the profits of an SPV which derive from transactions in shares, stocks and debentures of excepted private companies or interposed SPVs corresponding to the percentage of shares or interest in the SPV held by the offshore fund.

Anti-avoidance deeming provisions extended to SPVs

The existing anti-avoidance deeming provisions will continue to cover Hong Kong resident owners of offshore funds. Broadly, if a Hong Kong resident (together with its associates) beneficially holds a 30% or more interest in a tax-free offshore fund, the assessable profits of the fund will be deemed to be profits of the Hong Kong resident. The Amendment Ordinance introduces similar deeming provisions to the profits of SPVs.

Impact on the private equity sector in Hong Kong

This is a welcome development for the private equity sector in Hong Kong. The changes provide an exemption from profits tax for offshore private equity funds in respect of eligible investments, including shares in offshore private companies. It should be noted that transactions in shares in Hong Kong incorporated private companies (other than SPVs) still fall outside the exemption. Also, any offshore fund that carries on any trade, profession or business in Hong Kong involving any transaction other than a specified transaction, such as a transaction in Hong Kong private company shares, will disqualify the fund from the exemption on the whole of its profits for the relevant year of assessment.

Private equity managers will be able to perform more asset management activities in Hong Kong without attracting tax liabilities for their offshore funds. The Government anticipates that this will attract more private equity managers to Hong Kong and enhance Hong Kong's investment fund platform. Offshore funds will be able to establish Hong Kong incorporated SPVs to hold investments within the tax exemption. This has the advantage of such funds being able to access the growing number of tax treaties benefiting Hong Kong.

 

 

Austin Sweeney is the head of corporate, Asia. His practice extends across a broad range of company and commercial work including corporate finance, disposals, joint ventures, mergers and acquisitions and securities offerings. He has many years of experience working in London, Hong Kong, Singapore and Tokyo.

Tommy Tong advises on a broad range of corporate and commercial matters, specialising in equity capital markets transactions, public and private M&A and private equity. Tommy has also advised numerous international and domestic corporates, financial institutions and private equity funds in relation to mergers and acquisitions, corporate restructuring and regulatory compliance matters.

Susan Leung is a tax consultant. She has extensive experience in advising on international and regional tax matters, and structuring and implementing transactions in a tax-efficient manner. In particular, she has advised on numerous M&As, IPOs and group reorganisation transactions, the structuring of investment funds making investments into Hong Kong and Asia and other banking and structured finance transactions.

Herbert Smith Freehills is a Hong Kong partnership which is affiliated to Herbert Smith Freehills LLP (an English limited liability partnership). Herbert Smith Freehills LLP, its subsidiaries and affiliates and Herbert Smith Freehills, an Australian Partnership are separate member firms of the international legal practice known as Herbert Smith Freehills. For more information, please visit the website at www.herbertsmithfreehills.com.