Unified Fund Exemption Regime, Hong Kong

The Unified Fund Exemption (the “UFE”) regime introduced by Inland Revenue (Profits Tax Exemption for Funds) (Amendment) Ordinance 2019 (the “Ordinance”) has provided far reaching profit tax exemptions to funds offered in Hong Kong irrespective of the fund’s domicile i.e. onshore or offshore. The previous profit tax exemption regime for funds i.e. Offshore Fund Exemption (the “OFE”) made distinction between onshore and offshore funds and the nature of investments.

The below note describes what has changed under UFE and how will it impact the fund industry.

·       QUALIFYING FUNDS: A fund that fulfils the below mentioned conditions can seek tax exemption:

o   All privately offered funds: UFE extends the tax exemption to all privately offered funds (whose definition is equivalent to collective investment scheme under Securities and Futures Ordinance) in Hong Kong regardless of their place of domicile (i.e. onshore or offshore) and legal structure. The definition of fund covers corporations or partnerships whether Hong Kong incorporated / set-up or outside. This is a substantial improvement over the previous tax regime where onshore privately offered funds operating in Hong Kong did not have the tax exemption.

o   Location of central management and control: The location from where the fund is centrally managed and controlled is not a relevant factor for seeking tax benefit under UFE. This means, even when the board meetings and investment decisions are made in Hong Kong the fund can claim tax exemption benefit. This is another change from the previous regime where the tax exemption was not available if the central management and control of the fund was in Hong Kong.

o   Number of investors, their contribution and distribution to sponsor: Only those funds qualify for the tax exemption which have at least 5 investors contributing 90% of the fund’s capital. Further, the distribution to the sponsor and its associates should be limited to 30% of the net proceeds arising from the transactions of the fund.

o   Special Purpose Entities (SPE): SPE owned wholly or partly by a fund for holding private equity investments only through private companies in Specified Securities (as defined in the Ordinance) and its derivates can also take advantage of the UFE to the extend owned by the fund. This means if a SPE’s 40% shares are owned by an eligible fund, then the SPE can also claim tax exemption up to 40% of the profit from transactions in Specified Securities.

·       QUALIFYING TRANSACTIONS: The profit tax exemption would be available when the fund undertakes the following types of transactions.

o   Definition of transaction: the definition of the transactions covers only buying and selling of assets (as defined in the Ordinance). Therefore, the profit tax exemption is available only from buying and selling of these assets.

o   Private Hong Kong company: Another change from the existing tax exemption regime is that investment in private Hong Kong company will qualify for the tax exemption provided the investment is held for no less than 2 years subject to limitation on the investment in immovable property as explained below under anti avoidance provisions.

o   Infrastructure immovable property: The limitation with respect to immovable property does not apply for investment in infrastructure immovable property either directly by the fund or through private company and therefore profit from such investment will qualify for tax exemption.

o   Incidental transaction: Transactions incidental to the qualifying transactions not exceeding 5% of the trading receipts both from the qualifying transaction and incidental transaction.

o   Intermediary: The transaction should be arranged or carried out in Hong Kong by a person licensed by or registered with Securities and Futures Commission (the SFC”).

·       Tainted issue: Under UFE, it is allowed to separate qualifying and non-qualifying transactions and claim tax exemption benefit only on the qualifying transactions. This is a significant change from the OFE regime which denied tax exemption for all the transactions of the fund in case there was any transaction which does not qualify for tax exemption.

ANTI-AVOIDANE PROVISIONS: Some substantial limitation which would deny the tax exemption benefit to fund are as follows.

·       Investment by fund manager and its staff: Investment in the fund by persons who have day-to-day control over the management of the assets of the fund will deny the fund tax exemption benefit. This means a fund manager /staff of the fund manager who also invests in the fund will not be allowed to claim tax exemption benefit for the fund. This is a major drawback because both for hedge and private equity funds it is common for the fund manager to also make investment in the fund. Such an investment by the fund manager is sometime a necessary pre-requisite to attract investors in the fund.

·       Non qualifying transactions:

o   Investment in debt security: As per the transaction definition, only profit derived from trading income is considered a transaction and not the profit derived from holding of the securities. The implication is that the debt funds and income from fixed income securities will not fall within the UFE regime and will therefore have to pay tax.

o   Investment in Hong Kong immovable property:  Investment income from Hong Kong immovable property held either directly or through private company is not tax exempt. However, this limitation of tax exemption for investment in immovable property is relaxed in case the private company holds no more than 10% of its assets in immovable property.

o   Special purpose entity: The exemption from profit tax for the income from investment held through SPE is available only till the time SPE remains a private company or the investment is in unlisted securities. As and when the SPE becomes a public company then the exemption is not available.

·       Excluded entities: business undertakings for general commercial or industrial purposes, group captive funds and employee funds are excluded from the definition of the fund and therefore cannot take advantage of UFE regime.

The benefits of the UFE regime for the fund industry are substantial though some major limitation factors like dis-allowance in case of investment by the fund manager, exclusion of investment in debt securities or debt fund and exclusion if the SPE or the underlying company’s shares are listed do impose substantial unresolved issues for the industry. At the same time, the new substance requirement for fund managers in off-shore jurisdictions like Cayman Islands, BVI and Bermuda may make it practically difficult for fund managers to create substance in off shore jurisdiction by holding investment related board meetings there. So, each fund operator should make a business call whether it is overall beneficial for them to unify and simplify their operations locally.

Create the CAUSE to bring the EFFECT

Theory of Karma is not only a guiding principle to live one’s life by. The theory which teaches to create right CAUSE to bring the desired result (EFFECT) can be applied to our professions too. All it requires is determination, perseverance and hope.

I experienced first-hand the actual proof of this theory of CAUSE AND EFFECT when my friend and I ventured on an unknown path to hike with full hope and determination that we would find our way.

My friend and I decided to hike the hills of North Lantau Island. The hills of Lantau are rugged and harsh and we are occasional hikers for fun.  On the public holiday of Dragon’s Boat Festival, all we wanted was a light hike to use the holiday and do some easy 4 to 5 km shaded walk on a sunny day. We chose Section 11 of Lantau Trail but landed up on the Olympic Trail around 3:00 p.m. After walking down some distance, as per the directions, we came at a point with two paths but no direction. One path was across the circumference of the hill and the other had steps going up. We decided to take the steps up. There were 11 sections of 52 steps each. These steps were along a concrete water drainage but we had no idea what to expect after reaching uphill. Once we climbed all the steps, we came across a sort of dead end, except a narrow pathway going up which appeared to be traversed once in a while and also gave an impression of a dried spring.

We decided to take that pathway. It was a steep climb full of stones, large and small. We could not find anyone going up or down. We had only one water bottle each and had no idea of the steep climb up and the amount of water we would need on the way. However, we kept going with some concerns like where will we reach, how far is the top, can we come down the same way (climbing down will be difficult due to steep slope), need to reach down before dark as it was already around 5:00 p.m. etc. As we continued to move ahead, the climb became increasingly difficult, and we were getting breathless easily, and had to ration our water due to limited supply.  

After some time, we came across a couple climbing down and this assured us that we were not taking a completely unknown path and also that it was possible to climb down. We talked to them to find out where would we reach if we keep on climbing up. Though they knew little English, we were encouraged from whatever little we could understand from them. The important aspect was we became hopeful and this created determination though the climb was very tough.

After a while, we met an Indian couple who were climbing down too.  They told us that they normally do this route. From them we came to know that the top was still about half an hour hike. This helped us to take a decision that we could continue to climb up without worrying about it becoming dark.  Again, our efforts (The CAUSE) created the EFFECT to have hope and determination. By now it was about 5:45 p.m. and we came across few more people who were climbing down. Still not sure when we would reach the top, we were very exhausted; water in our body and the bottle was depleting, and lots of doubts if it is prudent to go on.  

Then a miracle happened. We bumped into an Indian who was actually climbing up in our direction even at that hour, and not going downhill. Obviously, we started to talk to him and were extremely surprised to know that for the last 15 years, he does 35 KM hiking every weekend and this hike was a warm-up for the next morning 35 KM hike.  He very much appreciated our efforts to be on a very tough hike that many people find difficult to do even though he had seen few healthy elderlies on this trail too, which surprised us. He gave us tips to cover our heads, continue to sip water and not to put steps very hard. He agreed to guide us down through the other side of the hill (by slowing down his speed) and also offered to show us one more easy and good hike route once we reach down. He showed us a spring where we could refill our water bottles. Finally, with his direction we came down. We hiked about 15 KM and the 80% of this was climbing up and down.

The point here is that our efforts kept us giving hope and determination to complete the hike with support from the universe which came our way since we continued to move, create cause, and take help and support.

But why am I telling this story here? On a blog related with corporate compliance? Because in all spheres of our life it is we the individual who has to create the CAUSE to bring the EFFECT we want to see in our life. The same holds true for our professions too. For instance, in the compliance function we regularly come across situations with no apparent straight forward solution and such situations require a judgement call. How to make a judgement call in such situations? For this, it is necessary to dig and seek more and more information on the facts of the case and apply the regulatory provisions to these facts to appreciate the possible implications. This invariably leads to finding possible solutions which balances and minimize the risks for the stakeholders. That is, it is necessary to create the CAUSE to come up with an effective solution i.e. EFFECT. When proper and effective cause is not created, it leads to unsatisfactory and unconvincing solution, customer dis-satisfaction and weak audit trail i.e. undesirable effect.

Additional Responsibilities of ROOF Fund Managers under FMCC, SFC Hong Kong

The revised Fund Manager Code of Conduct (the “FMCC”) of Hong Kong has made a non-statutory distinction between those fund managers who are responsible for overall operations of a fund (the “ROOF”) and other fund managers. Hong Kong based fund managers are likely to fall in the ROOF category. In this note, the additional obligations imposed on fund managers who fall in ROOF category are highlighted.

1.     Disclosures: ROOF fund managers have substantial additional disclosure obligations as listed below towards the investors on various parameters related with the management of the fund.

a.     Leverage: To disclose to the investors the expected maximum level of leverage which a fund manager can employ on behalf of the fund and the basis of calculation of the leverage which should be reasonable and prudent.

b.     Securities lending: To disclose the fund’s policy on securities lending, repo and reverse repo transactions, and risk management policy. The fund manager is also required to disclose the details of such transactions to the investors. Both the disclosure shall be made at least once in a year.

c.     Liquidity management: To disclose the liquidity management policy, the liquidity risk of the fund, and explanation of any tools or exceptional measures which could affect redemption rights of investors.

d.     Termination: When a fund manger decides to terminate a fund, then the fund manager shall disclose to the investors all material information in relation to the termination of the fund in an appropriate and timely manner.

e.     Custody: The fund manager is also required to disclose to the investors the details of the custody arrangement for the assets of the fund, the material risks associated with the custody arrangement and update on any significant changes.

f.      Audit report: The fund manager shall provide the annual auditor report of the fund to the investor on request of the investor.

g.      Side pockets: The fund manager is obligated to provide full information about side pockets including the categorisation, policy and rationale for investment in side pockets to the investors. The information should cover side pockets limits; fee structure and charging mechanism; differentiation in the redemption lock-up period from the ordinary units; etc.

h.      Information on the fund manager: The fund manager shall also disclose adequate  information about itself including business address, relevant conditions and restrictions of its business, and the status and identity of the persons acting on its behalf.

i.       Information on the fund: The fund manager shall also disclose information on the fund that is necessary for the investors to make an informed judgement about their investment in the fund including any change of such information.

j.       Charges: The disclosure of the basis and amount of the fund manager’s fees, and charges shall be disclosed to the investors. When the fund manager is acting as principal then the mark-ups for such transactions and the circumstances under which transactions are done shall also be disclosed.

2.       Liquidity management

a.         The ROOF fund manager shall have appropriate and effective liquidity management policy to monitor the liquidity risk of the fund.

3.       Termination

a.       The decision of a ROOF fund manager to terminate a fund should take in account the best interest of the investors in the fund.

4.       Custody

a.       A ROOF fund manager shall select and arrange to appoint a functionally independent and properly qualified custodian for keeping the fund assets. Self-custody is allowed provided the custodial functions are independent from the person’s fulfilling fund’s management functions.

b.       A ROOF fund manager shall ensure continued suitability and financial standing of the custodian.

c.       A formal custody agreement shall be executed detailing various duties and responsibilities of the custodian.

5.       Appointment of auditor

a.       An independent auditor shall be appointed to audit the financial statements of the fund and at the minimum an annual auditor report shall be provided by the auditor.

6.       Fund portfolio valuation

a.       Details with respect to the valuation requirement have been discussed in one of the previous note on the subject.  

7.       NAV calculation and pricing

a.       To ensure that the NAV calculation is done in accordance with the constitutive documents of the fund and the valuation policies and procedures thereof.

b.      The policies should be designed to detect any pricing errors and to compensate the investors for any material pricing errors.

8.       List of Policies and Procedures

a.       A ROOF fund manager shall maintain a list of policies and procedures for its fund management functions.

Overall, the FMCC puts obligations on a ROOF fund manager to maintain relevant policies, to disclose policies and other information about the operations of the fund to the investors and to ensure that the fund’s business is carried out in compliance with the relevant policies. Any operational deviation from the policies of the ROOF fund manager is likely to be viewed seriously by SFC.

Fund Manager Code of Conduct, Hong Kong and Valuation of fund assets

Managers of collective investment schemes and of discretionary accounts have to implement provisions related with valuation of fund assets as provided in the revised Fund Manager Code of Conduct (the “FMCC”) w.e.f. 17 November 2018 as part of their compliance journey and to monitor its compliance. In this regard, the step by step action to be taken by managers to keep themselves in compliance with the applicable provisions of FMCC are discussed below.

1.       Maintain and implement valuation policies, procedures and processes (the “Valuation Policy”)

a.       Mandatory to maintain a documented Valuation Policy

b.       The Valuation Policy should also cover the exception circumstances when price override or deviation can be done

c.       To ensure proper and independent valuation of the fund assets are performed

d.       The valuation is consistently applied to similar type of fund assets as per the Valuation Policy

2.       Considerations for drafting the Valuation Policy:

a.       The Valuation Policy has to be consistent with the requirement of section 5.3.1 to 5.3.7 of the FMCC

b.       Applicable accepted accounting principles as well as best industry standards and practices for valuing fund assets and follow the general principles as laid out in section 5.3.6 of the FMCC unless otherwise specified in the constitutive documents of the fund

c.       Ensure that the fund’s documentation on valuation is consistent with the Valuation Policy

3.       Periodicity of valuation must be appropriate for the fund assets and be aligned with the dealing frequency and timelines.

4.       Disclose the frequency of valuation and dealing and basis valuation to the investors in the fund.

5.       Independent review of Valuation Policy

a.       The Valuation Policy has to be reviewed by a functionally independent third party. Independent director and internal audit can be considered to be functionally independent third party

b.       The review must be done periodically but at least annually

c.       The first independent review must be completed before the anniversary of the implementation of FMCC

d.       Effectiveness and consistent application of the valuation policy over a period of time. The review shall specifically focus whether valuation policy appropriately value the assets of the fund as a function of the complexity of the assets held by the fund. This is a very critical area of focus and is also likely to invite the attention of the regulator.

6.       Outsourcing the valuation services to third parties, the manager has to ensure the suitability of the service provider, adherence to the manager’s valuation policy and manager continues to remain responsible for the valuation of the fund’s assets.