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.