Will open-ended fund companies (OFCs) serve as an option for Hong Kong-based hedge fund managers?

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1 Will open-ended fund companies (OFCs) serve as an option for Hong Kong-based hedge fund managers? The better the question. The better the answer. The better the world works.

2 The Securities and Futures Commission (SFC), which has been working closely with the Government of Hong Kong to establish the legal and regulatory framework for a new OFC structure, announced the implementation of the new OFC regime on 30 July The OFC regime will allow funds to be set up in an open-ended structure like a company, but with the flexibility to create and cancel shares in order to meet shareholder subscription and redemption requests, unlike conventional companies under the Companies Ordinance. This means that investment funds can now be established in corporate form with limited liabilities in Hong Kong and privately offered OFCs can enjoy profits tax exemption under the Inland Revenue Ordinance (IRO), if certain conditions are met. This may provide an alternative option for Hong Kong-based hedge fund managers who generally establish investment funds in the form of offshore limited liability companies, typically domiciled in the Cayman Islands. To seriously contemplate this alternative setup, it is important to understand two key aspects of the OFC regime, namely the structural requirements and the tax exemption regime. In addition, it is also important to take into account any upcoming regulatory developments relating to offshore fund taxation. What are the requirements? What is the tax exemption regime? What are the new regulatory developments? Is this what clients prefer? Will it lead to cost benefits? 2

3 Structural and governance issues Private OFC structure Features A private OFC is an open-ended collective investment scheme (CIS) not offered to the retail public, which is in corporate form with limited liabilities and variable share capital. An OFC is governed by a board of directors with investment management functions fully delegated to an investment manager licensed by the SFC. An OFC must appoint a custodian to ensure safekeeping of the OFC s assets. An OFC may have an umbrella fund structure with segregated liability between its sub-funds and can issue more than one class of shares. An OFC must be registered with the SFC and incorporated with the Companies Registry (CR). A private OFC will benefit from profits tax exemption when certain requirements are met. Professional investors only Open-ended CIS Variable share capital At least two directors Type 9 investment manager Corporate form Umbrella structure Profits tax exemptions subject to conditions Different classes of shares SFCapproved custodian Key operators Appoint Board of directors Delegate investment management function Appoint OFC Manage investments Investment manager Custodian Safekeeping of OFC s assets through custodian Assets Will open-ended fund companies (OFCs) serve as an option for Hong Kong-based hedge fund managers? 3

4 The board of directors The OFC Board of directors is subject to statutory and fiduciary duties. The OFC Board will have an overall duty to oversee the operations of the OFC, including the activities of the investment manager and custodian. The OFC must have at least two directors on its board. One of the directors must be an independent director who must not be a director or employee of the custodian. Directors profiles must be submitted to the SFC to ensure that they have the relevant qualifications and experience appropriate for the purpose of carrying out the business of the OFC. In addition, they must be of good repute and should not have any undischarged bankruptcy issues. Besides, they must not have been involved in any regulatory breaches or fraud. Non-Hong Kong residents can be appointed as directors, if they meet the above criteria, but they must appoint process agents. Investment manager The day-to-day management and investment functions of the OFC must at all times be delegated to an investment manager. The investment manager must have a SFC type 9 license, and must carry out its investment functions according to the instrument of incorporation and investment management agreement, including valuation and pricing of the scheme property. The investment manager must ensure compliance with all the applicable SFC codes and guidelines, including the OFC Code and the Fund Manager Code of Conduct. An application must be made to the SFC for the appointment of the investment manager of an OFC. Custodian Both public and private OFCs must appoint a custodian who must protect all the scheme property. Only the following entities are eligible: A bank licensed in Hong Kong A registered trust company, which is a subsidiary of a licensed bank in Hong Kong or of a banking institution incorporated outside Hong Kong, but subject to prudential regulation and supervision acceptable to the SFC A registered trust company approved by the Mandatory Provident Fund Schemes Authority (MPFA) Or A banking institution incorporated outside Hong Kong, but subject to prudential regulation and supervision acceptable to the SFC These are the same requirements for a custodian of a SFC-authorized fund under the Code on Unit Trusts and Mutual Funds. The custodian must also ensure proper segregation of assets and their record keeping, verify ownership of assets, and put in place adequate risk management measures. More importantly, it must be responsible for the appointment and ongoing monitoring of its delegates, such as sub-custodians. There can be delegation of functions, but not the responsibility. A non- Hong Kong-incorporated custodian must appoint a process agent, and the custody arrangements and material risks should be disclosed in the offering documents of the OFC. Process agents A process agent is authorized to accept service of any process or notice required to be served on the nonresident director or non-hong Kong custodian and can be an individual whose usual residential address is in Hong Kong, a registered company, or a firm of solicitors or certified public accountants. Process agents do not diminish the responsibilities of the overseas director or custodian. 4

5 Requirements of a private OFC Investment scope of a private OFC It is mandatory to invest at least 90% of the gross asset value of a private OFC in asset types the management of which constitutes a type 9-regulated activity, as defined under Securities and Futures Ordinance (SFO), and cash, bank deposits, certificates of deposit, foreign currencies and foreign exchange contracts. A private OFC may invest in other asset classes of a value not exceeding a maximum of 10% of the gross asset value of the OFC (10% de minimis limit). In the case of an umbrella OFC, the 10% de minimis limit is applicable to the gross asset value of each sub-fund as well as to the gross asset value of the umbrella OFC as a whole. Name of a private OFC An OFC s name has to be reviewed by the SFC in the context of the specific OFC s investment strategy and objectives. It must end with open-ended fund company or OFC, and state that it is a private OFC. It must not be the same as another existing OFC and must not be misleading or undesirable. Constitutive documents The OFC and relevant key operators shall comply with the instrument of incorporation, and offering documents of the OFC. The template for the instrument of incorporation of a private OFC with the basic mandatory disclosures is available on the SFC website. The instrument of incorporation must be submitted to the SFC at the time of application. The offering document of a private OFC must comply with disclosure requirements in the OFC Code. Examples include: The offering document of a private OFC must be filed with the SFC as soon as possible, following its registration. Flexibility is provided for private OFCs in terms of disclosure of fund operation provisions, including pricing, dealing, issue and redemption of shares, valuation, distribution policy, use of leverage, and fees and charges, which should be clearly set out in either the instrument of incorporation or offering documents as appropriate. Umbrella fund A private OFC can be set up as an umbrella and sub-fund structure with segregated liability between sub-funds. However, the risks, which are more commonly attached to the segregated liability regime, being that foreign courts may not enforce such provisions, are required to be highlighted in the OFC s offering documents. Application process Application submission SFC approval Applicant submits application documents to SFC Applicant pays relevant registration fees SFC issues notice of registration SFC passes documents for incorporation to CR Investment scope and restrictions Features of the OFC Custody arrangements and associated risks Summary of circumstances for termination Circumstances for cessation of office of key operators and removal procedures Statement on the segregated liability between subfunds and warning regarding the enforceability of such segregation in foreign courts for an umbrella OFC CR approval Registration process completed Certificate of Incorporation CR issues Business Registration Certificate Will open-ended fund companies (OFCs) serve as an option for Hong Kong-based hedge fund managers? 5

6 SFC registration Application for both public and private OFCs must be submitted to the SFC. The SFC facilitates a one-stop approach, whereby an applicant submits all the application documents and fees to the SFC. Upon satisfying the registration requirements, the SFC will coordinate with the CR, which then issues the Certificate of Incorporation. Termination process Termination commencement OFC submits a termination proposal OFC submits a solvency statement approved by the board of directors The relevant forms required by the SFC and CR, including application forms, information checklists, instrument of incorporation and the incorporation form, are all available on their websites. For private OFCs, a registration will be granted when all required documents confirming due compliance with applicable requirements are in order. Post registration matters Auditor and financial reports An OFC must appoint an independent auditor and publish an annual report for each financial year to be filed with the SFC. The report should be prepared under the Hong Kong Financial Reporting Standards or International Financial Reporting Standards. An OFC is an investment fund, so a directors report and business review are not required to be included in the annual report. Termination notice to shareholders Application to SFC OFC issues a termination notice to shareholders OFC can no longer accept subscription or market the OFC An application to the SFC made together with the final accounts and declaration of completion of the aforementioned procedures, after realization of assets, settlement of liabilities and distribution The annual reports of an OFC are expected to contain information as set out in the OFC Code, relating to investment portfolio; assets; liabilities; income and expenses of the OFC, such as value of investments, income, expenses, shares in issue, net asset value, distributions and dividends, and any cross sub-fund investments. An auditor s report, which includes the auditor s opinion whether the accounts have been properly prepared in accordance with the relevant constitutive documents and applicable requirements, must be included. Changes to the scheme and instrument of incorporation For a private OFC, material changes to the instrument of incorporation are required to be approved by shareholders and filed with the SFC after shareholders approval. For other changes to the instrument of incorporation, they must be passed by a majority of shareholders or certified by the board of directors to confirm that the nature of the changes fall within the OFC Code requirements while also obtaining a no objection confirmation from the custodian. Cancelation of registration with CR Notification to investors Termination completed Automatic cancelation of incorporation with CR upon cancelation of registration with SFC Written notification sent to investors 6

7 Scheme changes can be effected in accordance with the offering documents and the instrument of incorporation, and reasonable prior notice should be provided to shareholders for material scheme changes. For immaterial scheme change, the board of directors should certify that it is an immaterial change and obtain the custodian s confirmation that it has no objection. However, applications must be made for changes pertaining to the name of any OFC or sub-fund of any OFC, and the appointment of key operators, such as the directors, investment manager and custodian to seek the SFC s approval. A proposal for termination is required to be submitted to SFC. The submission should include a solvency statement, reason for the termination, proposed key procedures for such termination, consequences of such termination and effect on its shareholders. The OFC should conduct the termination in accordance with the instrument of incorporation. After the realization of assets, settlement of liabilities and distribution of proceeds to shareholders, an OFC may make an application to the SFC for cancelation of registration together with the final accounts of the OFC accompanied by the auditor s report, and a declaration signed by the OFC Board and the investment manager. This application is intended to confirm the completion of realization of assets and distribution of proceeds, and that there are no outstanding liabilities. The OFC must issue written notifications to investors prior to and upon cancelation of registration, with the reasons for the termination, key particulars, termination process, impact on shareholders and cancelation of registration. Cancelation of incorporation with CR will take place automatically upon cancelation of registration with SFC. Governance Regulatory framework The legislation for OFCs involves several sections of legislation, including: The Securities and Futures (Amendment) Ordinance 2016, which provides a legal framework for the OFC regime, and empowers the SFC to issue codes and guidelines with regard to the regulation of OFCs (OFC code) The Securities and Futures (OFCs) (Fees) Regulation, which sets out the fees charged by the SFC for privately offered OFCs and by the registrar of companies for all OFCs The Inland Revenue (Amendment) (No.2) Ordinance 2018 (the 2018 Amendment Ordinance), which extends the profits tax exemption to privately offered OFCs Given that OFCs are set up to function as an investment fund vehicle, the SFC is the primary regulator responsible for the registration and regulation of OFCs under the SFO. All OFCs will be required to be registered by the SFC under the SFO, and will be subject to the OFC Rules and OFC Code. The OFC Code contains Section I, which will apply to all OFCs, while Section II will apply only to nonpublic OFCs (private OFCs). The CR is responsible for the incorporation and statutory corporate filings of OFCs, whereas the official receiver is responsible for the winding-up procedures. Tax exemption regime for private OFCs Hong Kong profits tax exemption arrangements for privately offered Hong Kong resident OFCs were originally provided under the 2018 Amendment Ordinance, which was passed into law in March To avail the tax exemption under the 2018 Amendment Ordinance, the OFC has to satisfy certain conditions, including the non-closely held requirement. However, on 7 December 2018, the Government published in the Gazette, the Inland Revenue (Profits Tax Exemption for Funds) (Amendment) Bill 2018 (the bill) to provide profits tax exemption for eligible funds operating in Hong Kong. The Bill, which aims to introduce a unified tax exemption regime for all funds, will repeal the provisions for tax exemption in the 2018 Amendment Ordinance. As such, going forward, the conditions qualifying for tax exemption for privately offered OFCs will be consistent with other funds regardless of their structure. The Bill is proposed to be effective from 1 April For detailed discussion about the Bill, please refer to our tax alert at: ey.com/publication/vwluassets/ey-hk-tax-alert-issue-17- fs/$file/ey-hk-tax-alert-issue-17-fs.pdf The Securities and Futures (OFCs) Rules, which set out detailed statutory requirements concerning an OFC Will open-ended fund companies (OFCs) serve as an option for Hong Kong-based hedge fund managers? 7

8 Contacts Assurance Elliott Shadforth Asia-Pacific WAM Leader Christine Lin Hong Kong WAM Leader Philip Kwong Business Tax Services Paul Ho Charlotte Hui Alpha Tsang Sunny Liu EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Global Limited, each of which is a separate legal entity. Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com EYGM Limited. All Rights Reserved. EYG no Gbl BMC Agency GA ED None In line with EY s commitment to minimize its impact on the environment, this document has been printed on paper with a high recycled content. This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax or other professional advice. Please refer to your advisors for specific advice. ey.com International Tax Services Jacqueline Bennett jacqueline.bennett@hk.ey.com Vanessa Chan Associate vanessa-ps.chan@hk.ey.com Adam Williams adam-b.williams@hk.ey.com Asia-Pacific Regulatory Services Virginia Noronha Executive Director virginia.noronha@hk.ey.com