FSDC Paper No. 32. Proposals to Extend Offshore Private Equity Fund Tax Exemption to Hong Kong Businesses

Transcription

1 FSDC Paper No. 32 Proposals to Extend Offshore Private Equity Fund Tax Exemption to Hong Kong Businesses July 2017

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3 Index Executive Summary... 1 I. Background... 4 II. Limitations of the Current Rules on Offshore PE Fund Exemption... 8 Expansion of the offshore fund exemption to non-hong Kong PE investment Restriction on investment into Hong Kong private companies Restrictions on SPV functionality Considerations for expanding the offshore fund exemption to investment in Hong Kong businesses III. Recommendations / Proposals Excepted private company ( EPC ) call for an expanded definition Special purpose vehicle call for an expanded definition Tainting call for a relaxation Anti-tax avoidance Other comments / considerations... 22

4 Executive Summary 1. The Financial Services Development Council ( FSDC ) published papers relating to the private equity ( PE ) fund industry, namely: (i) Synopsis Paper Proposing Tax Exemptions and Anti-avoidance Measures on Private Equity Funds in the Budget in November 2013; and (ii) A Paper on the Tax Issues on Openended Fund Companies and Profits Tax Exemption for Offshore Private Equity Funds in December The Inland Revenue (Amendment) Ordinance 2015 (the Amendment Ordinance ) to amend Hong Kong s tax law to attract more PE funds to be managed in Hong Kong was enacted in July 2015 (the Offshore PE Fund Tax Exemption ) and the Inland Revenue Department ( IRD ) s Departmental Interpretation and Practice Notes No. 51 was published in May While the new tax exemption was initially welcomed by the PE industry, there has been no noticeable increase in the number of offshore PE funds managed in Hong Kong. 2. The FSDC reckons that this was due to the practical limitations of the current rules on the Offshore PE Fund Tax Exemption. Tax harmonisation could indeed be helpful in boosting the development of the relevant industry. With this in mind, this paper sets out these limitations, and the FSDC s recommendations to extend the Offshore PE Fund Tax Exemption to certain Hong Kong portfolio companies in order to boost the development of the industry. 3. In July 2015, the offshore funds tax exemption was extended to PE funds. Specifically, extending the scope to investments by offshore funds into offshore private companies as well as certain Hong Kong and non-hong Kong incorporated special purpose vehicles ( SPVs ) used by PE funds to hold offshore private companies. The conditions for the offshore funds tax exemption were also amended so that PE funds managed by fund managers that are not required to obtain a licence from the Securities and Futures Commission in Hong Kong could also qualify. 4. Despite this, the Offshore PE Fund Tax Exemption has some major limitations, the key two being: 1

5 a. Its restriction on investment into Hong Kong private companies the Offshore PE Fund Tax Exemption does not apply to investments in Hong Kong private companies and non-hong Kong private companies with substantial operations in Hong Kong, or which hold substantial Hong Kong real estate. Moreover, a single nonqualifying investment could taint the entire fund and disqualify the fund from being exempt. It is the Hong Kong SAR Government s policy to develop areas such as innovation and high-tech industries. It is therefore important to encourage investments and business especially for our home grown local companies and start-ups. To do this, these businesses should be on a level playing field as non- Hong Kong private companies, and get funding from offshore PE funds. b. Its restriction on SPV functionality the functions of an SPV are limited to holding (directly or indirectly) and administering one or more eligible offshore private companies, or another SPV. However, SPVs cannot undertake any other management activities except for the purpose of holding and administering one or more eligible offshore private company. 5. In order for Hong Kong to reinforce its role as Asia s leading asset management centre, the FSDC recommends that the Offshore PE Fund Tax Exemption should be enhanced to make it more business-friendly and conducive to the PE and venture capital funds industry. Particularly, it should not discourage investments in Hong Kong portfolio companies and should place Hong Kong and non-hong Kong investments on a level playing field to qualify for the PE fund tax exemption. In light of the above, the FSDC proposes the following: a. Extend the Offshore PE Fund Tax Exemption to cover investment in Hong Kong private companies and non-hong Kong private companies with substantial operations in Hong Kong, with the exception of those holding substantial Hong Kong residential properties; 2

6 b. Remove the provision relating to tainting such that an offshore PE fund investing in a non-qualifying investment would only be subject to tax in respect of the investment income derived from such nonqualifying investment, to the extent such investment income are Hong Kong sourced revenue gains; c. Introduce a provision to treat any gains derived from the disposal of a non-qualifying investment mentioned in paragraph 5(b) above as capital in nature if such an investment has been held for more than 2 years; and d. Expand the scope of allowable activities of an SPV. The above proposed changes should make our PE fund tax exemption regime more attractive and in line with the Government s policy to promote new business start-ups in Hong Kong. Therefore this would assist the growth and development of Hong Kong private companies some of which may function as head office of the regional business. As a result, the proposed changes would make the regime more attractive than Singapore and increase the competitiveness of Hong Kong as an asset management hub. 6. The FSDC considers there are adequate measures in the current tax law to prevent anti-avoidance and abuse of the recommendations / proposals, providing sufficient and effective safeguards. The FSDC urges the Government to consider the recommendations / proposals in light of the international environment. Changes to and certainty in the Hong Kong s tax rules are needed in order for Hong Kong to retain its position as the largest international PE centre in Asia. 3

7 I. Background 7. Hong Kong is currently the largest international PE centre in Asia. 1 The Government has taken bold and deliberate steps over the past few years to align Hong Kong s tax regime against this landscape. Following the Budget announcement to amend and extend the offshore funds tax exemption to PE funds in order to attract more PE funds to be managed in Hong Kong, the Inland Revenue (Amendment) Ordinance 2015 was enacted in July 2015 with retrospective effect from 1 April The Amendment Ordinance was, in principle, welcomed by the PE industry. However, when it comes to implementation in practice, the restrictions set forth by the IRD 2 on the operation of the Amendment Ordinance limit the ability of offshore funds to fully take advantage of the Offshore PE Fund Tax Exemption, and hence the exemption is yet to fulfil its intended purpose. After almost two years since the enactment of the Amendment Ordinance, there has been no meaningful increase in the number of PE funds managed from Hong Kong. 8. PE is an important sector of the global fund management industry. In Asia, the total Assets under Management of the PE industry is US$784 billion 3 and Hong Kong is the preferred centre for the majority of the regional investment and Mainland China US dollar-denominated investment groups. There is some cyclicality to PE fund raising over a five year period Hong Kong based PE fund investment advisors have accounted for 30% of total Asian PE fund raising 4. To provide an idea of the scale of PE fund raising over the last 5 years, it equates to 42% of the capital raised on the Hong Kong Stock Exchange through the initial public offering over this period Profiles/Private-Equity-Industry-in-Hong-Kong/hkip/en/1/1X000000/1X003VKV.htm Private Equity Industry in Hong Kong, HKTC, accessed 3 April IRD s Departmental Interpretation and Practice Notes ( DIPN ) No. 51 Profits Tax Profits Tax Exemption for Offshore Private Equity Funds Asian Venture Capital Journal Private Equity International ( PEI ) 4

8 Asian PE Fund Raising (US$bn) HKEX IPO v HK PE fundraising (US$bn) Hong Kong Mainland China Rest of Asia Source: PEI Hong Kong PE HKEx HKEX IPO IPO Source: PEI & HKEX 9. Tax neutrality in the fund management host jurisdiction is an important consideration for fund managers when they choose a jurisdiction to undertake fund management activities. Therefore, attracting PE funds requires a host jurisdiction to implement tax regulations, whether it be through tax incentives or otherwise, to ensure such tax neutrality can be achieved in practice with certainty, maximum flexibility and minimum risk. Tax incentives introduced by the Government in the past decade for a number of other industry segments have achieved remarkable success. 10. One representative example was the removal of all duty-related customs and administrative controls on wine trading in February Hong Kong s wine imports surged 80% in the following year with 850 new wine-related operators set up between 2008 and 2009, bringing the total number to 3,550. The wine sector recorded HK$5.5 billion incremental revenue in 2009, representing an increase of over 30% compared with the previous year, while the number of employees engaged in wine-related business increased by more than 5,000 to around 40,000 by the end of Such positive development in the sector would not have been possible without the Government s attempt to create a favourable operating environment to attract international and domestic businesses to establish their operations in Hong Kong. 5 Statistics from the Commerce and Economic Development Bureau of the HKSAR Government. 5

9 11. Another example was the abolition of estate duty in February 2006, with the objective to further developing Hong Kong as a leading private wealth management centre in the Asia-Pacific Region. Immediately following the abolition of estate duty, Hong Kong s private wealth management business grew 58% in 2006 to reach HK$1,967 billion. Further, the sector grew to a new high of HK$4,775 billion in 2015, representing a growth of 2.8 times since The abolition of estate duty was one of the major factors driving the growth of Hong Kong s private wealth sector especially from investors in Mainland China and other Asian countries. 12. Apart from addressing the deficiencies of the Amendment Ordinance (which will be elaborated in greater detail in the next section), the PE industry continues to evolve. Since the enactment of the Amendment Ordinance, there has been an increased focus on and interest in venture capital investments around the world. Such venture capital investments mainly target start-ups and businesses in the high technology industry. In order for Hong Kong to reinforce its role as the region s leading asset management centre, the Amendment Ordinance should be further refined to reflect such developments including in the venture capital sector, to stay competitive and remain relevant. 13. With this in mind, the FSDC conducted a study on the current Hong Kong tax rules / requirements applicable to the PE industry and saw, among others, real merit to extending the Offshore PE Fund Tax Exemption to certain Hong Kong portfolio companies. To facilitate the Government and the relevant tax authorities to consider extending the scope of the Offshore PE Fund Tax Exemption, the FSDC sets 6 Fund Management Activities Surveys , published by the Securities and Futures Commission. 6

10 out a number of proposals / recommendations, with reference also to the position of seven overseas jurisdictions. The jurisdictions studied include Australia, India, New Zealand, Singapore, Sweden, the United Kingdom and the United States. 14. As an overarching theme, achieving tax certainty is crucial for PE fund sponsors and managers. 7

11 II. Limitations of the Current Rules on Offshore PE Fund Exemption 15. PE funds are established investment vehicles for investors to contribute capital for investing into (typically) a blind pool of designated investments. One of the principal objectives of a PE fund from a tax perspective, as well as the expectation of investors, is that the fund itself should be treated as a tax neutral vehicle so that the investors in the fund are treated in the same manner as if they had invested directly in the underlying investment. 16. Funds may be subject to tax on gains made in the jurisdictions in which they invest or on distributions to investors in their home country, but there should be no further tax on such gains or profits at the fund level itself. Ultimately, if there is no tax neutrality at the fund level, investors will be dissuaded from investing into the fund due to the additional frictional tax costs of doing so which would erode their post tax returns. 17. Many jurisdictions have specific tax rules to ensure that the fund vehicle is tax neutral, either by treating the fund as tax transparent or by granting tax exemption to the fund vehicle. For PE fund managers and advisors in Asia, most funds they serve are domiciled in the Cayman Islands; however, Singapore has recently established a range of incentives to encourage funds to be managed from or domiciled in Singapore. 7 Hong Kong first introduced a specific tax exemption for offshore funds in March 2006, which operated to exempt offshore funds that were managed from Hong Kong from profits tax provided qualifying conditions were satisfied. The exemption broadly applied to non-resident funds that were managed through a licensed person in Hong Kong in respect of a wide range of eligible securities In December 2015, the FSDC published a report titled A Paper on Limited Partnership for Private Equity Funds, with a view to developing Hong Kong as an onshore hub for PE funds, amongst other objectives. The Revenue (Profits Tax Exemption for Offshore Funds) Ordinance 2006, hereafter referred to as the 2006 Ordinance. 8

12 18. Although the 2006 Ordinance works reasonably well for the hedge fund industry that typically invests in publicly traded securities, 9 it did not work well for PE funds. For the PE industry, the 2006 Ordinance was deficient in that it did not apply to investments in private companies or to debt investments issued by such private companies because the definition of securities specifically excluded securities of a private company. Further, if a fund invested into a non-qualifying investment such as a private company, the fund would lose its tax exemption on all of its investments thereby exposing the entire fund to direct taxation in Hong Kong. This is because the offshore funds tax exemption was drafted in such a way that the exemption was only available to a fund if the fund did not carry on any other business in Hong Kong other than specified transactions and transactions incidental to the carrying out of specified transactions. 19. As the 2006 Ordinance did not apply to investments in private companies, many PE funds operating in Hong Kong were unable to make use of that exemption to ensure that the fund was not exposed to direct taxation. Instead, they operated under a model whereby the fund management functions were performed outside of Hong Kong in order to fall outside the general profits tax charging provisions under the Inland Revenue Ordinance ( IRO ). This effectively reduced the functions, assets and risks that an offshore fund could localise in Hong Kong and therefore reduced the scale of investment management services that could be provided from Hong Kong. 20. In contrast, Hong Kong s closest competitor in the region, Singapore, recognised the importance of providing a tax exemption for PE funds and introduced a number of tax and regulatory incentives to attract and facilitate PE funds to Singapore. Currently, funds that are managed or advised by a fund management company in Singapore can obtain tax exempt status in Singapore under one of three 9 The FSDC notes, however, the 2006 Ordinance also presents limitations for the hedge fund industry. In particular, credit funds that invest in debt securities and earn interest income cannot fully benefit from the offshore funds tax exemption under the 2006 Ordinance given that the IRD in DIPN No. 43 has made it clear their position that interest can only be considered as derived from an incidental transaction and not a specified transaction. 9

13 tax incentive schemes. 10 The exemptions apply to allow either an offshore or Singapore domiciled fund to benefit from a tax exemption. 21. Singapore is fast becoming a popular Asian asset management centre; Singapore s tax exemption for funds, robust regulatory framework, availability of professional services, functionality as a platform to ASEAN countries and its Double Taxation Agreement network have collectively made Singapore a formidable competitor to Hong Kong as a leading PE centre in Asia. 22. In light of the developments in Singapore there is an urgent need for Hong Kong to improve its taxation framework for the PE industry, something which is recognised by the asset management industry of Hong Kong. Indeed, the PE industry associations advocated the need for legislative change to extend the 2006 Ordinance to private companies so as to maintain Hong Kong s competiveness as a key regional PE centre. 23. Extending the exemption to private companies would lead to an increase in the market presence of offshore PE fund managers in Hong Kong, thereby benefiting Hong Kong through the allocation of capital to Hong Kong businesses, which would ultimately increase demand for financial services professionals and related services in Hong Kong. The Hong Kong Government would in turn benefit from increased tax revenue from the economic activity generated from these businesses. Expansion of the offshore fund exemption to non-hong Kong PE investment 24. In 2013, the Hong Kong Government formally announced that it would expand the scope of the 2006 Ordinance to the PE industry in the Financial Secretary s 2013/14 Budget speech. The following year, the Financial Secretary reported that industry consultation for extending the tax exemption for offshore funds to facilitate PE investment into non-hong Kong incorporated private companies had 10 Sections 13CA (offshore funds), 13R (Singapore funds) and 13X (Singapore or offshore funds) of the Singapore Income Tax Act. 10

14 been completed. Draft legislation was introduced on 20 March 2015, which was subsequently gazetted on 17 July 2015 with retrospective effect from 1 April The Offshore PE Fund Tax Exemption covers investments by nonresident funds into non-hong Kong incorporated private companies (but critically not Hong Kong incorporated private companies) as well as certain Hong Kong and non- Hong Kong incorporated SPVs or qualifying SPVs used by PE funds to hold offshore investments. Further, the conditions to qualify for the exemption were also helpfully amended so that those PE funds that may not have needed a license from the Securities and Futures Commission in Hong Kong could also qualify for the Offshore PE Fund Exemption under an alternative qualifying fund test which requires the non-resident fund, among others, to have a certain minimum number of investors. 26. The Offshore PE Fund Tax Exemption was initially well received by the industry. It was an important development in the industry that enabled PE funds that invest predominantly in private companies to potentially make use of the offshore funds tax exemption to ensure that PE funds were treated as tax neutral vehicles. This should have cemented Hong Kong s status as a leading global PE centre. However, the Offshore PE Fund Tax Exemption has significant limitations, particularly in respect of its prohibition on investing into Hong Kong private companies and the narrow scope of activities an SPV could undertake. These limitations severely restrict the usefulness of the exemption for PE funds. Restriction on investment into Hong Kong private companies 27. First, the Offshore PE Fund Tax Exemption currently does not allow PE funds to invest into Hong Kong private companies, except in very limited circumstances where the indirect investment into a Hong Kong business falls under a de minimis threshold. Offshore PE funds that invest into non-hong Kong incorporated private companies that directly or indirectly hold Hong Kong assets in excess of a 10% de minimis value threshold will not qualify for the Offshore PE Fund 11 Inland Revenue (Amendment) (No.2) Ordinance 2015; sections 20AC and 20ACA of the IRO. 11

15 Tax Exemption. 12 Moreover, based on the IRD s interpretation, 13 a single nonqualifying investment could taint the entire fund and disqualify the fund as a whole from qualifying under the Offshore PE Fund Tax Exemption. This makes the Offshore PE Fund Tax Exemption unworkable in practice for funds with any sort of Greater China investment focus. 28. Given the role PE funds play in raising, and deploying, the much needed capital to businesses, particularly (but not limited to) start-ups and those in the high technology industry (i.e. the venture capital), the Offshore PE Fund Tax Exemption needs to be further extended to allow for investing into privately held companies in Hong Kong except those holding residential properties in Hong Kong. In this regard, PE funds should be able to invest into private companies regardless of where they are incorporated and where they undertake business. It is worth noting that investments into listed Hong Kong companies, which may carry out business activities in Hong Kong, are eligible for tax exemptions under the 2006 Ordinance, whereas investments into a privately held business in Hong Kong are not. The FSDC understands the Government s concerns over the real estate market in Hong Kong, especially the residential property market. In order not to conflict with any policy objectives, the FSDC suggests excluding Hong Kong residential properties from the extension. The FSDC believes that the extension of the Offshore PE Fund Exemption to cover investments in any Hong Kong businesses including start-ups in the high technology industry, infrastructure projects, and commercial properties in Hong Kong should be sufficient for the regime to regain attractiveness and stay competitive The private companies invested into by a PE fund must constitute Excepted Private Companies as defined in section 20ACA of the IRO. The legislation broadly defines Excepted Private Companies as privately held companies incorporated outside of Hong Kong that at all times within 3 years before a transaction in securities of a SPV, or the Excepted Private Company, does not: carry on business in Hong Kong through a permanent establishment, or have an indirect / direct investment in a company that does, or indirect / direct investment in Hong Kong real estate; such investment is permitted to the extent that it does not exceed 10% of the value of the Excepted Private Company s investments (de minimis threshold). Based on the IRD s application of the rules in DIPN No

16 Restrictions on SPV functionality 29. Secondly, the current Offshore PE Fund Tax Exemption rules also place very restrictive conditions on the operations of a qualifying SPV. The functions of an offshore PE fund s Hong Kong or non-hong Kong SPV(s) are limited to holding (directly or indirectly) and administering one or more eligible qualifying investments, or another SPV. However, SPVs cannot undertake any other management activities except for the purpose of holding and administering one or more eligible private companies These restrictions on an SPV s activities introduce unnecessary risk to an offshore PE fund that otherwise makes qualifying investments in non-hong Kong incorporated private companies; they also impose commercial constraints for SPVs whose commercial purposes include the active management of its portfolio investment holdings, as well as functioning as a transferrable investment holding vehicle for potential acquirers. This in turn introduces additional operational complexity. Fund managers need to ensure that detailed technical operational protocols are followed so that an offshore PE fund continues to qualify for the exemption in respect of its investment in a SPV, inclusive of the SPV s investment holdings. 31. The restriction on an SPV's activities also creates a tension with an SPV s ability to qualify as a Hong Kong tax resident for purposes of claiming benefits under a relevant Double Taxation Agreement. One of the main advantages to using Hong Kong SPVs is access to Hong Kong's growing network of Double Taxation Agreements. The IRD assesses the level of substance that an SPV has in Hong Kong in deciding whether a certificate of residence status in Hong Kong, often required to claim benefits under a Double Taxation Agreement, could be issued to an SPV. An SPV can expect to face challenges meeting this standard if by definition it can only engage in holding and administering underlying PE investments. 14 Section 20ACA of the IRO. 13

17 32. The broadening of the functionality of SPVs would make the Offshore PE Fund Tax Exemption more useful and reflect the ordinary commercial operations of typical PE funds, whereby SPVs can undertake more than a mere holding company or administrative function. Further, by easing the conditions for meeting the definition of an SPV under the Offshore PE Fund Tax Exemption, fund managers would be able to enjoy a higher degree of certainty and operational efficiency. Considerations for expanding the offshore fund exemption to investment in Hong Kong businesses 33. From a tax policy design perspective, funds (including PE funds) should operate as tax neutral collective investment vehicles for investors. In this regard, nonresident investors can fall outside the scope of the profits tax charge in Hong Kong on gains made from Hong Kong investments if they undertake their investment management activities outside of Hong Kong. Consequently, there should be no tax distinction between such non-resident direct investors and those that pool their capital through an offshore PE fund. Offshore funds can structure their transactions offshore such that they are not directly taxed on investments into Hong Kong private companies without relying on the Offshore PE Fund Tax Exemption. Clearly, there is no incidence of tax avoidance in either case because it is reasonable for investors to make a commercial decision as to where to carry out their investment management activities and under Hong Kong s territorial system of taxation, a non-resident person is not subject to profits tax if such person does not carry on business in Hong Kong. Moreover, an explicit tax exemption is available under the IRO for dividends paid from Hong Kong companies. 15 Consequently, the extension of the Offshore PE Fund Tax Exemption to Hong Kong private companies would not result in a loss of tax revenue, but rather would align the tax treatment of offshore PE funds with those of non-resident investors, who can already invest directly into both private and listed Hong Kong companies without being subject to profits tax. 34. Ultimately, the Hong Kong Government should not discriminate against investment by an offshore PE fund into Hong Kong private companies vis-à-vis an investment in offshore companies. The current exclusion under the Offshore PE Fund 15 Section 26(a) of the IRO. 14

18 Tax Exemption for investing into Hong Kong private companies adds unnecessary complexity and discourages funding for Hong Kong private companies. Regarding Hong Kong resident investors in an offshore PE fund, the current anti-abuse measures applicable under the current Offshore PE Fund Tax Exemption can continue to apply to prevent round-tripping On the basis of the above, the Offshore PE Fund Tax Exemption should be extended to Hong Kong private companies given it would: Provide an additional source of funding to Hong Kong private companies, and enhance the development of the venture capital industry Traditional means of financing can be difficult to obtain for businesses that do not have constant cash flows, for example, technology and research and development centric companies, which would be highly beneficial to the future growth and development of Hong Kong s economy. The additional funding would complement the existing start-up and local business development initiatives driven by the Hong Kong Government through the various Government Funding Schemes 17 and InvestHK 18. Achieve tax neutrality at a fund level without introducing tax avoidance Non-resident investors and offshore funds can already invest into Hong Kong private companies under the current rules without suffering direct taxation. Any tax avoidance concerns regarding Hong Kong resident investors can be addressed via the existing anti abuse rules under the current Offshore PE Fund Tax Exemption. Simplify the operation of offshore PE funds and provide greater certainty As the rules are currently drafted, a single non-qualifying investment into a Hong Kong private company could lead to the entire offshore PE fund not qualifying for the Offshore PE Fund Tax In the manner set out in sections 20AE and 20AF of the IRO

19 Exemption. Consequently, the fund manager has to constantly manage the risk of tainting the offshore PE fund. The proposed extension of the Offshore PE Fund Tax Exemption would result in operational efficiencies for fund managers and increase certainty as there would be reduced risk of the Offshore PE Fund Tax Exemption being inapplicable due to an inadvertent non-qualifying investment. Not discriminate against investment into Hong Kong private companies by introducing a tax bias Offshore funds can already invest into listed Hong Kong companies under the 2006 Ordinance 19, regardless of whether they carry on business in Hong Kong. In this regard, there does not appear to be any sound policy reason for prohibiting investment into Hong Kong private companies given the potential economic benefits to Hong Kong s economy and there being no facilitation of tax abuse by extending the exemption to Hong Kong private companies. 19 See footnote 8. 16

20 III. Recommendations / Proposals 36. In order for Hong Kong to reinforce its role as Asia s leading asset management centre, the tax law should be further refined to address the limitations highlighted above. The Offshore PE Fund Tax Exemption should be enhanced to make it more business-friendly and conducive to the PE and venture capital funds industry. Particularly, it should not discourage investments in Hong Kong (or onshore ) portfolio companies and should place Hong Kong and non-hong Kong investments on a level setting to qualify for the Offshore PE Fund Tax Exemption. 37. With the above in mind, the FSDC recommends the following proposals to extend the Offshore PE Fund Tax Exemption to Hong Kong portfolio companies, except those holding residential properties in Hong Kong. These proposals take into account certain key overarching principles or elements, which the FSDC considers to be critical in making Hong Kong s Offshore PE Fund Tax Exemption regime more competitive and attractive. The tax exemption should have a wider applicability and be less prescriptive on target investments. It should appeal to a broader investor base, with no (or few) restrictions or limitations to the investments. Excepted private company ( EPC ) call for an expanded definition 38. The tax law, as it currently stands, favours offshore investments, which inhibits the growth of Hong Kong businesses generally. As it is, Hong Kong already lags behind our neighbours in its development in areas such as innovation and the promotion of high-tech industries. It is therefore important to encourage investments and business in those areas, especially for our home grown local companies. To promote investments in Hong Kong and local businesses, the FSDC proposes that the definition of EPC as set out in the existing tax law 20 should be expanded to cover investment in all Hong Kong companies (including Hong Kong incorporated private companies), except those that hold substantial residential properties in Hong Kong. 20 Section 20ACA of the IRO. 17

21 39. The FSDC understands that the original design of the tax exemption is that to qualify, a portfolio company, subject to a de minimis rule, should not hold any share capital in Hong Kong private companies, and non-hong Kong private companies carrying on business in Hong Kong or hold any immovable property in Hong Kong. The aim of such restrictions is to prevent abuse of the exemption by local entities by simply converting their taxable profits or gains in investments in real estate to non-taxable income via an offshore fund structure. However, the FSDC considers such restrictions to discourage PE funds investments in Hong Kong businesses, including start-ups and those in the high technology industry, infrastructure projects and commercial properties that will help create more employment opportunities in Hong Kong. Investments in Hong Kong residential properties are excepted as they are currently subject to the Government s demand-side management measures to cool down the residential property market in Hong Kong. The FSDC believes these changes will make the regime more attractive than Singapore When ascertaining whether or not an EPC holds substantial residential properties in Hong Kong, reference can be made to the 10% de minimis threshold included in the current tax law. However, such threshold should only apply to residential properties in Hong Kong, and should be determined in accordance with the value (of the Hong Kong residential properties) stated in the latest audited financial statements of the EPC The tax exemptions for funds in Singapore cover a list of designated investments. Designated investments do not include, among others, stocks and shares of companies that are in the business of trading or holding of Singapore immovable properties (other than the business of property development). The rationale for this is that a portfolio company may account for its Hong Kong residential properties at historical book value under the Cost Model or at fair value under the Revaluation Model under the Generally Accepted Accounting Principles. Insisting on computing the 10% threshold based on market value in such instance would place undue burden on the investment fund in case the EPC has adopted a Cost Model and would be difficult to comply with in practice. In accordance with Hong Kong Accounting Standards (HKAS) 16 Property, Plant and Equipment, an entity can choose either the Cost Model or the Revaluation Model as its accounting policy and shall apply that policy to an entire class of property, plant and equipment. Under the Cost Model, after recognition as an asset, an item of property, plant and equipment shall be carried at its cost less any accumulated depreciation and any accumulated impairment losses. Under the Revaluation Model, after recognition as an asset, an item of property, plant and equipment whose fair value can be measured reliably shall be carried at a revalued amount, being its fair value at the date of the revaluation less any subsequent accumulated depreciation and subsequent accumulated impairment losses. 18

22 41. The FSDC is of the view that widening the investment scope should not result in any tax leakage or loss of tax revenue to Hong Kong since a Hong Kong portfolio company would be liable to pay Hong Kong profits tax in respect of its Hong Kong sourced profits under the provisions of the IRO anyway. Widening the investment scope would encourage and promote not only investments in local business but more investment managers to base themselves in Hong Kong. Special purpose vehicle call for an expanded definition 42. The definition of SPV should be expanded, and the scope of allowable activities should be made as broad as possible (not limited to holding and administering the EPCs as the IRO currently stands). SPVs should be permitted to undertake more substantive activities, e.g. providing investment management and other related services to or in respect of its portfolio investment holdings without affecting the ability of the offshore PE fund to qualify for the Offshore PE Fund Tax Exemption. Where the activity of an SPV exceeds mere investment holding and administration for example, if the SPV derives income other than income from specified transactions and transactions incidental to the specified transactions, the SPV and the offshore fund should not lose their entitlement to profits tax exemption entirely. Rather, the scope of the profits tax exemption should be limited to the income derived from specified transactions and incidental transactions only. Any other non-qualifying income would then be assessable to profits tax only to the extent chargeable under the provisions of the IRO. 43. If the definition of allowable activities of the SPV is expanded, it would bring inherent benefits to Hong Kong including employment creation opportunities within or supporting the SPVs, which would contribute to the Hong Kong economy. It would also assist the substance test that an SPV has, relevant to deciding the certificate of tax residence status. 19

23 Tainting call for a relaxation 44. Regarding the issue of tainting, the FSDC considers that the current position should be relaxed such that where a portfolio company fails to meet the definition of an EPC (for whatever reason), the PE fund that invests in that portfolio company should be subject to Hong Kong profits tax only on gains derived from the disposal of that portfolio company to the extent such gains are Hong Kong sourced trading receipts. The PE fund should continue to enjoy tax exemption on gains derived from the disposal of other portfolio companies to the extent such other portfolio companies meet and continue to meet the definition of EPC. 45. As an illustration, in Example 1 below, a PE fund holds three investments. Private Company ( PC ) (1) and PC(3) qualify as EPCs, while PC(2) does not meet the definition of EPC because it (as an example) holds residential properties in Hong Kong the value of which exceeds 10% of the value of its own assets. 46. The FSDC recommends that the IRO be revised to include a non-tainting rule and clarify that, in Example 1, the gains derived by the PE fund from the direct or indirect disposal of PC(1) and PC(3) will continue to be eligible for profits tax exemption. Whether or not gains from the direct or indirect disposal of PC(2) would be assessable to Hong Kong profits tax would be subject to the ordinary assessment provisions of the IRO. Example 1: 20

24 47. To further enhance the regime, the FSDC recommends that the IRO be further revised to make provision that where a PE fund invests in a non-epc (i.e. PC(2) in Example 1) but holds the investment for (say) two years or more, any gains derived from the disposal of the investment (i.e. PC(2)) can be considered capital in nature and therefore not subject to Hong Kong profits tax. This provides PE funds with more certainty on the tax liability of their investment activities in Hong Kong, which is an important element for developing a successful and competitive PE environment. The FSDC has noted that Singapore has similar provisions in its tax law. 48. Regarding the two year period stated above, the FSDC suggests that the two year period can be counted from: a. the date of the first funding or the date of the first capital commitment to the investment, whichever is later; or b. the date of each tranche of funding for the investment, whichever is later. Anti-tax avoidance 49. The FSDC understands there may be concerns that the above proposals to extend the Offshore PE Fund Tax Exemption to Hong Kong portfolio companies might lead to potential abuse. However, the FSDC believes that there already exist adequate measures in the current IRO to prevent anti-avoidance and abuse of recommendations / proposals. First, there are deeming provisions under sections 20AE and 20AF of the IRO, which were enacted to prevent abuse, or round-tripping, by resident persons disguised as non-resident persons to take advantage of the tax exemption. Second, where tax avoidance is involved, the Commissioner can consider invoking the general anti-avoidance provisions under section 61A of the IRO as appropriate to counteract the tax benefits obtained. These provisions should already provide sufficient and effective safeguards against any abuse of the PE fund exemption regime or tax avoidance. 21

25 Other comments / considerations 50. The FSDC also notes that jurisdictions like Singapore provide investment funds with certainty of tax incentives as well as of obtaining tax residency certificates. Such certainties in tax and administration have successfully attracted many offshore PE and venture capital funds to Singapore in recent years. Hong Kong should take note of the competitive international environment and strive to continuously improve its tax rules in order to remain its position as the largest international PE centre in Asia. 51. When preparing the recommendations / proposals contained in this paper, the FSDC is also cognisant of the fact that Hong Kong does not wish to be seen internationally (including by the OECD) as a tax harmful jurisdiction. The FSDC believes that these recommendations / proposals would help align the inherent inconsistencies and biases in the current tax position. 22

26 About the Financial Services Development Council The Hong Kong SAR Government announced in January 2013 the establishment of the Financial Services Development Council (FSDC) as a high-level and cross-sector platform to engage the industry and formulate proposals to promote the further development of Hong Kong s financial services industry and map out the strategic direction for development. The FSDC advises the Government on areas related to diversifying the financial services industry, enhancing Hong Kong s position and functions as an international financial centre of our country and in the region, and further consolidating our competitiveness through leveraging the Mainland to become more global. Contact us enquiry@fsdc.org.hk Tel: (852) Website: