Modernizing Hong Kong’s Private Equity Funds' Regime

The past 12 months have seen some encouraging developments as Hong Kong seeks to grow as a funds management and domiciliation hub.

In the Hong Kong Budget in February, the Financial Secretary announced the Government will examine the feasibility of introducing a limited partnership regime in Hong Kong for private equity funds to facilitate Hong Kong's development into a full-fledged fund service center.

FSTB Consultation Paper

On 4 April, the Hong Kong Financial Services and Treasury Bureau (FSTB) released a consultation paper on the reform of Hong Kong’s Offshore Fund Exemption Regime. In the paper, the FSTB proposed to extend the Offshore Fund Exemption to onshore funds and to remove the limitation on investing in Hong Kong private companies.

These two proposed changes at the fund and investment level would remove limiting features of the current regime and are very welcome provided the stipulated definitions and conditions are workable.

1. At the fund level, the proposal is to introduce an over-arching definition of “fund” covering all types of funds, irrespective of the “central management and control” location by adopting a modified definition of Collective Investment Scheme (CIS) from the Securities & Futures Ordinance. It is essential the definition of CIS be wide enough to encompass all types of funds / arrangements relying on the current regime.  For example, sovereign wealth funds, funds of one and managed accounts should all be able to rely on the exemption provided they are bona fide.
2. The paper also sets out conditions that must be satisfied for a sale of shares in a private company to be exempt. The tax exemption of income and gains from the sale of shares in private companies is fundamental to the utility of the exemption regime for private equity funds. The FSTB proposed two primary tests for the tax exemption, both of which should be satisfied: 

• The 1st test, is that the company should not hold Hong Kong immovable property greater than 10% of the company’s total value; and
• The 2nd test requires the investment be held for 5 years. 

Whilst the limitation on investing in Hong Kong immovable property is expected, the 5 year holding period condition is unlikely to be acceptable to the private equity industry given the normal life of a private equity fund is 8-10 years. 

Realistically, a holding period no longer than 12-24 months would meet industry expectations.

There is also a third test, which may provide an escape if the holding period cannot be met. This condition states that if a fund holds a controlling investment in a private company for less than 5 years, it could still be exempt if the private company does not hold more than 50% of the value of its assets in short-term assets.

The challenge with this condition is that it requires the value of certain assets to be measured and compared at certain points in time which introduces administratively burdensome tracking and hence uncertainty.

Hopefully sense will prevail and the holding period test will be reduced to a more reasonable period and the 3rd test would only need to be relied upon in exceptional cases. 

Tax Exemption for SPVs

The other critical point not explicitly covered in the consultation paper is the inclusion of special purpose vehicle (SPVs) as part of the exemption regime.

The tax exemption of SPVs or sub-holding companies is important for normal fund operations, particularly for private equity funds. For this reason, under the amended regime, tax exemption should also be granted to SPVs, or sub-holding companies, owned by a qualifying fund.

What Next?

 Hong Kong needs a workable onshore funds regime for private equity funds if it is going to remain internationally and regionally competitive as a fund management and domiciliation hub. 

The first step is to make sure the amended profits tax exemption is workable. 

The next step is the introduction of a brand new limited partnership ordinance which is fit for purpose to go hand in hand with the amended profits tax exemption regime.   

Very encouragingly, as foreshadowed by the Financial Secretary, this is now clearly on the Government’s agenda and eagerly awaited by the private equity industry in Hong Kong.

The views expressed in this post are mine and do not necessarily represent EY’s position.