New profits tax exemption for private funds provides welcome boost to Hong Kong’s fund industry

Darren Bowdern, Malcolm Prebble, Sandy Fung and Johnson Tee

A look at the implications of the profits tax exemption for private funds in Hong Kong

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Darren Bowdern, Malcolm Prebble, Sandy Fung and Johnson Tee


The Inland Revenue (Profits Tax Exemption for Funds) (Amendment) Ordinance 2019 will become effective from 1 April 2019. The new regime contains a new comprehensive exemption from profits tax for private funds operating in Hong Kong.

The new legislation contains two profits tax exemptions, being:

  1. An exemption for funds that meet the prescribed qualifying criteria; and
  2. An exemption for “special purpose entities” established by a qualifying fund

The broad nature of the new exemption will provide opportunities for funds with Hong Kong operations to simplify their current operating protocols and undertake more investment-related activities in Hong Kong. This is a welcome development for the funds industry.

Brief history of Hong Kong tax exemptions for funds

The Revenue (Profits Tax Exemption for Offshore Funds) Ordinance 2006 first introduced a profits tax exemption for offshore funds that satisfied certain qualifying conditions, but the exemption did not cater for the types of investments made by private equity funds. Legislation was enacted in 2015 to extend the exemption to offshore private equity funds. Further legislation was enacted in 2018 to provide profits tax exemption to offshore fund companies (OFCs) incorporated in Hong Kong. The latter exemption was to supplement amendments to the Companies Ordinance to allow the use of OFCs in Hong Kong.

Overall, the then-existing fund exemptions have worked well for some types of funds – particularly hedge funds – operating in Hong Kong. However, the tainting provision in the legislation made many private equity firms reluctant to rely on the tax exemptions in their operating structure planning. As such, the new exemption should be welcomed by industry participants.

The new regime

The need for the comprehensive exemption has arisen through both practical and technical difficulties with the key existing profits tax exemptions for funds. The offshore funds exemption (revised in 2015) and the exemption for OFCs (introduced in 2018) had made many funds with investment teams in Hong Kong reluctant to rely on those exemptions.

The objectives of the new legislation are to:

  1. Address some concerns raised by the Organization for Economic Cooperation and Development and the European Union in relation to Hong Kong’s then-existing offshore funds exemption; and
  2. Represent a significant step contributing to the government’s long-stated objective of further developing the asset management industry in Hong Kong. It is also something that should be welcomed by the funds industry, in particular, private equity participants

In addition, the existing exemption for offshore funds continues to apply for any entities that do not satisfy the new qualifying criteria.

Key features of the new exemption

The new exemptions are quite broad and apply to both resident and non-resident funds, transactions undertaken by special purpose entities (SPEs) established by those funds, and most types of investments typically contemplated by private equity or other forms of alternative funds.

The wide range of potential funds that could use the exemption is certainly a positive move, and an improvement on the status quo. The specific inclusion of sovereign wealth funds within the “fund” definition is a good example of this, as is the potential ability for pension funds and other forms of single investor funds to rely on the exemption.

However, as is noted below, further clarity is needed on the ability of the latter to categories to qualify as a “fund.”

Welcomed developments

The broad nature of the new exemption will likely provide opportunities for funds with operations in Hong Kong to simplify their current operating protocols and undertake more investment-related activities in Hong Kong. This is clearly a positive move and is something that the fund industry has been seeking for some time. It should also make it much easier for funds looking to establish new operations in Hong Kong. There are also potential opportunities for funds to invest in new classes of assets in Hong Kong (e.g. infrastructure assets) without the risk of additional tax on the investment returns received by the fund.

Another welcomed feature of the new funds exemption regime is the removal of the tainting provisions from the previous legislation. Accordingly, if a fund makes an investment that does not satisfy the qualifying conditions, it will no longer preclude the fund from relying on the exemption for all other investments. This is a big step forward and should allow fund organizations to rely on the exemption even though they make insignificant non-qualifying investment. This feature would provide comfort to the fund organizations to bring more of their key investment management activities onshore.

It had been proposed, before the amendment bill was introduced, in a consultation initiated by the Financial Services and the Treasury Bureau that the then-existing non-resident person’s exemption would be repealed in the new legislation. However, instead of repealing the exemption, the new legislation combined the exemptions for non-resident persons (including offshore funds) with an exemption for OFCs incorporated in Hong Kong. This is a welcomed development as there was real concern about the impact on the wider wealth management industry from a proposed repeal of the exemption for non-resident persons.

Remaining areas for improvement

While overall, the new exemption is a significant step forward, there are a number of issues that should be addressed to ensure that funds can obtain sufficient comfort to place reliance on it. Some of these issues are not new and unfortunately, were not addressed in the final legislation. Past experience suggests that governance procedures adopted by medium- and large-sized funds (i.e. the types of funds that the government would like to attract to Hong Kong), will place greater emphasis on the legislative wording than interpretive guidance issued by tax authorities, particularly if the guidance does not clearly address their specific concerns. Examples of some of the areas of uncertainty include:

  • The SPE can only hold and administer investments in private companies. Therefore, the status of listed security investments held by an SPE of a fund is unclear. For example, if a private equity fund makes a range of listed and non-listed investments and uses SPEs to hold those investments, the SPE exemption would appear not to apply to the listed investments. However, the listed securities should be exempt if held directly by the fund, but legal and other non-tax considerations would often preclude this.
  • There does not appear to be any clear policy reason why listed investments or other non-corporate investments (e.g. partnership, trusts) should not be covered by the SPE exemption. While deliberating over the legislation, the government provided a written response that investments in a partnership or a trust qualifies as specified transactions as these are collective investments schemes. Nevertheless, the final legislation was not updated to reflect this, and may only be addressed through guidance (note, this is an example of an issue where funds are unlikely to be able to place reliance on guidance that is not consistent with the content of the legislation).
  • Both the fund exemption and SPE exemption are subject to carve outs in relation to investments held for less than two years. For any such investments, the exemption does not apply where the fund or SPE has control over a portfolio company and that company has (directly or indirectly) “short term assets,” the value of which exceeds 50 percent of the value of that company’s total assets.
  • The definition of “short term assets” is quite broad and could inadvertently capture a portfolio company of a fund with trading stock or other trading assets that represent more than 50 percent of the total value of that portfolio company regardless as to the location of that business or those assets. It is unclear what arrangements these provisions are trying to address, but at a minimum, it should be limited to portfolio companies with assets in Hong Kong and not global assets.
  • The legislation specifically mentions that sovereign wealth funds can qualify as “funds” for the purposes of the new exemption. However, it is less clear on the status of pension plans or other single investor investment vehicles. It appears that the intention is that the exemption should cover these types of investment vehicles, and this has been clarified by the Hong Kong government through a written response to submission to the Bills Committee. The Inland Revenue Department should address this through its guidance notes.

Conclusions and proposed action items for the government

The introduction of the new funds exemption represents a positive step forward for the government’s efforts to promote the asset management activity in Hong Kong.

At first glance, the new funds exemption for private funds appears to be something that private equity funds with operations in Hong Kong could look to place reliance upon. This should help to alleviate the need for such funds to follow detailed operating protocols and structure investments in such a way that they would not expose the fund to Hong Kong tax. This should help to place Hong Kong on a level playing field with other fund centres which provide clear and comprehensive tax exemptions for funds with operations in those locations.

However, there are still some areas where the draft legislation could be improved, and we hope that the government is willing to address those areas in the guidance notes to the legislation. There is no doubt that doing so will help with the government’s stated goal of promoting the asset management industry in Hong Kong.

Our observation has been that interest in OFCs for private funds has been very limited to date, due to both the burden associated with obtaining the required regulatory approvals and some onerous aspects of the profits tax exemption for OFCs. The new legislation repeals in full the OFC profits tax exemption and incorporates OFCs into the new comprehensive private fund tax exemption. In doing so, the onerous qualifying conditions for the OFC tax exemption have fallen away, which is a positive move. However, the regulatory aspects may still continue to limit the use of OFCs in practice.

A further welcomed move is that the initial proposal to codify the taxation (or at least partial taxation) in Hong Kong of carried interest has not been included in the draft legislation. Similar provisions where included in the legislation enacted earlier this year to introduce the OFC profit tax exemption and were initially expected to be included in this legislation. Significant lobbying from the private equity industry has taken place in respect of this issue and it is pleasing that the government appears to have taken on board the likely impact that introducing such a change would have had on decisions by private equity funds on establishing and maintaining investment teams in Hong Kong.


Darren Bowdern is Head of Alternative Investments, Hong Kong, Malcolm Prebble is Tax Partner of Alternative Investments, Sandy Fung is Tax Partner of Alternative Investments and Johnson Tee is Senior Manager of Corporate Tax Advisory at KPMG

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March 2019 issue
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