Staying agile - an Asset Management perspective

Like many other financial centers, Hong Kong (SAR), China has been impacted by the changing international tax environment over the last ten years. Many of the developments to date have been positive from the perspective of the institutional fund management industry in Hong Kong. However, as the global community looks to push forward with the minimum tax proposals under BEPS 2.0, and as high tax jurisdictions look to increase their tax base to tackle the deficits arising from COVID-19, Hong Kong will have to remain agile to maintain its position.

At the time of the global financial crisis, Hong Kong only had three double tax agreements in place. In those days, exchange of information was regarded by Hong Kong as an invasion of the right to privacy. However, the OECD’s initiative to push for wider exchange of information quickly inspired Hong Kong to change its laws and join the stampede to implement double tax agreements containing information sharing clauses. Hong Kong now has over forty comprehensive double tax agreements covering most of the major jurisdictions in Asia and Europe, and although some important exceptions remain, it has helped to move Hong Kong into the world of holding jurisdictions of use to institutional investors.

The historical legacy of Hong Kong’s system of low and simple taxes remained in place. As the OECD’s agenda shifted to the first stage of BEPS, Hong Kong’s simple, territorial system proved robust against concerns about harmful tax practices. As a matter of course, Hong Kong does not tax dividends, capital gains or offshore profits. Hong Kong also does not impose withholding tax on interest or dividends. So, the fundamental building blocks of a tax efficient holding vehicle were in place without the need for any regimes or hybrid instruments that might be considered harmful. The combination of a benign tax regime and access to tax treaties inspired the use of Hong Kong vehicles as holding companies.

One of the practices the BEPS actions sought to tackle was the granting of treaty benefits in “inappropriate circumstances”, addressed through the multilateral instrument and its principal purpose test or limitation of benefits clause. When a treaty partner has required evidence of an entity’s residence in Hong Kong in order claim treaty benefits, Hong Kong has historically applied a conservative approach, with the Internal Revenue Department (“IRD”) focusing on the substance of individual entities when determining whether to grant tax residence certificates, rather than evaluating the group as a whole. Fortunately, as a leading global financial center, there is no shortage of suitably qualified people here able to perform the necessary roles to establish substance to the Inland Revenue Department. 

The Hong Kong government has recognized the importance of the private equity (PE) industry and has implemented PE-focused initiatives over the last few years.

The most important of these initiatives is the introduction of a specific exemption for certain funds and their Special Purpose Vehicle (SPV) holding companies. The exemption provides for tax-free gains on the disposal of equity investments by either qualifying funds or their qualifying SPVs, provided certain conditions are met. The exemption will apply to vehicles resident in Hong Kong, and the IRD has indicated that it will issue tax residence certificates to Hong Kong resident funds where the regional investment platform is located in Hong Kong.

Although a welcome step, the exemption contains restrictions which reduce its universal appeal. For example, investments in Hong Kong real estate are not included, and the exemption does not apply to credit funds. There are also certain restrictions on the activities of holding companies and the types of entity in which they can invest that may be too restrictive for some investors. Nevertheless, the exemption is an important step in providing flexibility to Hong Kong fund managers.

From a legal perspective, the government has also worked to increase the range of vehicles open to investors. Open ended fund companies were introduced a couple of years ago and the government has just brought forward a new limited partnership fund vehicle. This is important because while historically many institutions maintained a strong investment team presence in Hong Kong, the legal fund structures were offshored for lack of a suitable local alternative. The new vehicle will be exempt from tax and is designed to operate similarly to limited partnerships currently used by funds in other jurisdictions. Further details can be found here.

Finally, the government has also launched a consultation on providing a concessional rate of tax for carried interest. This will hopefully help resolve the uncertainty surrounding the tax treatment of carried interest - whether it is a tax-free return on dividends and capital gains or, as the IRD has claimed, a disguised remuneration for services rendered. The full details of the concession are yet to be determined.

A global minimum tax under Pillar Two of BEPS 2.0 could have substantial tax implications for Hong Kong’s fund industry. The proposals are still being developed, although the OECD has suggested some support for exempting certain institutional investors, in particular sovereign funds and pensions funds, from its remit. It may also be that the nature of certain funds structures will be outside the effective remit of the provisions. Too little is clear to be definitive at this stage, and we will need to stay abreast of developments.

One thing that can be said, though, is that all the financial centers will be affected by the developments, and other commercial factors could play decisive roles in determining where to establish a fund or holding company. Hong Kong remains a viable option as it operates under the common law system, has a strong regulatory system and an open economy. Finally, it is strategically located for many of Asia’s key markets. Hong Kong’s government has shown a strong commitment to maintaining Hong Kong as a fund management center in recent years and a continued focus will be critical in navigating future developments in international tax. Click here to read other articles in this series which look at Abu Dhabi, Ireland and more.