FSDC Paper No. 32 Proposals to Extend Offshore Private Equity Fund Tax Exemption to Hong Kong Businesses July 2017 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 ...... 10 Restriction on investment into Hong Kong private companies .............................. 11 Restrictions on SPV functionality ........................................................................... 13 Considerations for expanding the offshore fund exemption to investment in Hong Kong businesses ...................................................................................................... 14 III. Recommendations / Proposals ............................................................................... 17 Excepted private company (“EPC”) – call for an expanded definition .................. 17 Special purpose vehicle – call for an expanded definition ...................................... 19 Tainting – call for a relaxation ................................................................................ 20 Anti-tax avoidance .................................................................................................. 21 Other comments / considerations ............................................................................ 22 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 2013-14 Budget in November 2013; and (ii) A Paper on the Tax Issues on Open- ended Fund Companies and Profits Tax Exemption for Offshore Private Equity Funds in December 2015. 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 2016. 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 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 non- qualifying 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 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 non- qualifying 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 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 2013-14 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 2015. 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 IRD2 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$784 billion3 and Hong Kong is the preferred centre for the majority of the regional investment and Mainland China US dollar-denominated investment groups. There is some cyclicality to PE fund raising – over a five year period Hong Kong based PE fund investment advisors have accounted for 30% of total Asian PE fund raising4. To provide an idea of the scale of PE fund raising over the last 5 years, it equates to 42% of the capital raised on the Hong Kong Stock Exchange through the initial public offering over this period. 1 http://hong-kong-economy-research.hktdc.com/business-news/article/Hong-Kong-Industry- Profiles/Private-Equity-Industry-in-Hong-Kong/hkip/en/1/1X000000/1X003VKV.htm Private Equity Industry in Hong Kong, HKTC, accessed 3 April 2017. 2 IRD’s Departmental Interpretation and Practice Notes (“DIPN”) No. 51 – Profits Tax – Profits Tax Exemption for Offshore Private Equity Funds 3 Asian Venture Capital Journal 4 Private Equity International (“PEI”) 4 Asian PE Fund Raising (US$bn) HKEX IPO v HK PE fundraising (US$bn) 20 40 15 30 10 20 5 10 0 0 2012 2013 2014 2015 2016 2012 2013 2014 2015 2016 Hong Kong Mainland China Rest of Asia Hong Kong PE HKExHKEX IPO IPO Source: PEI Source: PEI & HKEX 9. Tax neutrality in the fund management host jurisdiction is an important consideration for fund