Hong Kong Hedge Edge

Hong Kong Hedge Edge

Julia Charlton, Partner, Charltons, Solicitors Hong Kong and Shanghai
Originally published in the June 2006 issue

Recent changes to Hong Kong’s tax legislation provide an exemption for offshore funds from Hong Kong’s 17.5% profits tax. The aim of the new legislation, according to Hong Kong’s Secretary for Financial Services, Frederick Ma, is to increase Hong Kong’s competitiveness in attracting new offshore funds to come to Hong Kong and to encourage existing funds to continue to invest in Hong Kong. The new legislation puts Hong Kong’s tax treatment of offshore funds on a par with that of other major international financial centres such as London and New York. Significantly, Hong Kong’s tax position is also now more favourable than that of other jurisdictions, notably Singapore, in that the exempt status of an offshore fund in Hong Kong depends solely on the non-resident status of the fund, irrespective of the resident status of its owners. In Singapore, for example, the comparable exemption requires the offshore fund to be at least 80% beneficially owned by non-residents.

Under the new legislation, profits received by an offshore fund entity (which covers individuals, partnerships, corporations and trustees of trust estates) from specified securities trading transactions undertaken in Hong Kong are exempt from profits tax, provided that the offshore fund does not carry on any other business in Hong Kong. The concept of “central management and control” is used to determine whether or not the fund is resident in Hong Kong for the purpose of the exemption. The qualifying transactions are transactions in securities, futures contracts, foreign exchange contracts, foreign currencies and exchange-traded commodities and the making of deposits other than by way of a money-lending business. These activities must also be carried out through a corporation or authorized financial institution licensed or registered, respectively under Hong Kong’s Securities and Futures Ordinance. The exemption applies retrospectively to the year of assessment 1996 to 1997.

Income from transactions which are “incidental” to the carrying out of the exempt transactions is also exempt from profits tax provided that such income does not exceed 5% of the total income earned by the non-resident from the exempt and incidental transactions. The legislation contains anti-avoidance provisions to prevent round-tripping, i.e. resident funds disguised as offshore funds taking advantage of the exemptions. These bring the relevant profits of Hong Kong residents who have a 30% interest in, or are associates of, a tax-exempt offshore fund, back into the Hong Kong tax net.

Another initiative to facilitate the further development of Hong Kong as a leading asset management centre in Asia was the abolition of estate duty with effect from 11 February, 2006. The prime objective behind the abolition was to encourage more local and overseas investors to hold assets in Hong Kong. Prior to the abolition, estates worth HK$7.5 million or above were subject to estate duty at rates ranging from 5% to 15%.

According to Frederick Ma, speaking at a conference in December 2005, the potential for Hong Kong to expand its asset management business is substantial. The rise in personal wealth and increased personal savings have resulted in greater demand for a wider variety of investment products. A further factor contributing to the growth of Hong Kong’s asset management industry is the Mainland’s gradual relaxation of its capital control policies: the Mainland authorities are progressively allowing funds and institutions such as insurance companies and the national Social Security Fund to invest overseas. According to Mr. Ma, Hong Kong aims to capitalize on its proximity, linguistic and cultural affinities and increasingly close economic cooperation with the Mainland to position itself as the preferred asset management centre for the Mainland.

Figures compiled by Eurekahedge published in Hong Kong’s South China Morning Post show that of 79 new hedge funds set up in Asia 2005, 20 set up in Hong Kong compared with 19 in Singapore. Assets under management in Hong Kong in 2005 (US$12.08 billion) were however more than double those in Singapore (US$5.14 billion). According to the South China Morning Post, the data indicates that while boutique start-up funds are drawn to Singapore, larger funds wanting to be closer to China are setting up in Hong Kong. An example of the trend for traditional US and European hedge fund houses to set up in Hong Kong is Citadel Investment Group which was licensed to carry on asset management activities in Hong Kong in October last year.

Hong Kong’s Securities and Futures Commission (the “SFC”) has however stressed that it will not compromise its regulatory standards to attract business to Hong Kong. Any fund manager managing a portfolio of securities or futures contracts is required to be licensed by the SFC to carry on asset management activities, whether he manages for institutional or retail investors. This requires the fund manager to meet certain standards of competence, corporate governance, internal control and risk management. The product itself will not however need to be authorized unless it is to be marketed to the general public.

Hong Kong was among the first jurisdictions to allow retail hedge funds. In May 2002, the SFC adopted its guidelines for the authorization of hedge funds for offer to the general public in Hong Kong. These were updated in September 2005. The advantage of authorization is that it allows a hedge fund to be advertised and offered to the retail public. Since the implementation of the guidelines, the SFC has authorized 13 hedge funds of which 5 are single hedge funds and 8 are FoHFs. It is however far more difficult to find data for unauthorized hedge funds, offered to institutional and professional investors or on a private placement basis, which greatly outnumber authorized funds.

In response to the rapid growth ofthe hedge fund industry, the SFC has designated a specific team to handle licence applications of hedge fund managers and respond to related enquiries. As noted above, a hedge fund manager must be licensed by the SFC even though its products are not to be offered to retail investors. The SFC has stated the average processing time for a fund management company application including assessing its corporate governance and control systems to be approximately 10 weeks. It is also possible for an overseas fund manager wishing to gain early exposure in Hong Kong, to apply for a temporary licence to conduct the business of advising on securities. Such a temporary licence allows the fund manager to give investment advice to clients before its asset management licence is granted.

This article does not constitute legal advice and should not be regarded as a substitute for detailed legal advice in individual cases.