hk tax alert - 17jul2015_fs

7/23/2019 HK Tax Alert - 17Jul2015_FS

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Law enacted toexempt privateequity funds

The Inland Revenue (Amendment) Bill 2015 (the Bill), which sought to extend the

current Profits Tax exemption for offshore funds to private equity funds (PE funds),

was enacted today (the new law). The new law will apply to relevant transactions

occurring on or after 1 April 2015.

The provisions of new law are identical to those of the Bill, i.e., no changes were

made to any of the provisions of the Bill when they were scrutinized and passed intolaw by the Legislative Council. As such, in addition to this alert, clients can also refer

to our previous alert issued on 31 March 2015 (2015 Issue No. 5), in which we

explained and commented on the key provisions of the Bill.

We welcome the enactment of the new law which will generally enable a PE fund to

invest in overseas private companies without exposing itself to tax in Hong Kong.

Previously, in order to avoid such an exposure, a PE fund may have deliberately

limited its activities in Hong Kong and as a result faced certain constraints in terms

of its operations, e.g., ensuring that purchase and sales contracts relating to shares

in a private company were not effected by an investment advisor in Hong Kong.

Furthermore, by allowing the use of a Hong Kong incorporated special purpose

company as a vehicle for investing in an overseas private company, the new law may

make it easier for PE funds to take advantage of Hong Kongs tax treaty network.

Under the new law, in addition to ensuring that an overseas private company falls

within the scope of the exemption, PE funds also need to be aware that certain

provisions of the new law may require further clarifications by the Inland Revenue

Department (IRD). The IRD has undertaken to make these clarifications by way of a

practice note to be issued shortly. These issues could be complicated in certain

circumstances. Clients should seek professional tax advice where necessary.

17 July 20152015 Issue No. 13

Hong Kong

Tax Alert


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The new law

Under the profits tax exemption regime for offshore

funds, a non-resident person is exempt from profits tax

in Hong Kong if their activities in Hong Kong are

restricted to specified transactions carried out through

or arranged by specified persons and transactions thatare incidental to the specified transactions. Specified

persons generally refer to persons licensed by the

Securities and Futures Commission.

Non-resident PE funds, however, were not able to take

advantage of this exemption regime due to the fact that,

before the enactment of the new law, specified

transactions excluded transactions in private

companies. A key provision of the new law is that

transactions in certain private companies [referred to as

excepted private companies (EPCs)] now also fall within

the definition of specified transactions.

Broadly, an EPC must be incorporated outside HongKong. In addition, subject to the 10% threshold explained

in Appendix 1 to this alert, an EPC cannot carry on

business in Hong Kong through a permanent

establishment nor own any immovable property located

in Hong Kong.

Furthermore, given that a non-resident PE fund may

typically use a special purpose vehicle company (SPV)1

to hold its investment in an EPC, the new law provides

that any gains made by such an SPV from the disposal of

an EPC would also be exempt from tax in Hong Kong at

the SPV level. Similarly, to cater for a holding structure

involving more than one SPV, the new law also providesthat any gains (i) made by an SPV from the disposal of

another SPV (i.e., an interposed SPV); or (ii) made by the

non-resident PE fund from the disposal of an SPV would

also be exempt from tax in Hong Kong at the SPV or the

fund level respectively.

The diagram in Appendix 2 to this alert illustrates how

the new law applies to a two-tier SPV holding structure

adopted by a non-resident PE fund for its investment in

an EPC as explained above.

Another key provision of the new law is that

transactions in an EPC do not need to be carried out

through, or be arranged by, a specified person so long

as the non-resident PE fund satisfies the conditions of

being a qualifying fund. This provision is to take into

account the fact that a PE fund may not need to engage

a specified person to undertake its transactions in the

normal course of its business.

A PE fund would be regarded as a qualifying fund

where, not including the originator and its associates, it

has more than 4 investors and these investors

contribute more than 90% of the capital of the fund.

Furthermore, the fee income received by the originator

and its associates from the fund cannot broadly exceed

30% of the profits made by the fund.

The exemption tax regime for offshore funds is primarily

intended to benefit non-Hong Kong resident investors.

As such, in order to discourage round-tripping of fundsby Hong Kong resident investors, there is a deeming

provision contained in the current regime to deem a

Hong Kong resident investors share of the exempted

profits of a non-resident fund to be their assessable

profits in Hong Kong. To cater for the situation that the

exempted profits may be made at the SPV instead of at

the fund level, the new law also contains an additional

deeming provision to deem a Hong Kong resident

investors share of the exempted profits of an SPV,

through their interests in an exempt PE Fund, to be their

assessable profits in Hong Kong. The Hong Kong

resident investor is also required to report to the IRD

their assessable profits under these two deeming

provisions.

In general, these deeming provisions will be triggered if

a Hong Kong resident investor holds 30% or more in an

exempt PE Fund, or any percentage if such Hong Kong

resident investor is associated with the exempt PE Fund.

The new deeming provision will not however apply to a

Hong Kong resident investor, regardless of their

percentage of ownership in an exempt PE fund, if such

PE fund is one which is bona fide widely held.

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1. An SPV is broadly defined to include a corporation,partnership, trustee and other entity which fulfils all of thefollowing conditions:

a) Being wholly or partially owned by a non-residentperson;

b) Being established solely for the purpose of holding,directly or indirectly, and administering one or more

EPCs;c) Being incorporated, registered or appointed in or

outside Hong Kong;

d) Does not carry on any trade or activities except for thepurpose of holding, directly or indirectly, andadministering one or more EPCs; and

e) Not being itself an EPC.


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Commentary

While welcoming the new law, PE funds need to be aware

that certain terms of the new law may require further

clarifications by the IRD by way of a practice note. For

example, as regards whether a private company qualifies

as an EPC, the IRD may need to specify the method ofdetermining the capital value of any subsidiary (held

directly or indirectly), any immovable property and any

other assets owned by the private company concerned

during a 3-year look back period, e.g., whether the

amount is based on historical cost or market value and

whether only assets as reflected in the accounts are

relevant. In addition, in relation to whether a private

company carries on business in Hong Kong through a

permanent establishment (PE), the IRDs practice note

may need to elaborate on what constitutes a PE for this

purpose.

In relation to whether a PE fund satisfies the condition ofbeing a qualifying fund of more than 4 investors, it is

hoped that the IRD will adopt a liberal interpretation

under which PE funds with not more than 4 feeder funds

as their investors would nonetheless qualify by way of

also counting the investors behind the feeders.

As regards the application of the deeming provisions, it

is also hoped that the practice note will provide a new

set of rules for determining whether a PE Fund is bona

fide widely held. This may be required given that one of

the criteria under the exemption regime for determining

whether an offshore fund is bona fide widely held,

namely that the fund has no less than 50 investors, maybe too high when extended to PE funds in general.

The SPV provision of the new law, which allows PE Funds

to use a Hong Kong incorporated company as a vehicle

for holding their offshore investment, would facilitate

the development of Hong Kong as a holding company

jurisdiction. It however remains to be seen whether an

SPV, ultimately partially or wholly owned by a non-Hong

Kong resident PE fund, formed solely for the purposes of

holding and administering from Hong Kong an EPC,

would create enough substance in order to claim

treaty benefits. This may be of particular relevance

given the increasing emphasis that some jurisdictions,including mainland China, are placing on substance,

often taking account of factors such as the number and

seniority of employees hired, the business operations

conducted and the assets owned by an applicant when

determining whether to grant treaty benefits or not.

Furthermore, as a result of the enactment of the new

law, a PE fund may consider whether it would be

desirable to change its previous operational protocol and

relocate more of its functions or activities from overseas

to Hong Kong. In such case, the PE fund may also need

to review the transfer pricing arrangements between

Hong Kong and the overseas jurisdictions involved.

These issues could be complicated in certain

circumstances. Clients should seek professional tax

advice where necessary.

Appendix 1

Definition of EPC

An EPC is defined as a private company incorporated

outside Hong Kong which satisfies the following

conditions at all times within a period of 3 years before

the transaction which gives rise to the relevant profits iscarried out:

a) Did not carry on any business through or from a

permanent establishment in Hong Kong; and

b) Falls within either one of the following descriptions

I. It did not hold (whether directly or indirectly)

share capital (however described) in one or

more private companies carrying on any

business through or from a permanent

establishment in Hong Kong;

II. It held such share capital, but the aggregate

value of the holding of the capital is equivalent

to not more than 10% of the value of its own

assets; and

c) Falls within either one of the following descriptions -

I. It neither held immovable property in Hong

Kong, nor held (whether directly or indirectly)

share capital (however described) in one or

more private companies with direct or indirect

holding of immovable property in Hong Kong;

II. It held such immovable property or share

capital (or both), but the aggregate value of the

holding of the property and capital is equivalent

to not more than 10% of the value of its own

assets.

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The following examples illustrate how under various circumstances a private company would or would not qualify as an EPC

for the purposes of the new law.

Assumptions: the respective values of the relevant assets during the 3-year look-back period remained constant in each

example.

Example 2

Example 1

Company A would qualify as an EPC. This is because the aggregate value of the share capital in Subsidiary X and Subsidiary Y,

which carry on business in Hong Kong through a permanent establishment, does not exceed 10% of the value of the total assets

of Company A [i.e., (HK$10 + HK$10) / (HK$10 + HK$10 + HK$200) = 9.1%].

Company A(incorporated overseas)

Value of other overseasbusiness assets HK$200

Subsidiary X

Permanent establishmentin Hong Kong

Value of share capitalHK$10


Subsidiary Y

Permanent establishmentin Hong Kong

Company B would qualify as an EPC. This is because the value of share capital in Subsidiary Z does not exceed 10% of the value

of the total assets of Company B [i.e., HK$10 / (HK$10 + HK$200) = 4.8%]. The value of the underlying immovable property in

Hong Kong would not be relevant in determining the 10% threshold.

Company B(incorporated overseas)


Subsidiary Z


Value of immovable property inHong Kong HK$200



Example 3

Company C would not qualify as an EPC. This is because the aggregate value of the holding of the immovable property and

share capital exceeds 10% of the value of the total assets of Company C [i.e., (HK$55 + HK$15) / (HK$600 + HK$55 + HK$15)

= 10.4%].

Company C(incorporated overseas)



Subsidiary M

Value ofimmovableproperty I inHong KongHK$55

Value ofimmovableproperty II inHong KongHK$80

Example 4

Assuming that the maintenance of the rented warehouse, which only stores Company Ds own goods pending delivery to its

customers in the region, is the only presence which Company D has in Hong Kong, the warehouse would not constitute a

permanent establishment of Company D in Hong Kong. As such, Company D would not be regarded as carrying on business in

Hong Kong through a permanent establishment. Therefore, Company D would qualify as an EPC.

Company D(incorporated overseas)


Operates a rentedwarehouse inHong Kong



Appendix 2

* A non-Hong Kong resident fund, including a corporation, partnership or trust, means a fund whose central management and

control is exercised outside Hong Kong. If not for the exemption granted under the new law, such a non-resident fund may however

be exposed to taxation in Hong Kong if it is regarded as having derived Hong Kong sourced profits from a business carried on in Hong

Kong, e.g., through its investment advisor located in Hong Kong.

Potential application of thetwo deeming provisions

Non-Hong Kong residentfund*

HK resident investors,if any

SPV

Non-HK residentinvestors

Potential disposal of SPV

SPV(interposed SPV)

Potential disposal of interposed SPV

EPC

Potential disposal of EPC


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2015 Ernst & Young Tax Services Limited.All Rights Reserved.

APAC No. 03002116ED None.

This material has been prepared for general informational purposesonly and is not intended to be relied upon as accounting, tax, orother professional advice. Please refer to your advisors for specificadvice.

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