Hong Kong

Tax Alert
17 July 2015
2015 Issue No. 13

Law enacted to
exempt private
equity 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 into
law 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.

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 that
are 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 Hong
Kong. 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 provides
that 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.

1.

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 funds
by 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.

An SPV is broadly defined to include a corporation,

partnership, trustee and other entity which fulfils all of the
following conditions:
a) Being wholly or partially owned by a non-resident
person;
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 the
purpose of holding, directly or indirectly, and
administering one or more EPCs; and
e) Not being itself an EPC.
Hong Kong Tax Alert

Commentary

Appendix 1

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 of
determining 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.

Definition of EPC

In relation to whether a PE fund satisfies the condition of

being 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.

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 is
carried 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 -

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, may
be 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.

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.

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.

Hong Kong Tax Alert

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 1

Company A
(incorporated overseas)

Value of share capital

HK$10
Value of other overseas
business assets HK$200

Value of share capital

HK$10

Subsidiary X

Subsidiary Y

Permanent establishment
in Hong Kong

Permanent establishment
in Hong Kong

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%].

Example 2

Company B
(incorporated overseas)

Value of share capital

HK$10
Value of other overseas
business assets HK$200

Subsidiary Z

Value of immovable property in

Hong Kong HK$200

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.

Hong Kong Tax Alert

Example 3

Company C
(incorporated overseas)

Value of share capital

HK$15
Value of other overseas
business assets HK$600

Subsidiary M

Value of
immovable
property I in
Hong Kong
HK$55

Value of
immovable
property II in
Hong Kong
HK$80

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%].

Example 4

Company D
(incorporated overseas)

Value of other overseas

business assets HK$200

Operates a rented
warehouse in
Hong Kong

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.

Hong Kong Tax Alert

Appendix 2

Non-HK resident
investors

HK resident investors,
if any

Potential application of the

two deeming provisions

Non-Hong Kong resident

fund*

Potential disposal of SPV

SPV

Potential disposal of interposed SPV

SPV
(interposed SPV)

Potential disposal of EPC

EPC

* 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.

Hong Kong Tax Alert

Financial Services
Hong Kong office
Ian McNeill
Managing Partner, Tax, Asia-Pacific
+852 2849 9568
ian.mcneill@hk.ey.com
Principal tax contact
Florence Chan
Partner
+852 2849 9228
florence.chan@hk.ey.com
Business Tax Services

International Tax Services

Transfer Pricing Services

Paul Ho
Partner
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paul.ho@hk.ey.com

James Badenach
Partner
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james.badenach@hk.ey.com

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Partner
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justin.kyte@hk.ey.com

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Partner
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michael.stenske@hk.ey.com

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Partner
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Director
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Director
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michelle.yan@hk.ey.com
Peggy Lok
Director
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peggy.lok@hk.ey.com

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