February 7, 2005
BY FAX (2530-5921) & BY MAIL
Principal Assistant Secretary for the Treasury (Revenue) Treasury Branch Financial Services and the Treasury Bureau 4th Floor, Central Government Offices, Main Wing Lower Albert Road Hong Kong
Dear Sirs, Re: Hong Kong Venture Capital & Private Equity Association ("HKVCA") Response Paper to The Second Consultation Paper on Exemption of Offshore Funds from Profits Tax dated December 31, 2004
Thank you for sending the HKVCA a copy of the second consultation paper, dated December 31st 2004, which sets out the details of the proposed revised approach being considered by the Government to amend the IRO to exempt offshore funds from Profits Tax. As mentioned in our submission dated February 25th 2004 to the January 2004 consultation paper, we are of the view that profits generated on investments made by venture capital / private equity funds are typically capital in nature and are therefore not subject to Profits Tax in Hong Kong irrespective of where the funds source their capital, either from Hong Kong or non-Hong Kong residents or investors. We are therefore pleased to see in paragraph 15 of the second consultation paper confirmation that the Deeming Provisions would not extend the charge of Profits Tax to non-taxable capital gains or offshore profits. Moreover, we also note that the second consultation paper has addressed many of the other concerns raised in our earlier submission. In particular, we believe that the abolishment of (a) the 80% nonresidency threshold, and (b) the record-keeping requirement for fund managers / advisers and non-resident investors will make the revised approach much more workable for us as venture capital / private equity fund managers / advisers based in Hong Kong. Regarding the issue as to whether investments made by venture capital / private equity funds are capital in nature or not, we would like to draw your attention to the statement, dated May 26th 1987 and issued by the British Venture Capital Association and approved by the U.K. Inland Revenue and the U.K. Department of Trade and Industry, on the use of limited partnerships as venture capital investment funds which made it clear that the activity of acquiring and holding shares and securities as part of venture capital / private equity investment activity would not be construed as a trading activity for the purposes of U.K. income tax. The same issue was also the subject of a ruling in 1989 by the Special Commissioners for Income Tax in favour of a U.K. domiciled venture capital and private
equity company. (Details of such statement and the ruling of the Special Commissioner have been provided by the HKVCA to the Inland Revenue Department for their reference). To bring Hong Kong on par with major financial centres such as London in this regard, the HKVCA urges the Inland Revenue Department to clarify, through the issue of a departmental interpretation and practice note, that venture capital / private equity investment in Hong Kong is typically capital in nature. Notwithstanding the HKVCA’s view that venture capital / private equity investments are typically capital in nature, the HKVCA notes that many venture capital / private equity managers / advisers may wish to use the proposed Profits Tax exemption to establish a clear tax status for their funds and would therefore like to raise the following issues which are of particular relevance to the venture capital / private equity industry. 1. Exclusion of Shares in Private Companies from the Definition of "Securities" According to the definition of "securities" in Schedule 1 of the Securities and Futures Ordinance (Cap. 571), "securities" does not include shares or debentures of a company that is a private company within the meaning of section 29 of the Companies Ordinance (Cap. 32). As the focus of venture capital / private equity activity is to invest in shares and debentures of private companies, the revised approach would exclude virtually all offshore venture capital / private equity investment in Hong Kong companies from the proposed Profits Tax exemption. We believe that this is not the intention of the Government to exclude private companies from the proposed legislative amendment as such exclusion would discriminate against venture capital / private equity as an asset class within the fund management industry. It may also deter venture capital / private equity funds from investing in Hong Kong which would exclude small and medium enterprises in Hong Kong from an important source of capital. 2. Definition of “associate” and “independent capacity” in section 20AA of the IRO In the second consultation paper, it appears that all the existing requirements of Section 20AA will need to be satisfied in order for the proposed Profits Tax exemption to be effective. If it is intended for all the conditions of Section 20AA to be fulfilled, almost all offshore venture capital / private equity funds, which are managed by venture capital / private equity managers / advisers based in Hong Kong, may be ineligible for the proposed exemption. Of particular concern to offshore venture capital / private equity funds are the requirements that the approved broker / investment adviser must not be an “associate” of the offshore fund and the approved investment adviser must be acting for the offshore fund in an “independent capacity”. The definition of “associate” is defined widely to include persons or corporations under control or common control, whether by way of voting power or shareholding or management. For offshore venture capital / private equity funds, the typical structure involves the venture capital / private equity manager / adviser owning a portion of the shares or voting powers of the offshore fund and managing such offshore fund pursuant to an investment management contract. Under the definition of “associate”, as set out in Section 20AA, an offshore venture capital / private equity fund would be treated as “controlled” by the relevant private equity manager / adviser notwithstanding that such relationships are customary in the international venture capital and private equity industry and are established for the administrative efficiency of the fund.
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It is also unclear whether the typical structure of an offshore venture capital / private equity fund as described above would meet the subjective criteria for “independent capacity” as set out in Section 20AA. Accordingly, we recommend that the requirements in Section 20AA that the approved broker / investment adviser not be an “associate” of the offshore fund and the approved investment adviser act for the offshore fund in an “independent capacity” be removed for the purposes of the proposed Profits Tax exemption. 3. Deeming Provisions - Concept of “bona fide, widely held” and application where the proposed 30% beneficial interest threshold is breached. In paragraph 13 of the second consultation paper, it is stated that “it is unlikely for the resident to carry out round-tripping transactions through holding interests in a nonresident fund exempted from tax under Section 26A(1A) of the IRO or a fund that is, though not authorized, bona fide widely held.” We assume that there will be a new legislative or administrative amendment to extend the exemption of Profits Tax to offshore funds (including venture capital / private equity funds) which although not authorized are bona fide, widely held (as opposed to limiting the scope of the exemption to funds falling within the conditions and restrictions set out in Section 26A(1A)). Accordingly, we would recommend that there be no requirement for an offshore fund to be regulated and the term “bona fide, widely held” in this context be defined to mean where the resident shareholder, directly or indirectly, alone or with associates hold no more than 50% of the beneficial interest in the offshore fund, with no specific requirements as to the number of shareholders in the fund. From the venture capital / private equity fund perspective, because of the nature of its funds and the profile of its investors, the present definition of “bona fide widely held” in the DIPN No.20 (Revised) for Unit Trusts, Mutual Fund Corporations and Similar Collective Investment Schemes would typically not be satisfied. Such DIPN envisages that a fund is required to be regulated and would only be treated as bona fide, widely held if at no time did fewer than 50 persons hold all the units or shares in the funds and at no time during the year did fewer than 21 persons hold units or shares in the fund that entitled such holders to 75% or more of the income of the fund. Venture capital / private equity funds typically are unregulated because they are marketed exclusively to sophisticated investors and have only a small number of such large institutional investors e.g. pension funds or insurance companies which would therefore make it difficult for the criteria specified in such DIPN to be satisfied. It is also recommended that the threshold referred to in paragraph 14 of the second consultation paper likewise be increased from 30% to no more than 50%. “Putting your money where your mouth is” represents a powerful fund-raising tool for venture capital / private equity managers / advisers and it is a common practice around the world for venture capital / private equity manager / adviser groups to own up to 50% of the capital of the fund that they are managing / advising yet still remain “bona fide, widely held” in the eyes of the outside investors. Accordingly, it would be inappropriate for such funds to be excluded from the proposed exemption to Profits Tax because of an overly narrow interpretation of “bona fide, widely held” in the context of the Hong Kong IRO.
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Overall, we would like to re-iterate that the proposed revised approach being considered by the Government to amend the IRO to exempt offshore funds to Profits Tax has addressed the practical issue of the administrative burden on fund managers / advisers which was raised in our February 25, 2004 response letter. However, to the extent that offshore venture capital / private equity funds may be regarded as deriving taxable profits from securities trading transactions carried out in Hong Kong, the way in which the Exemption and Deeming Provisions have been set out in the second consultation paper would exclude almost all offshore venture capital / private equity funds active in Hong Kong. We do not believe that this is the intention of the Government and trust that the drafting of the Exemption and Deeming Provisions will take into consideration the characteristics of the venture capital / private equity industry in Hong Kong and the specific issues that we have raised in this letter. The HKVCA views this as an important piece of legislation for the fund management industry in Hong Kong and appreciates the complexity of drafting the revised legislation taking into consideration all the issues raised and discussed by the various parties involved. Accordingly, we would be pleased to discuss these issues further with the Financial Services and Treasury Bureau. Finally, we would like to request in advance a copy of the draft legislation such that we can provide our comments prior to its submission to the Legislative Council.
Yours sincerely,
Hanson Cheah Chairman
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