Penelope Shen, Partner, Kwok Yih & Chan, and Stephen Wong, Director of Fund Administration, Amicorp Hong Kong Ltd, shed light on open-ended fund companies and ask us to keep the faith with this new regime.
Over a year has passed since Hong Kong introduced the Open-ended Fund Company (OFC) regime, yet at the time of writing just one such entity has been launched even though the structure promises participating companies, on paper at least, a more efficient and cheaper regulatory process.
An OFC is an open-ended collective investment entity that enables investment funds to be structured in Hong Kong in corporate form, which is a form more familiar to many investors than Hong Kong’s other available fund, the unit trust structure. The OFC regime was launched on 30 July 2018 as part of Hong Kong’s efforts to boost itself as an international asset and wealth management centre, and earlier this September, Hong Kong–based fund manager Pacific Hawk (HK) Ltd launched the city’s first OFC.
So why haven’t more fund managers used the structure?
One reason for the lukewarm take-up – that is, before April this year – lay in the tax treatment for private OFCs.
This was never an issue for publicly offered OFCs, which enjoy profit tax exemption under Section 104 of the Securities and Futures Ordinance (Cap 571) (SFO). Under this law, when an investment fund, regardless of its domicile, is authorised by the Hong Kong Securities and Futures Commission (SFC) to be publicly offered in Hong Kong (Authorised Fund), the fund is exempted from profits tax in the city.
On the other hand, a private OFC had to satisfy certain conditions, such as the non-closely held requirement, which aimed, for one, at preventing the tax exemption from being abused by just a few investors repackaging its operations as an OFC. It was difficult for a private OFC to satisfy these criteria and consequently fund managers stuck to what they knew best: the Cayman Islands–domiciled structure.
It was not until the enactment of the Inland Revenue (Profits Tax Exemption for Funds) (Amendment) Ordinance 2019 (Amendment Ordinance) of 1 April 2019, which gave private OFCs a different tax exemption regime, that fund managers took a second look at OFCs.
The Amendment Ordinance began as a bill in December 2018 to address ring-fencing concerns raised by the Organisation for Economic Co-operation and Development (OECD) and the European Union. But it also defined entities like the OFC as a ‘fund’ if it, among other things, engaged a ‘specified person’ to arrange or carry out its transactions – which means an OFC would be exempted from profits tax in Hong Kong on its assessable profits in relation to certain transactions.
So now when a fund – more or less defined in the same way as a ‘collective investment scheme’ contained in Part 1 of Schedule 1 to the SFO, with modifications made to cater for the purpose of the proposed tax exemption – appoints an SFC-licenced investment manager to conduct Type 9 (asset management) regulated activities and invest in certain transactions, it can then rely on the profits tax exemption under the Amendment Ordinance.
Investment requirements and custody arrangement
Another reason that OFCs have not flown off the shelves is that they are more or less aimed at non-private equity investments, since in essence they exclude investments in real estate or Hong Kong private companies, due to the 10% de minimis limit on investments. And the fact is that in the past year or so we have observed fund managers making more private equity investments than non-private equity ones.
Further, the asset custodian for a private or retail OFC would typically be a bank or trust company if it is to satisfy criteria similar to that of an Authorised Fund. But for fund managers managing private investment funds that have traditionally relied on self-custody arrangements, or those with prime brokers and brokers, hiring a bank or trust company incurs costs that may be too high to bear for funds with smallish assets under management.
On the other hand, fund managers will greatly appreciate the one crucial advantage of using an OFC: the efficiency of having to deal with one single regulator, the SFC, and a single layer of service providers, which naturally translates to substantial cost savings.
For example, the SFC registration fee (pre- and post-) for a single sub-fund umbrella OFC is approximately HK$12,000. Contrast this with the same set-up for a Cayman Islands segregated portfolio company with a single segregated portfolio, whose government fees, plus registration fee with the Cayman Islands Monetary Authority, come to roughly US$7,000 (about HK$54,000).
A traditional Cayman Islands–domiciled fund managed in Hong Kong will also have to deal with legal costs from both those jurisdictions.
A common misconception that has further dissuaded OFC use is that the manager of such a fund could be subject to even more SFC scrutiny. The truth is, where a private OFC is concerned, the SFC need not even review or approve its offering memorandum – which needs to be filed with the regulator – once the investment fund is launched, regardless of domicile.
This does not reflect a laxer regime since a fund manager licensed for Type 9 (asset management) activities will already have to comply with, among other things, the Fund Manager Code of Conduct, which looks into issues such as sound liquidity management policy.
Another impediment to the OFC take-up is the political uncertainty now engulfing Hong Kong, which is of no benefit to any investment scheme.
The bottom line remains that we have little doubt that when sentiment recovers, we will see the establishment of more private OFCs.
It merely makes good business sense.
Penelope Shen, Partner
Kwok Yih & Chan
Stephen Wong, Director of Fund Administration
Amicorp Hong Kong Ltd