Hong Kong Private Equity
Fund Formation, Management & Operations

Though Hong Kong has been a major centre for private equity in the Greater China region for many years, historically, Hong Kong private equity fund sponsors have opted for offshore fund structures, with a particular emphasis on Cayman limited partnerships. However, beginning in 2019, the Hong Kong Government introduced a number of legislative changes to encourage the formation of domestic Hong Kong private equity funds. These changes create a new Hong Kong private equity fund vehicle in the form of limited partnership funds, exempt Hong Kong private equity funds from profits tax in respect of profits earned from qualifying private equity transactions and minimize profits tax in respect of Hong Kong earned carried interest distributed by such funds. In this article, we explore legal, regulatory and tax considerations for Hong Kong private equity firms in light of these changes. If you are interested in setting up a Hong Kong private equity fund, please contact our Private Equity lawyers.

The legal and tax landscape for Hong Kong private equity has seen significant changes since 2019. These changes include the introduction of a new private equity fund structure in the form of limited partnership funds under the Limited Partnership Funds Ordinance (“LPFO”) as well as tax relief not only in respect of Hong Kong private equity funds (i.e. funds operated from Hong Kong) but also in respect of carried interest earned in Hong Kong from such funds. These changes, together with an increasingly hostile environment in the Cayman Islands and other offshore jurisdictions, have created a paradigm shift as Hong Kong private equity sponsors have begun to turn away from the traditional offshore fund structures in favour of domestic Hong Kong structures. In the 2 months since the introduction in August, 2020 of the limited partnership fund structure, 29 funds have registered as limited partnership funds under the LPFO.

Historical Private Equity Setup

Historically, Hong Kong private equity fund sponsors have opted for Cayman exempted limited partnership structures. In part, this was because Hong Kong limited partnerships under the Limited Partnership Ordinance (“LPO”) were poorly adapted for private equity, lacking for example flexibility in capital withdrawal and limited partner privacy. In part, this was because the Cayman Islands offered an efficient alternative that was well understood by investors.

However, changes in the Cayman Islands to comply with global base erosion and profit shifting (“BEPS”) and money laundering and terrorist counter-financing (“AML”) initiatives have undermined the offshore haven’s attractiveness to Hong Kong private equity fund sponsors. For example, the Private Funds Law (“PFL”), introduced in February 2020, requires private equity funds for the first time to register with the Cayman Islands Monetary Authority (“CIMA”), to file their offering document with CIMA and to comply with ongoing operational requirements including in respect of the valuation and safe keeping of assets, cash monitoring, and the filing of annual accounts.

Limited Partnership Funds: The New Hong Kong Private Equity Funds Vehicle

As in many common law jurisdictions, under the LPFO, limited partnership funds are not separate legal entities. Instead, they are partnerships of persons who, by means of registration under the LPFO, limit the liability of their investor partners as limited partners.

Under the LPFO, a partnership can qualify as a limited partnership fund if it meets prescribed criteria. These criteria include:

• GP and LP – The partnership must have at least one general partner (“GP”) and one limited partner (“LP”). The GP can be a Hong Kong incorporated company or a non-Hong Kong incorporated company registered in Hong Kong as an overseas company. As is common with other jurisdictions, the GP has unlimited liability for the debts and obligations of the limited partnership fund and has ultimate responsibility for the management and control of the limited partnership fund.
• Hong Kong Registered Office – The partnership must have a registered office in Hong Kong to which communications can be sent.
• External LP – Not all of the partners of the partnership are corporations in the same group of companies.
• Investment Manager – The partnership must appoint an investment manager but the GP itself can serve as the investment manager. If the GP does not serve as the investment manager, any Hong Kong company or non-Hong Kong incorporated company registered in Hong Kong as an overseas company may be appointed as the investment manager.

Terms of Limited Partnership Funds

Under the LPFO, the rules of equity and common law applicable to partnerships apply to limited partnership funds to the extent they are not inconsistent with the LPFO. Similarly, the LPFO implies into limited partnership funds a number of default partnership provisions of the Partnership Ordinance. Otherwise, the LPFO has few restrictions on the terms of the partnership agreement, meaning that partners are generally free to agree upon the terms and conditions of the fund. Thus, the partnership agreement may, amongst other things, provide for:

• the investment scope and strategy of the limited partnership fund
• the admission and withdrawal of partners into and from the limited partnership fund
• the organization, management structure, governance and decision-making procedures of the limited partnership fund
• the scope of fiduciary duties of the GP and the remedies for breach or default
• the financial arrangements among the partners in the limited partnership fund, such as capital contributions, withdrawals of capital, distribution of proceeds and clawback obligations of the partnership
• the frequency of financial reporting and verification of net asset value
• the transfer of interests in the limited partnership fund by LPs
• the life of the fund.

Requirement for External LP

The LPFO prohibits the partners of the fund from all being corporations in the same group of companies. This prohibition effectively requires that at least one of the LPs in the fund be an external investor unrelated to the GP.

The LPFO however, recognizes that until the completion of capital raising, the sole and initial LP may be related to the GP. As a result, a fund can still be registered as a limited partnership fund if the applicant can ensure that all the fund partners are no longer corporations in the same group of companies after two years of the issuance of its certificate of registration. If all the partners remain in the same group of companies after the two-year period, the Registrar of Companies (“Registrar”) may strike the fund’s name off the register of limited partnership funds (“LPF Register”).

Limited Partner Participation in Management

In common with limited partnership structures in other jurisdictions, the LPFO provides that an LP is not liable for the debts and obligations of the limited partnership fund beyond the amount of the partner’s agreed contribution provided that the LP does not have day-to-day management rights or control over the assets held by the limited partnership fund and does not take part in the management of the limited partnership fund. 

For these purposes, an LP is not regarded as taking part in the management of the limited partnership fund only because the LP:

• Serves or appoints a person to serve on a board or committee of the limited partnership fund or the GP or to serve on a board or committee of any corporation in which the limited partnership fund has an interest, or any corporation having a business relationship with the fund
• Advises the GP, another LP or the investment manager about the business, prospects, affairs or transactions of the limited partnership fund
• Approves the GP, another LP or the investment manager to do anything in relation to the business, prospects, affairs or transactions of the limited partnership fund
• Attends partners’ meetings or exercises rights conferred by the limited partnership agreement, including the right to vote on fund transactions, amendments to the limited partnership agreement, an extension of fund term or changes in management

It is significant to note that, like other jurisdictions, the limited liability afforded to LPs under the LPFO may offer no protection in jurisdictions outside of Hong Kong. A limited partnership fund is not a separate legal person. It is merely a partnership of persons, the LPs of which are given statutory protection from liability as a result of compliance with Hong Kong legislation.

Withdrawal of Capital and Distributions

Though there are no requirements to maintain capital contributed to the limited partnership fund, withdrawals of capital contributions and distributions of profits and assets is only permitted if the limited partnership fund remains solvent following such withdrawal or distribution.

Filings, Anti-Money Laundering and Publicity

Formation

A limited partnership fund is registered by filing an application to the Registrar of Companies. The application must be submitted by a Hong Kong law firm or solicitor and must, amongst other things:

• describe the proposed investment scope and proposed principal place of business,
• identify the proposed GP, investment manager and money laundering control responsible officer of the GP.

There is no requirement to file any copy of any private placement memorandum or similar offering document which the limited partnership fund may use for capital raising purposes. Similarly, there is no requirement to file a copy of the limited partnership agreement governing the limited partnership fund. 

There is no requirement to make any filings with the Registrar of Companies in respect of the identity of the LPs either at the time of the application for registration or thereafter. However, as noted below, for anti-money laundering control purposes, a responsible officer of the GP must maintain a register of LPs and make this register available to prescribed government authorities including the Companies Registry (“CR”), Securities and Futures Commission (“SFC”), the Hong Kong Monetary Authority (“HKMA”), the Insurance Authority (“IA”), the Hong Kong Police Force, and the Inland Revenue Department (“IRD”).

Unlike the LPO, there is no capital duty on capital contributions to a limited partnership fund.

Annual Return

Every limited partnership fund must file an annual return. The annual return must contain a declaration by the GP that the fund has been in operation or has carried on business as a fund during the preceding 12 months and will be in operation or will carry on business as a fund in the following 12 months.

Public Access to Filings

The Registrar of Companies must make available to the public for inspection a register of limited partnership funds, such register to enable the public to ascertain (i) whether a member of the public is dealing with the GP of the fund, the investment manager of the fund and (ii) the particulars of the limited partnership fund, the GP, the investment manager and any former GP or investment manager.

There is no public access to the annual returns or to the register of LPs to which the Registrar of Companies has access.

Money Laundering Control Officer

The GP of every limited partnership fund must appoint a person as a responsible officer for money laundering control purposes. A responsible officer must be a bank (i.e. an authorized institution under the Banking Ordinance), an SFC licensed corporation, a Hong Kong accountant or accounting firm, a Hong Kong solicitor or foreign lawyer registered in Hong Kong. A responsible officer must conduct due diligence on LPs to comply with requirements of the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (“AMLO”).

Management Arrangements

Though the LPFO permits a GP of a limited partnership fund to serve as the investment manager, because the GP bears all the liabilities of the limited partnership fund, it is desirable for the GP to be a special purpose vehicle created specifically for each limited partnership fund. It follows that the investment manager will ideally be a legal entity separate from the GP.

Traditionally, in a limited partnership private equity fund, the GP exercises investment discretion and retains an investment manager to advise it. Under this arrangement, the investment manager helps in the capital raising process, the sourcing and identification of investment opportunities, the execution of investments and the provision of corporate finance services to portfolio investments.

SFC Licensing

An issue in this context is whether the GP or the investment manager must be SFC licensed. The LPFO sets no express requirements as regards SFC licensing of the GP or the investment manager. Historically, some Hong Kong private equity sponsors have taken the view that SFC licensing requirements do not apply to either the GP or the investment manager as fund investments are limited to unlisted securities. Indeed, under the SFO, each of the regulated activities subject to licensing requirements is defined by reference to “securities”, which is in turn defined to exclude shares of private companies under the Companies Ordinance ("CO"). However, private companies under the CO refers only to Hong Kong incorporated companies. 

Licensing of GP

Given the foregoing, a key question is whether the GP needs to be licensed for Type 9 (asset management) regulated activity, particularly if it exercises investment discretion. This is a difficult question for which there is no clear authority.

Under the SFO, licensing requirements may arise where a person carries on a business (or holds himself out as carrying on a business) in a regulated activity. Type 9 regulated activity (asset management) includes, subject to exemptions, managing a portfolio of securities for another person. Whilst it may appear that in managing a limited partnership fund the GP may be managing a portfolio of securities for the LPs, under the common law, the portfolio would appear to be held by the GP on its own behalf and as trustee for the LPs. On this basis, it may be the case that while the GP does manage a portfolio of securities, it does so as principal both for itself and in its capacity as the trustee for the LPs.

Licensing of Investment Manager

It is likely that a Hong Kong based investment manager of a limited partnership fund will need to be SFC licensed. However, the license required will depend upon the scope of the investment manager’s activities.

• Dealing in Securities – Generally, a person deals in securities if he makes or offers to make an agreement with another person or induces or attempts to induce another person to enter into an agreement for or with a view to acquiring, disposing of or subscribing for securities. An investment manager may deal in securities, for example, by raising capital on behalf of a limited partnership fund or by arranging for a limited partnership fund to enter into an agreement by which the fund makes an investment.
• Advising on Securities – Subject to exemptions, advising on securities includes advising on whether, which, the time at which or the terms and conditions upon which a person should acquire or dispose of securities. In the private equity context, an investment manager may be advising on securities by recommending an investment to the limited partnership fund or its GP.
• Asset Management – An investment manager may need be carrying on a business in asset management if it makes investment decisions on behalf of the limited partnership fund.

Taxation of Hong Kong Private Equity Funds

To the extent that a limited partnership fund may be said to be carrying on a business in Hong Kong, profits which arise in or derive from that business in Hong Kong may be subject to profits tax. In the former regard, whether a limited partnership fund carries on a business in Hong Kong is a question of fact. One significant consideration in this respect is whether the GP or the investment manager is located in Hong Kong and has general authority to contract on behalf of the fund.

Capital Gains

Whilst some jurisdictions treat gains on the value of private equity investments as capital gains subject to preferential tax treatment, the Hong Kong Inland Revenue Department ("IRD")does not take that view. Hong Kong does exempt from profits tax profits from the sale of capital assets. However, on the IRD's view, the intention at the time of acquisition of an asset is a primary consideration in determining whether the asset is or is not a capital asset. As a result, gains in the value of private equity investments may not be regarded as profits from the sale of capital assets. This is because in a typical private equity investment, at the time of the investment, there is an intention to sell that investment.

Unified Funds Tax Exemption

In the past, it was common for the Hong Kong private equity fund sponsors to locate the GP and its activities outside of Hong Kong with a view to taking the fund outside the territorial ambit of Hong Kong profits tax. Indeed, the Hong Kong Government actively supported this approach, with an earlier tax exemption (“Offshore Funds Exemption”) requiring the GP and hence, the fund, to be non-resident as a condition for relief.

Consistent with Hong Kong Government policy to ensure that Hong Kong is a tax neutral fund destination, in 2018 the Hong Kong Government introduced proposals to relax conditions by which private funds, including Hong Kong private equity funds, may be exempt from profits tax, and following that the Inland Revenue (Profits Tax Exemption for Funds) (Amendment) Ordinance 2019 created a new exemption (“Unified Funds Exemption”) from profits tax for qualifying private equity transactions which, unlike the Offshore Funds Exemption, applies even if the fund is resident in Hong Kong. As a result, the Unified Funds Exemption may provide tax relief for a Hon Kong private equity fund in the form of limited partnership fund even if the GP were based in Hong Kong.

Though the statutory language of the Unified Funds Exemption is unclear in some key respects, the IRD has clarified its approach. In broad terms, under the Unified Funds Exemption, the profits of a limited partnership fund may be exempt from Hong Kong profits tax if:

• the profits are derived from qualifying transactions; and
• either (i) the transactions are carried out or arranged by an SFC licensed corporation or an SFC registered bank, or (ii) the fund is a qualifying fund.

Qualifying Transactions

Under the IRO, transactions eligible for relief are transactions in shares, debentures and other prescribed asset of or issued by a private company. In this respect, prior limits in respect of investments in Hong Kong private companies have been relaxed but restrictions remain in respect of investments in Hong Kong real estate. 

Qualifying Investment Fund

If the limited partnership fund is not managed by an SFC licensed corporation or an SFC registered authorized institution (i.e. a bank), the fund may need to meet qualification criteria in order for its profits to be eligible for exemptive relief from Hong Kong profits tax. These criteria include a minimum of 4 outside LPs who together account for more than 90% of capital commitments as well as a 30% cap on the carried interest payable to the GP, the investment manager and their affiliates.

Taxation of Hong Kong Private Equity Sponsors

The GP and the investment manager may be subject to profits tax in Hong Kong on the basis that either or both carries on a business in Hong Kong with profits arising in or derived from Hong Kong. 

As noted above, the traditional approach has been to situate the GP outside of Hong Kong for tax purposes and to situate the investment manager in Hong Kong, thereby minimizing tax on the basis that carried interest and management fees earned by the GP is outside the territorial ambit of Hong Kong profits tax. The investment manager would only receive a portion of the management fees earned by the GP, thereby limiting the extent of management fee subject to Hong Kong profits tax.

The traditional approach has come under significant attack with governments around the world increasingly focused on ensuring that taxes reflect the substance of underlying economic activities. In Hong Kong, the focus has culminated not only in more aggressive enforcement and reliance on anti-avoidance provisions but also in the introduction of BEPS legislation which, empower the IRD to assess tax on the assumption that transactions between affiliated persons are conducted on an arm’s length basis even if, in fact, they are not.

Taxation of Carried Interest

To attract more private equity funds to domicile and operate in Hong Kong, in August 2020, the Government issued a consultation paper proposing to introduce a tax concession for carried interest distributed by eligible Hong Kong private equity funds. The tax concession is retroactive, taking effect from April 1, 2020.  

Under the proposal, a GP or an investment manager of a Hong Kong private equity fund may be eligible to a concessionary rate of tax on carried interest distributed to it by the fund if a number of conditions are satisfied. These conditions include:

• Qualifying Carried Interest – The carried interest must be (i) a profit based return earned from (ii) the provision of investment management services (iii) in Hong Kong in respect of (iv) transactions in shares, debentures and other prescribed assets in or issued by a private company.
• Eligible Recipient – The recipient of the carried interest must be an SFC licensed corporation, an SFC registered authorized institution (i.e. a bank) or another person providing investment management services to a qualifying fund (i.e. a fund eligible for exemption under the Unified Funds Exemption). At the same time, the recipient must have substantial activities in Hong Kong, including an adequate number of full-time employees and no less than HK$3 million of expenditure.
• Eligible Investment Management Services – The recipient of the carried interest must provide capital raising, deal sourcing, or deal execution services to the fund or investment banking services for the fund’s portfolio companies.
• Qualifying Fund – The fund must be validated by the HKMA both on an initial and on an ongoing basis to ensure the fund is engaged in private equity transactions and the recipient of the carried interest engages in substantial activities in Hong Kong.

Capital Raising for Hong Kong Private Equity Funds

The SFO requires offers to the public to subscribe for interests in limited partnership funds to be authorized by the SFC unless exempted. One exemption is for offers to professional investors, as defined under the SFO.