Traditionally, private equity fund sponsors in Hong Kong have used offshore vehicles such as Cayman Islands exempted limited partnerships and limited liability companies for establishing private equity funds. They were discouraged from using a domestic Hong Kong structure because (a) Hong Kong’s existing Limited Partnerships Ordinance (Cap. 37), which was enacted approximately 100 years ago, does not meet the needs of private equity fund sponsors, and (b) the other available Hong Kong fund structures, such as unit trusts and open-ended fund companies, are more suitable for public funds or hedge funds rather than private equity funds.
In order to attract private equity funds to establish and operate in Hong Kong, the Hong Kong government introduced the Limited Partnership Fund Bill (Bill) in March 2020 to establish a registration regime for qualifying funds to register as limited partnership funds (LPFs) in Hong Kong. The Bill is expected to be enacted by 31 August 2020.
Key requirements of an LPF
An LPF must have:
(a) a general partner1;
(b) at least one limited partner;
(c) a constitution (i.e., a limited partnership agreement);
(d) a registered office in Hong Kong;
(e) an investment manager2 to carry out the day-to-day investment management functions of the LPF, and the general partner may appoint itself to take up such role;
(f) a Hong Kong auditor;
(g) a “responsible person”3 to carry out anti-money laundering and counter-terrorist financing functions; and
(h) an “authorised representative”4, if the general partner has no separate legal personality, which shall be responsible for the management and control of the LPF and jointly and severally liable with the general partner for the debts and obligations of the LPF.
Key features of an LPF
The characteristics of an LPF include the following:
(a) there is no separate legal personality;
(b) no restrictions on its investment scope and strategy are imposed by the Bill;
(c) the general partner (together with the “authorised representative”, if any) shall have:
(i) unlimited liability in respect of all debts and obligations of the LPF; and
(ii) ultimate responsibility for the management and control of the LPF;
(d) each limited partner shall have limited liability towards the LPF only up to their agreed contribution, provided that it does not participate in the management of the LPF, and the Bill sets out certain permitted safe harbour activities for a limited partner, such as serving on an advisory committee of the LPF;
(e) there is no requirement to appoint a third party custodian to hold the assets of the LPF, but proper custody arrangements must be specified in the limited partnership agreement of the LPF;
(f) there is no requirement to have any offering documents, information memorandum or summary of terms; and
(g) the partners shall have freedom of contract on the operational matters of the LPF, including the scope of fiduciary duties of the general partner, and distribution and dissolution procedures.
Ongoing compliance and confidentiality
The general partner of an LPF must:
(a) file an annual return with the Hong Kong Companies Registry (HKCR) each year;
(b) notify the HKCR of certain changes regarding the LPF, such as a change in the investment scope, registered address of the LPF, and the identity of the general partner, investment manager and “responsible person”; and
(c) maintain proper records in relation to the LPF’s operation and transactions.5
The HKCR shall maintain an index of LPFs and a register of LPFs containing information about each registered LPF, including the name, address of the registered office, principal place of business, investment scope, and name and address of the general partner, investment manager and any “authorised representative” (but excluding the identity of the limited partners), which will be available for public inspection.
Tax treatment
An LPF, which will be treated as a separate entity for Hong Kong tax purposes, will be able to benefit from the unified fund regime under the Inland Revenue Ordinance (Cap. 112) and be exempt from Hong Kong profits tax like any other offshore fund if it meets the relevant exemption conditions.
Hong Kong managers and advisers of an LPF will be subject to Hong Kong profits tax in the same way as they would in respect of an offshore fund. The Hong Kong government has proposed providing tax concessions for carried interests issued by private equity funds operating in Hong Kong but details have not yet been announced.
Transfers of interests in the LPF will not be subject to stamp duty in Hong Kong.
Go onshore or stay offshore?
An LPF structure would generally allow a Hong Kong based fund sponsor to achieve certain cost and regulatory benefits:
(a) A Hong Kong based fund sponsor can centralise the place of a fund’s domicile, operations and management in Hong Kong such that it will only have to comply with the regulatory requirements in Hong Kong, thereby avoiding the cost of complying with multiple regulatory regimes and having to engage additional service providers, which would otherwise be required if an offshore structure were used.
(b) The use of Cayman Islands vehicles for private equity funds has recently resulted in an increasing cost and regulatory burden for fund sponsors:
(i) effective from January 2019, the Cayman Islands introduced certain “economic substance” laws requiring Cayman Islands incorporated managers to maintain a level of economic substance in the Cayman Islands, involving increased regulatory reporting and oversight, if they carry out certain relevant activities such as discretionary fund management;
(ii) in February 2020, the Cayman Islands was added to the European Union’s list of non-cooperative jurisdictions for tax purposes, which may result in further restrictions and measures from individual European Union (EU) member states and thereby discourage EU investors from investing in Cayman Islands fund vehicles; and
(iii) in February 2020, the Cayman Islands enacted the Private Funds Law requiring certain Cayman Islands closed ended funds to, among others, appoint auditors in the Cayman Islands and to register with, and be regulated by, the Cayman Islands Monetary Authority.
(c) The application and registration cost of an LPF is HK$3,034,6 which is considerably less than the equivalent cost for registering a Cayman Islands exempted limited partnership or a limited liability company.
Potential concerns relating to an LPF structure include the following:
(a) An LPF is compelled to appoint an investment manager to carry out day-to-day investment management functions. Although a Cayman Islands exempted limited partnership is not required to appoint an investment manager, this may make limited practical difference to a Hong Kong fund sponsor given that (i) the general partner of an LPF can take up the role of an investment manager itself, and (ii) it is a common industry practice to appoint an investment manager for fund management and track record building purposes.
(b) In managing an LPF, if the general partner or investment manager carries out functions which constitute a “regulated activity” (as defined under the Securities and Futures Ordinance (Cap. 571)) in Hong Kong, it will need to obtain the appropriate licence(s) from the Hong Kong Securities and Futures Commission (SFC). However, this should not be an issue for Hong Kong private equity fund sponsors, which already hold such licence(s).
(c) It is argued that use of an offshore private equity fund, general partner, carried interest partner and investment manager may make it easier for those persons to avoid being liable for Hong Kong profits tax on their carried interest and management fees (which benefit may not be available in respect of an LPF). However, the liability of the general partner, carried interest partner and investment manager to pay profits tax in Hong Kong depends on whether they carry on a business in Hong Kong and have profits arising in or derived from Hong Kong, which are questions of fact. In addition, the Inland Revenue Department may seek to tax such fees (including carried interests) if they have been “improperly” allocated offshore as an artificial or fictitious transaction, or under the various transfer pricing rules if such transaction has not been determined on an arm’s length basis, in respect of which detailed rules apply that are beyond the scope of this note.
The way forward
Hong Kong private equity fund sponsors should give serious consideration to use of the proposed LPF, which offers a cost-effective and practical alternative to equivalent fund structures offered in leading common law fund jurisdictions such as the Cayman Islands. If, as promised, Hong Kong legislates to provide tax-effective exemptions for the earning of carried interest, Hong Kong could become one of the most competitive jurisdictions in the world for private equity sponsors.
- The general partner must be a Hong Kong private company, an overseas company registered with the Hong Kong Companies Registry, a limited partnership, an LPF or an individual.
- The investment manager must be a Hong Kong private company, an overseas company registered with the Hong Kong Companies Registry or a Hong Kong resident.
- The “responsible person” must be a Hong Kong authorised institution, a corporation licensed by the Hong Kong Securities and Futures Commission, a Hong Kong accountant or a Hong Kong lawyer.
- The “authorised representative” must be a Hong Kong private company, an overseas company registered with the Hong Kong Companies Registry or a Hong Kong resident.
- These records may be maintained by the investment manager instead of the general partner and may include the LPF’s audited financial statements (which should be made available for inspection by the partners), a register of partners, records of its transactions and due diligence information in respect of the partners. These records need not be made publicly available but must be available to Hong Kong law enforcement agencies.
- This excludes fees for applying for a business registration certificate, which is required for an LPF (currently HK$250 for one year and HK$3,950 for three years).
Client Alert 2020-272
