In Depth: Hong Kong’s Strategy to Break Cayman Islands’ Stranglehold on Offshore Funds
Hong Kong’s efforts to lure private equity (PE) and venture capital (VC) funds away from offshore tax havens such as the Cayman Islands and the British Virgin Islands could get a significant boost in November when two new local laws go into effect.
The legislation will allow funds registered elsewhere to relocate their registration and operations to Hong Kong. It marks the latest step in Hong Kong’s strategy to bolster its position as an international asset and wealth management hub, following previous legislation to allow new fund structures and tax incentives for private funds.
The latest changes should make it easier and cheaper for existing funds, especially those that do business in Hong Kong but are domiciled elsewhere, to move their registration to the special administrative region (SAR) instead of having to dissolve and then set up new ones from scratch, thus attracting more fund managers from other locations.
Asia is seen as the world’s fastest-growing region for what’s known as alternative asset management, investments outside the traditional publicly traded classes of stocks, bonds and cash. They include PE, VC, hedge funds, real estate, and infrastructure, and because of their more complex and opaque nature along with less stringent regulation, alternative assets are usually held by wealthy individuals and institutional investors, such as insurance companies and pension funds.
Asia-Pacific private capital assets under management (AUM) rose eightfold to $1.7 trillion in the decade through September 2020, according to a report released in June by Preqin, a data and analytics provider for the alternative asset industry. Much of that growth is being driven by China — comprised of the Chinese mainland, Hong Kong, Macao and Taiwan — which in 2020 accounted for $1.4 trillion of the region’s private capital AUM.
China raised the most funds of any in the world for China-focused PE and VC funds from 2010 to the first quarter of 2021, according to the Preqin report. Even so, many of the funds are not domiciled in the region but in tax havens, notably the Cayman Islands, a self-governing British overseas territory in the Caribbean.
Companies who run hedge funds, as well as PE and VC funds, usually choose to domicile, or register, their funds in offshore jurisdictions because their governments provide a range of attractive services and benefits for entities that are not resident and do not conduct business there. The funds are subject to local laws, regulations, and taxes but not those of the country where they operate. Tax havens offer other business-friendly benefits such as a less stringent legal environment and few requirements to make public disclosures about their ownership or activities.
Tougher regulatory environment
But regulations in offshore tax havens are being tightened up following pressure from governments around the world, including in the European Union, which has become increasingly concerned at the use of these jurisdictions by companies for money laundering, fraud, and tax avoidance and evasion. The Cayman Islands, for example, has changed its laws and introduced requirements that entities domiciled there have a physical presence in terms of staff and record income-generating activities.
The tougher regulatory environment in offshore jurisdictions is giving added impetus to Hong Kong’s efforts to boost its attraction as an alternative location both for offshore funds and funds that are based in the SAR but domiciled elsewhere.
The night view of the Central District of Hong Kong, China. Photo: VCG
To make Hong Kong more competitive with other major international financial centers, the city’s government has been modernizing out-of-date legislation and regulations over the past few years to provide the legal framework necessary to promote the development of the private fund industry.
The first step was to establish corporate structures suitable for funds to domicile. In July 2018 the government introduced the open-ended fund company (OFC) structure, which, for the first time, allowed a private open-ended fund to be established in Hong Kong as a corporate vehicle. Controls on the types of assets OFCs could invest in were subsequently scrapped and they were given tax exemptions on some types of profit. They must be registered with, and supervised by, the Hong Kong Securities and Futures Commission (SFC).
This was followed by the launch of the limited partnership fund (LPF) structure in August 2020, which allowed private funds to register locally as investment vehicles. The LPF is a widely used structure for private fund managers to raise capital for investment. The similarities between Hong Kong’s structure and those in other jurisdictions such as the Cayman Islands, along with its relatively low cost, made it a competitive and viable alternative.
“Managers and investors expect and want to be able to invest through limited partnerships,” said James Ford, a partner in the Asia-Pacific Funds & Asset Management group at law firm Allen & Overy. “If a limited partnership isn’t available in a specific jurisdiction, the likelihood is that they’ll establish a fund as a limited partnership in another jurisdiction… So until the LPF came in, Hong Kong was kind of closed out of the market that would use a limited partnership,” Ford told Caixin.
Private funds using the LPF structure were also exempted from profit tax and were not required to be authorized or regulated by the SFC, which freed them from the obligation of making public disclosures about their operations and ownership.
The next step was providing tax concessions and subsidies to make domiciling in Hong Kong competitive with other low-tax jurisdictions such as Luxembourg and the Cayman Islands.
Hong Kong already offered profit tax exemptions to all funds, both onshore and offshore registered. But to make the city more competitive, a new regulation was enacted in May offering tax concessions on carried interest, which means qualified fund managers do not have to pay tax on their compensation or on their share of the fund’s profit.
The final step was to address a key omission in the OFC and LPF laws, which didn’t allow existing overseas-registered funds to move their domicile to Hong Kong. That meant the funds would need to be dissolved and new funds set up and registered in the SAR, involving significant cost and red tape, obstacles that were likely to deter most funds from re-domiciling.
The government hopes the two new pieces of local legislation — the Securities and Futures (Amendment) Bill 2021 and the Limited Partnership Fund and Business Registration Legislation (Amendment) Bill 2021 — that kick in on Nov. 1 will resolve the problem by authorizing new mechanisms to allow existing offshore funds to re-domicile in Hong Kong without having to dissolve and set up anew.
The 64-million-dollar question now is how successful these initiatives will be in boosting Hong Kong’s allure as a location for alternative-asset managers and whether the city can become a serious challenger to the Cayman Islands, which is a popular location of domicile for investment funds licensed to operate in Hong Kong.
A total of 351 LPFs had registered their domicile in Hong Kong by Oct. 20, roughly 14 months after the LPF ordinance went into effect, according to the city’s Companies Registry. Although that’s a fraction of the 13,820 private funds domiciled in the Cayman Islands as of the end of June, the number has exceeded the initial registration trends for similar structures in Singapore and Luxembourg, according to the Hong Kong LPF Association (HKLPFA), an organization set up in 2020 to promote the structure in the SAR and encourage more fund managers and investors to use it.
The city could become a more appealing domicile than Singapore for private funds because it is seen as a gateway to and from China, where the private investment fund market is booming and offers greater opportunities, said Lorna Xin Chen, Asia regional managing partner of Shearman & Sterling LLP, a U.S. law firm.
In the past some investors with a government background, especially Asian ones, may not have wanted to invest in funds with an offshore structure for compliance reasons, but had no choice other than to invest in Cayman Islands-domiciled funds, which dominate the private investment fund market, Chen said. Now that the compliance costs for managers of Cayman Islands-domiciled funds have gone up, Hong Kong’s LPF regime provides an alternative place of domicile for the fund industry, she said.
A recent HKLPFA survey of 87 institutions involved in asset management, primarily Chinese mainland and Hong Kong institutions, showed that 10% of the respondents have already set up funds in Hong Kong using the LPF structure and 82% said they intend to do so, pointing to the fact that setting up and maintaining a structure in Hong Kong is simpler and more convenient than establishing an offshore structure in jurisdictions such as the Cayman Islands. The tax incentives on offer are also attractive, many respondents said.
But many investors are taking a wait-and-see approach, and want to evaluate how the first batch of LPFs registered in Hong Kong are managed and taxed before taking the plunge, said Li Ying, a co-founder of the HKLPFA.
Most respondents in the HKLPFA survey said they believed Hong Kong would become an “important place of registration” for international private funds, with 21% saying it would happen in two to three years and 50% estimating it would take three to five years. Just 6% believed it would never happen.
Allen & Overy’s Ford agrees. “In the short-to-medium term, I think the majority of funds will continue to be in Cayman because of the familiarity,” he said. “However, having implemented very competitive frameworks, Hong Kong and Singapore will soon pick up market share.”
The HKLPFA survey showed that 94% of respondents said they had existing funds that were domiciled in the Cayman Islands while only 28% said they had funds domiciled in Hong Kong.
So far, Hong Kong’s attraction seems to be limited to fund managers with a Chinese background. Most newly registered LPFs in the city have Chinese names and are likely to be associated with Chinese money.
Jiang Jingjing, a partner with law firm King & Wood Mallesons in Hong Kong, estimates that 95% of the LPFs set up in Hong Kong are backed by Chinese capital. “The first to use the Hong Kong LPF structure are large state-owned institutions, but now some private institutions have started to take up the structure, and quite a few have European or U.S. investors as limited partners, so it’s possible that European and U.S. investors will gradually accept the LPF structure in Hong Kong,” he said.
It will take time for European and U.S. funds to accept the LPF structure in Hong Kong, said Au King-lun, executive director of the Hong Kong Financial Services Development Council, a government-backed think tank. “They aren’t familiar with the new regime, so they are hesitant to register in Hong Kong,” he said.
Darren Bowdern, head of alternative investments at KPMG China, said his firm is helping international private investment funds to register in Hong Kong, explaining to them the new structure and designing tax arrangements.
There are still challenges to overcome, however. Respondents to the HKLPFA survey had reservations about using the LPF structure, pointing out that as it is relatively new and untested, investors aren’t familiar with it and might be reluctant to use it, which could deter funds from choosing to domicile in Hong Kong. There are also concerns about whether favorable policies such as tax concessions can be effectively implemented and whether the legislation on re-domiciling will allow the process to be conducted smoothly.
Respondents also pointed out that despite all the regulatory changes, private fund managers in Hong Kong are still more tightly regulated than those in Singapore and the Cayman Islands and said the SFC should consider relaxing licensing requirements for PE fund managers.
Contact reporter Zhang Yukun (email@example.com) and editor Nerys Avery (firstname.lastname@example.org)
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