Sponsors who wish to establish investment funds in Hong Kong will soon have the choice of a new investment structure, the open-ended fund company (OFC). The introduction of the OFC is designed to boost Hong Kong’s development as a fund manufacturing hub. It is part of the Hong Kong government’s commitment to enhance Hong Kong as an asset management centre.
What is an OFC?
The OFC is an alternative to the unit trust structure for Hong Kong investment funds. An OFC is a company that can issue redeemable shares and make payments out of capital without being subject to the restrictions on capital reduction and capital distributions that exist under the Companies Ordinance. It is specifically designed for use as an investment fund.
An OFC is a separate legal entity that has its own board of directors and is able to contract and hold assets in its own name. In contrast, a unit trust is not a separate legal entity. Assets are held by the trustee in its capacity as trustee of the unit trust and contracts are entered into by the trustee in its capacity as trustee of the unit trust (or by the manager, where permitted by the trust deed).
Why use an OFC?
Potential reasons to use an OFC include:
- Greater investor familiarity with a company structure, rather than a unit trust structure
- Ability for the OFC to contract and hold assets in its own name, which may lead to greater administrative efficiency in dealing with third parties
- For Hong Kong managers, the convenience of having the investment fund and the investment manager subject to the same jurisdiction and the same regulator
- For custodians, a narrower role than acting as trustee of a unit trust and so a potential reduction in exposure
If a sponsor intends to market an OFC to the public in Hong Kong, the regulatory requirements are substantially the same as for a Hong Kong unit trust. In addition to the requirements specific to OFCs, the OFC will need to comply with the Code on Unit Trusts and Mutual Funds.
If a sponsor wishes to establish a private fund as an OFC, the regulatory requirements will be greater than if the private fund were established in an offshore jurisdiction such as the Cayman Islands (currently the most common choice for private equity funds and hedge funds that are managed by Hong Kong managers). The sponsor would also need to consider whether (i) the investment requirements for private OFCs are sufficient for the proposed investment strategy, and (ii) it is confident the private OFC will satisfy the criteria for exemption from Hong Kong profits tax.
When will OFCs be available?
The OFC regime is targeted to come into effect on 30 July 2018.
Key features of an OFC
An OFC is a company. It can issue multiple classes of shares and can be structured as an umbrella fund with multiple sub-funds. Creation, termination and change of name of a sub-fund are subject to approval by the Securities and Futures Commission (SFC). There are statutory provisions to provide for segregated liability of sub-funds and to permit cross-investment between sub-funds of the same OFC.
The SFC is the primary regulator of OFCs. Certain documents must be filed with the Registrar of Companies (CR) and with the Inland Revenue Department.
The OFC must have at least 2 directors and must appoint an investment manager, a custodian and an auditor.
Each director must be an individual aged 18 or above. At least one of the directors must be independent, meaning the director is not an employee or director of the custodian. An employee or director of the investment manager will be independent for the purpose of this requirement. Director appointments are subject to SFC approval. Directors are subject to statutory duties of care and also required to use reasonable care, skill and diligence to oversee the activities of the investment manager and the custodian. Directors do not need to be Hong Kong residents but an overseas director must appoint a process agent to facilitate the service of process.
The board of directors must delegate the investment management, valuation and pricing of the scheme property of the OFC to an investment manager. The investment manager must be licensed with the SFC to conduct type 9 regulated activity, asset management. The investment manager, and any changes in investment manager, are subject to SFC approval.
An OFC must also have a custodian to whom all the scheme property is entrusted for safe-keeping. It is unclear whether an OFC can appoint more than one custodian. The eligibility requirements for the custodian follow those for custodians of SFC-authorised funds (mainly banks and trust companies). The custodian is required to take reasonable care, skill and diligence to ensure the safe-keeping of the scheme property. In terms of sub-custody, the custodian must exercise due care in the selection, appointment and monitoring of its delegates, including sub-custodians and each sub-custodian is required to take reasonable care, skill and diligence to ensure the safe-keeping of scheme property entrusted to it. Eligible overseas custodians are permitted but need to appoint a local process agent. The custodian, and any changes to the custodian, are subject to SFC approval.
An OFC must appoint a person or firm that holds a practising certificate or that is licensed as a corporate practice under the Professional Accountants Ordinance to act as its auditor. The auditor must be independent of the investment manager, the custodian and the directors. An OFC may apply Hong Kong Financial Reporting Standards or International Financial Reporting Standards (or such other accounting standards as may be considered acceptable by the SFC).
An OFC that is offered to the public in Hong Kong (an SFC-authorised OFC) will need to comply with the investment restrictions in the Code on Unit Trusts and Mutual Funds.
A private OFC will need to comply with the following investment restrictions:
- at least 90% of the OFC’s gross asset value should consist of (1) those asset types the management of which would constitute a Type 9 regulated activity (securities, futures and OTC derivatives (once the new licensing regime for OTC derivatives-related activities comes into effect)), and (2) cash, bank deposits, certificates of deposit, foreign currencies and foreign exchange contracts;
- the OFC may invest in other asset classes of a value not exceeding a maximum of 10% of the gross asset value of the OFC (10% de minimis limit); and
- in the case of an umbrella OFC, the 10% de minimis limit is applicable to each sub-fund as well as to the umbrella OFC as a whole.
In addition, a private OFC must not be a business undertaking for general commercial or industrial purpose.
An SFC-authorised OFC will benefit from the exemption from Hong Kong profits tax for SFC-authorised collective investment schemes.
A private OFC will be exempt from Hong Kong profits tax only if it meets certain qualifying criteria. In particular, the private OFC must not be closely held, which will depend on the number and nature of the investors and how much each investor has invested in the OFC. There is a 24 month grace period for a private OFC to satisfy the requirement that it is not closely held. If it fails to satisfy this requirement within 24 months of the initial investment, the private OFC will lose its exemption from Hong Kong profits tax from its inception. The qualifying criteria set a high threshold and may be a significant deterrent to use of private OFCs.
Incorporation of OFCs
The SFC seeks to ensure that set-up of an OFC is a straightforward as possible for the applicant. It involves a one-stop process under which the SFC handles the registration application and liaises with the CR, who will issue the incorporation certificate. A similar process will apply to business registration with the Inland Revenue. The process for ongoing filings will be similar, with those which require SFC approval being submitted only to the SFC (the SFC will then pass the documents to the CR after approval) and certain filings which do not require SFC approval being submitted only to the CR.
The OFC’s governing documents are called its instrument of incorporation. It must include a statement that the object of the OFC is its operation as a collective investment scheme. Amendments to the instrument of incorporation can be made where shareholders’ approval has been obtained or where the directors have certified the immateriality of the change or that it is necessary to comply with statutory or regulatory requirements.
An OFC must have a Hong Kong registered office.
The legislative framework for OFCs
The detailed requirements for OFCs and the tax treatment of OFCs are set out in the following ordinances, rules, regulations and codes:
- Securities and Futures (Amendment) Ordinance 20161
- Securities and Futures (Open-ended Fund Companies) Rules2
- Securities and Futures (Open-ended Fund Companies) (Fees) Regulation3
- Code on Open-ended Fund Companies – available at Appendix B of the Consultation Conclusions on Securities and Futures (Open-ended Fund Companies) Rules and Code on Open-ended Fund Companies4
- Inland Revenue (Amendment) (No. 2) Ordinance 20185
The introduction of the OFC as a new legal structure for investment funds in Hong Kong is welcomed. For sponsors of SFC-authorised funds, the OFC may prove attractive and the additional process involved in registering an OFC versus establishing a unit trust should not add a significant regulatory burden. For sponsors of private funds, the decision whether to use an OFC will need to balance potential benefits against the lighter regulatory touch and simpler Hong Kong tax position that will apply to private funds established in the leading offshore jurisdictions.
Scott has considerable experience in the establishment of private and retail investment products, including hedge funds and insurance-based investment products, as well as the authorisation for public sale in Hong Kong of Hong Kong unit trusts and offshore mutual funds. Scott also advises on all regulatory aspects of investment business, including licensing requirements, establishment and marketing of collective investment schemes, authorisation of automated trading systems (ATS) and compliance issues. Formerly the regional counsel for PIMCO, a leading global investment manager, Scott was responsible for all legal, compliance and regulatory matters across offices in Hong Kong, Singapore and Australia.
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