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Hong Kong - Taxation of Hedge Funds
Ray Heath, SCMP

October 2002


Hong Kong wants more fund managers. It's in danger of having fewer if the threat of taxation now hanging over the industry is not removed soon. Threats of an exodus to Singapore, Hong Kong's traditional arch-rival in the battle to attract funds; have been bandied around as the Inland Revenue continues to circle the industry. Anxious managers have banded together, backed by the Alternative Investment Managers' Association in a bid to persuade the government to call the tax-man off the industry.

For as long as anyone can remember offshore funds based in Hong Kong have never been taxed. This follows the practice in all major fund centres in the world. But while some have their freedom from tax enshrined in legislation or practice notes, Hong Kong has always run with a less formal arrangement. If that were to end, offshore managers could find themselves being presented with tax bills on their funds going back up to six years.
"That would mean bankruptcy," said one lawyer involved in the growing crisis.

The tax time-bomb appeared to have been defused as long ago as May, several months after the tax man began to show what fund managers regarded as an unhealthy interest in their affairs. They became nervous late last year when the IR started requesting reports on their earnings from funds that are incorporated offshore, but are partly invested in local securities. Such reports are usually followed up by tax demands, and could have meant the funds paying the 16% corporation tax imposed on all other companies in Hong Kong. This led to a flurry of lobbing by fund managers, which appeared to have done the trick.

In May, Hong Kong's Financial Secretary, Anthony Leung, publicly reassured offshore fund managers that there were no plans to tax them.
"We are aware of the fund industry's concerns arising from recent actions by the Inland Revenue Department," Mr Lueng told a lunchtime gathering of managers. "I would like to stress that these actions were triggered by availability of new information about the identity of fund management companies."

Although there were sighs of relief, and a general conviction that Mr Lueng had ended the matter, the Inland Revenue has since continued to press funds for information. There has even a dismaying rumour that one fund has been advised by its lawyers to pay up. If that were the case, cry other managers, a nasty precedent would be set. As Mr Lueng's reassurances obviously never reached the Inland Revenue, the industry is now looking for something stronger than a speech from the financial secretary.

In November, contact was made with Tony Miller, former housing director, now Permanent Secretary for Financial Services and Treasury. Mr Miller, agree fund managers, is sympathetic. He was asked to clarify, and solidify, the tax exempt status of unauthorised funds in Hong Kong. Funds authorised by the Securities and Futures Commission already enjoy tax breaks, and one avenue of hope was that SFC could be persuaded to change its code of practice on what are considered to be offshore funds.

Mr Miller came back, asking for more detailed suggestions. A group of fund managers got together, and by November another letter was drafted by lawyers acting for funds, setting out more detailed proposals and circulated for comments. Avoiding the need for special legislation was regarded as crucial.

The Hong Kong government, while anxious not to scare away a very promising industry as it fights to re-invent the economy, is concerned that it should to be seen to be handing out favours in troubled times. When serious suggestions are being made to tax domestic helpers to help fund the government's burgeoning deficit, introducing legislation which would favour "rich' fund managers could be political dynamite.
"The government has been wondering whether legislative action would be successful and whether they really wanted to fight it out in Legco, so we came in with suggestions about that," said a manager close to the affair.

The government has indicated that they are now actively looking at the problem, and would like to have the matter resolved by the time the annual budget is introduced in March. It might not be that easy. While senor officials are keen to have the issue go away, and fund managers to stay, they are not as familiar with the technical issues that might be involved in confirming offshore funds' tax exempt status. This could mean a solution could be moved much further down the road as all the relevant issues were addressed. The big fear is that, meanwhile, the Inland Revenue will start issuing tax demands. This would put the funds in a nearly impossible position. Auditors would insist that provisions were set aside for the payments. That money would come from earnings, which have been depressed by the slow state of markets. The demands take in the good years from the good years, so managers could find themselves in deficit. Worse, clients would be scared off. As one manager argued, the 16 per cent tax charge would to have been added to the expenses, so reducing returns on the funds. "That would mean their performance would instantly lag 16 points behind that of rivals in the US, Britain and Singapore. Who is going to put money with a fund which automatically is 16 points behind the game?" Some funds are pushing for swift action to head off the tax man. Suggestions include issuing a practice note which would prevent those pressing claims.

Some militants believe the Financial Services Bureau, which is also supposed to promoting Hong Kong as a money magnet for managers industry, is not taking the issue seriously enough.
"The FSB would like us believe that when Anthony Leung made his statement, that was the end of the matter. But it was so woolly, and the Inland Revenue had nothing to do with it. They are the hounds that have to be called off," stated one irate manager for major international fund group.

Much of the lobbying has been done by the alternative investment managers, and there are some who feel the long-only community has not done enough to support the cause.
"It's annoying because hedge funds are not the area most affected. Private equity funds, mezzanine funds, all unauthorised funds are involved. The frustrating thing is that there are many members of the community who don't want to understand this, and are not terribly bothered," complained one activist.

If a swift solution is not found, and the Inland Revenue goes ahead, warns many managers, the whole industry and the economy will suffer.
"It's the easiest thing in the world to shift the money down to Singapore - just the touch of a button."


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