The Hong Kong Financial Services and Treasury Bureau ("FSTB") issued its second consultation paper on the proposed exemption of offshore funds from Hong Kong profits tax on 31 December 2004, 11 months after the first paper was issued in January 2004. It is hoped the proposed exemption will provide much needed comfort to Hong Kong fund managers' and offshore investors' uncertainty as to when offshore funds are subject to Hong Kong tax.

The paper sets out the FSTB's revised and simplified approach to providing a tax exemption for offshore funds on their Hong Kong-sourced "securities trading profits" from transactions carried out through "section 20AA brokers/approved investment advisors". Offshore profits and capital gains will remain exempt.

New anti-avoidance measures in the form of "deeming provisions" have also been introduced to prevent substantial Hong Kong resident investors from disguising themselves as offshore funds to avail of the exemption ("round-tripping"). It is proposed that a resident may be taxed on its share of an offshore fund's Hong Kong-sourced securities trading profits where it is associated with the fund or, together with its associates, holds more than 30% of the beneficial interest in the fund.

Reaction to the Revised Approach

Interested parties have had one month to respond to the FSTB with their comments and concerns on the proposals, and the consultation period ended on Monday last, 31 January 2005. The direction of the new approach has been generally welcomed as the requirements in the first paper for "80/20" ratio of non-resident to resident investors and the onerous record-keeping requirements on investment advisors/brokers have been removed. However, a number of hurdles still need to be overcome if the exemption is to work in practice.

It is unclear from the proposed exemption provisions whether all of an offshore fund's income will be tax exempt. The provisions appear to be relatively narrow due to the section "20AA broker/approved investment advisor" requirement (which involves more than merely obtaining a Securities and Futures Commission licence) and the restriction of the exemption to "securities trading profits". Funds are likely to earn income from many kinds of derivative transactions other than "securities trading" as currently defined (foreign exchange profits and income from distressed debts and non-performing loans are common examples) and it is not clear from the current wording whether these will be exempt from tax.

Concern with the proposed "deeming provisions" has also been expressed. It is widely thought that the suggested 30% threshold is too low for anti-avoidance purposes, due to the fact that a 30% unit holder would be unlikely to have the ability to access the records of the fund necessary to comply with the reporting requirements. The proposed deeming provisions may also give rise to several seemingly unintended consequences including, inter alia, exposing genuine offshore investors to Hong Kong tax and creating double taxation issues for Hong Kong residents. The Inland Revenue Department's new authority to "see through" residents' offshore investments and tax them on a portion of the undistributed offshore profits is also a significant development.

On the whole, the revised approach has received a more positive response than the original, but work remains to be done to ensure the exemption can be workable in practice and will be capable of providing the Hong Kong funds industry with the growth stimulus it requires.