It has been a general perception that offshore funds making profits in Hong Kong are not taxed in Hong Kong or the Hong Kong Inland Revenue Department ("IRD") will not seek to tax the offshore funds. This perception is not entirely wrong. Funds authorised by Hong Kong Securities and Futures Commission ("SFC") and certain unauthorised funds which are "bona fide widely held" and subject to a supervisory authority in an "acceptable regulatory regime" are exempt from Hong Kong profits tax on their profits made in Hong Kong. Cayman Islands, British Virgin Islands and, ironically, Hong Kong are not in the list of "acceptable regulatory regime". In reality, many other offshore funds making profits in Hong Kong were not paying profits tax in Hong Kong. This is not because they were exempt from profits tax in Hong Kong but may be due to the fact that the IRD was not aware of the extent of activities carried out by the offshore funds in Hong Kong and was probably short of resources to probe into their activities in Hong Kong. Hong Kong, however, does not levy tax on profits sourced outside Hong Kong and on capital gains.

There is always a risk that unauthorised offshore fund may be subject to profits tax in Hong Kong (currently at 17.5%) if it is considered to be carrying on a business in Hong Kong and the "Hong Kong source profits" was derived from such business in Hong Kong. "Offshore fund(s)" hereinafter mentioned refers to unauthorised offshore fund(s). The Hong Kong Inland Revenue Ordinance ("IRO") does not define what is and what is not sourced in Hong Kong. It is, however, clear from case law that profit from trading in shares listed on the Hong Kong Stock Exchange is sourced in Hong Kong. An offshore fund may be regarded as carrying on business in Hong Kong by itself or through a discretionary agent which constitutes a permanent establishment in Hong Kong. This would arise where the offshore fund has a Hong Kong investment manager with full discretionary power to negotiate and conclude contracts on behalf of it in Hong Kong. Obviously, there is a difference in the way the Hong Kong tax legislation should be interpreted and the way the fund industry reckons on the Hong Kong profits tax position of the offshore funds.

The "tax uncertainty" issue facing by the offshore funds was publicly addressed by the Hong Kong Financial Secretary in his budget speech in early 2003. The then Financial Secretary said that the Government of the Hong Kong Special Administrative Region ("Government") intended to amend the tax legislation to exempt offshore funds from Hong Kong profits tax. Two rounds of consultation on the different approaches for effecting the proposal of providing profits tax exemption for offshore funds with the fund industry, interest parties and the public were conducted in early 2004 and early 2005.

The consultation paper of January 2004 proposed to effect the exemption and the anti-avoidance measure by granting exemption only to a non-resident person (including a corporation, a trustee of a trust estate or a partnership) which is mainly owned by non-resident beneficial owners. In the consultation paper, the exemption threshold of non-resident interest was set at 80% or above, ie, the exemption would not apply if the aggregate beneficial interests in the non-resident person held by non-resident investors are less than 80%. In response to the consultation paper, the fund industry and other interest parties raised much concerns about the practicality of such an approach proposed.

A revised approach was proposed in the second consultation paper of December 2004. The fund industry and other interest parties generally expressed support to the revised approach and the revised approach became the blueprint for the Revenue (Profits Tax Exemption for Offshore Funds) Bill 2005 (the "Bill") of June 2005.

The Revenue (Profits Tax Exemption for Offshore Funds) Bill 2005 (the "Bill")

The Bill proposed to introduce five new sections and a new Schedule into the IRO. The key provisions are as follows:

1. Exemption Provisions
   
   Exemption from Hong Kong profits tax will be granted to non-resident persons (including natural persons, corporations, trustees and partnerships) in respect of certain profits from dealing in securities, dealing in futures contracts and leveraged foreign exchange trading ("exempt transactions") in any year of assessment commencing on or after 1 April 1996 (ie giving retrospective effect). These activities must be carried out through certain specific types of SFC licensed "specified persons" and the non-resident must not carry on any other business in Hong Kong. Income from transactions which are "incidental" to the carrying out of the exempt transactions will also be exempt from tax provided such income does not exceed 5% of the total trading receipts earned by the non-resident from the exempt and incidental transactions in Hong Kong.
   
   
2. Losses from Exempt Transactions
   
   Losses sustained by a non-resident person from exempt transactions in a year of assessment will not be available for set off against assessable profits for tax purposes.
   
   
3. Deeming Provisions
   
   The Deeming Provisions provide that (i) a resident person who, together with his associates, holds a direct or indirect interest of 30% or more in an exempt non-resident person or (ii) a resident person who, together with his associates, holds any interest, direct or indirect, in an associated exempt non-resident person will be subject to Hong Kong profits tax on its share of the non-resident's exempt profits. The purpose of the Deeming Provisions is to avoid abuse of the Exemption Provisions by Hong Kong residents and they will apply from the date of enactment of the Bill. The Deeming Provisions will not apply however in cases where the beneficial interest in the non-resident is regarded by the Commissioner of Inland Revenue as "bona fide widely held".

Major concerns made by the deputations from the fund industry and interest parties on the Bill include: (1) the interpretation of the concept "central management and control" for non-resident persons, (2) the scope of transactions exempt from Hong Kong profits tax, and (3) the impact of the "Deeming Provisions" on Hong Kong investment managers/advisors. After extensive discussions and listening to the presentations made by deputations from the investment industry and interest parties, the Government proposed a number of amendments to the Bill (hereinafter refers to as the Revised Bill) in late November 2005. The amendments are overall in line with the industry's expectations and the industry and interest parties indicated that they give full support to the Revised Bill.

The following discuss the salient features of the Bill and the Revised Bill.

1. Non-Resident Persons and Central Management and Control
   
   The first condition for an offshore fund in getting Hong Kong profits tax exemption is to ensure that it is a non-resident person of Hong Kong. The scope of non-resident persons in the Bill is wider than that proposed in the consultation paper of January 2004 which did not include individuals. The Bill provides that an individual is a Hong Kong resident if he or she ordinarily resides in Hong Kong or stays in Hong Kong for more than 180 days in a year of assessment (from 1 April to 30 March of the following year) or 300 days in two consecutive years of assessment. The Bill further provides that a non-individual entity is a Hong Kong resident if its central management and control is exercised in Hong Kong. The place of incorporation of the fund itself is not conclusive evidence of offshore residence. The IRD indicated that they will look at the substance rather than the form in ascertaining where the central management and control of a non-individual entity is located. The IRD also agreed to issue a Departmental Interpretation and Practice Notes to explain and state their view on this issue.
   
   
2. Transactions Exempt From Hong Kong Profits Tax
   
   The Bill initially proposed to grant profits tax exemption to offshore funds for profits derived from dealing in securities, futures contracts and leveraged foreign exchange trading provided that these transactions were carried out through "specified persons". The meaning of "securities", referring to the Hong Kong Securities and Futures Ordinance, is very restrictive and does not clearly cover many instruments or products that are typically invested by funds such as derivatives, warrants, option, swaps, commodities, private equities and so on. Furthermore, the scope of proposed exemption is merely restricted to "securities", "futures contracts" and "leveraged foreign exchange trading". Deputations from the fund industry and the interest parties were not satisfied with this proposal. After extensive discussion and consultation with the fund industry and the interest parties, the Government decided to develop a new definition of "securities" for tax exemption purposes and expand the scope of exempt transactions in the Revised Bill by adding a new schedule to the IRO. The Revised Bill also proposed to give power to the Commissioner of Inland Revenue to revise the schedule from time to time if necessary. The scope of exempt transactions is expanded to six categories in the Revised Bill, they are:
   
   

   (a)	a transaction in securities.
   (b)	a transaction in futures contracts.
   (c)	a transaction in foreign exchange contracts.
   (d)	a transaction consisting in the making of a deposit other than by way of a money-lending business.
   (e)	a transaction in foreign currencies.
   (f)	a transaction in exchange-traded commodities.

   
   For policy reasons, the Government reiterated that "securities" does not include shares or debentures of, or rights, options or interest in, or in respect of, shares or debentures of, a company that is a private company within the meaning of s.29 of the Hong Kong Companies Ordinance. Hence, profits derived from trading of these instruments are not tax exempt. Furthermore, inter alias, profits from dealing in real estate in Hong Kong are not tax exempt.
   
   The Bill initially required that the exempt transactions to be carried out through "specified persons". In the Bill, "specified persons" meant a few out of the 9 SFC licences would qualify. The Revised Bill now allows the exempt transactions to be carried out through or arranged by "specified persons". The Revised Bill also extended the scope of "specified persons" to cover all 9 SFC licence types' holders and authorised institutions registered with the SFC. This amendment gives more flexibility to fund managers in how they arrange their business in Hong Kong.
   
   
3. Deeming Provisions
   
   The Deeming Provisions will be invoked when a Hong Kong resident is associated with a non-resident person and the Hong Kong resident also directly or indirectly holds beneficial interests in that tax exempt non-resident person. A Hong Kong resident corporation is associated with a non-resident corporation if the Hong Kong resident corporation controls the business affairs of the non-resident corporation or they are both under the common control of a third person. The effect of the Deeming Provisions is that the Hong Kong resident person is required to report the Hong Kong sourced profits earned by the non-resident person attributable to him/her/it in his/her/its tax return in Hong Kong regardless of whether there is any actual distribution of profits. In practice, the investment managers, especially for Cayman Islands incorporated funds, are required to hold management shares in the funds. Under this situation, if the investment manager is a Hong Kong corporation, it will fall squarely within the Deeming Provisions. This may increase the tax burden of the Hong Kong investment manager even if it holds a very small interest in the offshore fund and may also discourage fund cum investment manager to manage the fund in Hong Kong. The Revised Bill now proposes to carve out the management shares without participating rights held by the Hong Kong fund managers from the Deeming Provisions. This definitely relieves the resident investment manager from Hong Kong tax burden in holding the management non-participating shares in the offshore funds. The Revised Bill also proposes that the Deeming Provision will become effective from the year of assessment immediately following the year of assessment in which the Bill is enacted. That is to say, if the Revised Bill is enacted in March 2006, the Deeming Provision will become effective in the year of assessment 2006/07 (commencing on 1 April 2006). If the Revised Bill is enacted after 1 April 2006, the Deeming Provision will become effective in the year of assessment 2007/08 (commencing on 1 April 2007).

The Government is expecting the Revised Bill to become law in the first quarter of 2006. It is very likely that the Revised Bill will be enacted in its present form. Offshore funds should now (not too late though) take necessary steps to ensure they would satisfy all the exemption conditions. Although the exemption takes retrospective effect back to 1 April 1996, offshore funds must satisfy all the exemption conditions in each year of assessment from 1996. It is possible for the IRD to scrutinise the tax positions of the offshore funds if they carried on business in Hong Kong and earned Hong Kong sourced profits in back years after the proposed legislation is enacted into law.