Hong Kong: Structuring cross-border M&A into Hong Kong surge
Hong Kong is a popular investment destination. Here, Darren Bowdern and Benjamin Pong of KPMG China, look at why this is and assess the provisions taxpayers must be aware of when structuring cross-border M&A transactions into the jurisdiction.
During the first three quarters of 2013, the volume of M&A transactions into Hong Kong increased by 14% compared to 2012, data from Merger Market shows. For 2013 Hong Kong's inbound M&A investment surged to $23.8 billion with a deal value of $12.3 billion in the last quarter of 2013 (an increase of 84% in M&A deals over the fourth quarter of 2012). Hong Kong's M&A transactions were mainly dominated by increases in investment in consumer markets followed by computer software and financial services.
The new Companies Ordinance
The new Companies Ordinance, which was passed by the Hong Kong Legislative Council in July 2012, will come into effect on March 3 2014. The new Companies Ordinance modernises the law and will ensure better regulation, enhance corporate governance and facilitate business.
Under the new Companies Ordinance, five types of companies can be formed (compared with eight under the existing Ordinance). Unlimited companies without share capital are abolished; companies limited by guarantee, whether private or non-private are amalgamated and become companies by guarantee; and non-private companies become public companies. The concept of par value of shares is abolished and a general court-free procedure based on a solvency test is introduced as an alternative to reduction of capital.
Further, the new ordinance makes available a court-free regime for amalgamations of wholly-owned companies within the same group. Two types of amalgamation are provided for: (i) a vertical amalgamation (of a holding company and its wholly-owned subsidiaries) and (ii) a horizontal amalgamation (of wholly-owned subsidiaries of a company).
Extension of the offshore fund tax exemption
In the 2013/14 Budget, the Hong Kong Government announced that the existing offshore fund tax exemption would be extended to private equity (PE) funds. Under the existing exemption, protection is provided from Hong Kong Profits Tax for investment returns by a number of funds, in particular hedge funds, even if those funds have key investment professionals making investment decisions in Hong Kong.
By contrast, PE fund investment professionals have had to structure their operations to ensure that key activities take place outside Hong Kong so that they are not considered to fall within the Hong Kong tax net and can thereby achieve a tax neutral pass-through vehicle that most PE investors require as a prerequisite for investing. This operating model leads to increased compliance and operational costs on the fund in terms of how they are structured and operated, as well as uncertainty on whether they would be subject to challenge by the Hong Kong Inland Revenue Department to follow onerous operating protocols to prevent the investment returns of the fund they represent being taxed in Hong Kong.
It is proposed that the offshore funds exemption be extended to cover specified transactions in private companies incorporated or registered outside Hong Kong and which do not hold any Hong Kong properties or conduct business in Hong Kong. While this is a positive move for the funds industry, some key issues will need to be resolved during the consultation phase to make the change truly effective.
In particular, it will be important that transactions involving the use of Hong Kong SPVs to hold investments in China and other Asian countries are covered by the offshore funds exemption. Otherwise, investment professionals would need to continue following current operating protocols for such investments. The Government's principal concern appears to be about the application of the offshore funds exemption to the Hong Kong property industry. It is important that these concerns are dealt with through the use of targeted exclusions from the offshore funds exemption for direct or indirect investments in Hong Kong property rather than applying them to all transactions which involve the use of Hong Kong SPVs.
An additional issue which needs to be resolved, is whether all Hong Kong-based advisory companies to offshore PE funds should be licensed in Hong Kong. Currently, to rely on the offshore funds exemption, transactions covered by the exemption must be arranged through a person licensed with the Securities and Futures Commission (SFC). We do not believe that subjecting all PE fund advisers to the SFC licensing requirements is desirable or necessary and that PE funds need to be appropriately catered for.
Hong Kong-based PE funds should be giving consideration to what the proposed changes will mean for them. The most important change should be the ability to relax strict operating protocols around investment decision-making. For example, it should no longer be necessary for all investment committee meetings to be held offshore, to make trips to Macau to execute investment agreements, or to have management monitor the composition of board and investment committee members to achieve the right tax outcome. However, the flip side of having key investment activities performed in Hong Kong is that the basis for remunerating Hong Kong advisory companies would need to change. This may result in more of the overall management fee being paid onshore and thereby subject to Hong Kong Profits Tax.
Proposals for open-ended investment companies (OEICs)
At present, unit trusts dominate the market, as the Companies Ordinance does not permit establishment of a variable capital investment vehicle in Hong Kong. The Government announced in the 2013/14 Budget that it was considering legislative amendments to introduce OEICs in Hong Kong to attract more traditional mutual funds and hedge funds to domicile in Hong Kong. The introduction of an OEIC regime provides alternative flexibility as to the types of investment vehicle available for use in Hong Kong. Unlike a unit trust, an OEIC has separate legal personality and does not require a trustee and will provide an attractive investment vehicle for mutual recognition with the Mainland.
It has been recommended that a distinction be drawn between public / SFC authorised OEICs (Public OEICs), which may be offered to the public subject to obtaining authorisation from the SFC, and private / unauthorised OEICs (Private OEICs), which will not require SFC authorisation and will therefore only be capable of being offered on a private placement basis (for example to professional investors).
The basic premise for Public OEICs is that, like retail unit trusts, these should mainly be governed by the SFC Code on Unit Trusts and Mutual Funds (the Code). It is not considered appropriate to impose additional requirements on Public OEICs which are not contained in the Code, except in very limited cases, nor to grant exceptions from Code requirements. The Code is neutral as to the legal form of schemes authorised by the SFC and already applies to foreign OEICs established in other jurisdictions seeking SFC authorisation in Hong Kong.
Private OEICs should have greater flexibility without imposing undue restrictions on their terms or investment scope.
With the increasing number of PE funds being set up in Hong Kong in the past few years, transfer pricing has become a common issue for PE fund managers.
The Hong Kong Inland Revenue Department ("IRD") issued Departmental Interpretation and Practice Note (DIPN) No. 46 entitled Transfer Pricing Guidelines – Methodologies and Related Issues in 2012. The DIPN states that, generally, the Commissioner would seek to apply the principles in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, except where they are incompatible with the express provisions of the IRO.
The cost-plus method has been the common transfer pricing method used for compensating Hong Kong based PE fund managers. However, recently the IRD enquiries have been re-visiting this basis. The cost-plus method is typically used for compensating services of a support nature. Accordingly, to the extent that a Hong Kong PE fund manager performs services which go beyond a support nature, the cost-plus method may not reflect the most appropriate method of remuneration.
Expansion of HK double tax treaties and use of HK as an investment holding jurisdiction
In recent years, Hong Kong has been and continues to be the key investment holding jurisdiction for Asia Pacific investments. This has been enhanced by its extensive double taxation agreement (DTA) network and its favourable treatment of foreign sourced income and capital gains.
Hong Kong continues to expand its DTA network and has now concluded 29 agreements. Negotiations are underway with a number of other jurisdictions, including South Korea, India and South Africa. The development of Hong Kong's DTA network enhances its position as a regional investment and trading hub in Asia Pacific.
The outlook for 2014
According to Merger Market data, Hong Kong M&A deals recovered strongly in the last quarter of 2013 with 46 M&A deals (accounting for 35% of total M&A deals in 2013). Up to early March 2014, there have been 17 Hong Kong M&A deals with a total deal value of approximately $1 billion predominantly in financial services industry.
With the Hong Kong SAR Government continuing to strengthen Hong Kong's position as a leading global international finance centre through the extension of the offshore fund exemption to include PE funds as well as the introduction of OEICs in Hong Kong, KPMG remains optimistic that the upward trend in M&A deals in Hong Kong will continue into 2014.
Tel: +852 2826 7166
Darren Bowdern is a partner in corporate tax. For more than 19 years, he has been involved in developing appropriate structures for investing into the Asia Pacific region, tax due diligence reviews in connection with M&A transactions and advising on cross-border transactions. Many of these projects comprise tax effective regional planning including consideration of direct and indirect taxes, capital and stamp duties, withholding taxes and the effective use of double taxation agreements. He also advises on establishing direct investment, private equity and other investment funds in Hong Kong.
Tel: +852 2143 8525
Benjamin Pong is a tax director for inbound M&A and private equity for KPMG China. He is based in Hong Kong and is part of the national tax practice serving private equity clients. Benjamin focuses on due diligence and tax structuring of inbound M&A transactions and foreign direct investments in Hong Kong and the region. He has advised many strategic investors and PE funds on tax issues concerning a wide range of inbound M&A transactions in the region in the areas of real estate, infrastructure, sales and distribution, manufacturing, and financial services.