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Offshore economic substance laws: Implications for Hong Kong SAR’s funds sector


The implementation of economic substance laws in offshore jurisdictions will impact funds with management and advisory teams in Hong Kong SAR. Darren Bowdern and Johnson Tee explain how these changes will prompt a revisiting of fund group holding structures.

Effective from January 1 2019, entities established in recognised offshore jurisdictions will need to satisfy the new economic substance laws (ES laws). These laws have been introduced in response to efforts made by the OECD to enhance global tax transparency under Action 5 of the BEPS initiative, as well as an investigation by the EU's Code of Conduct Group into certain low– or no–corporate income tax regimes.

Offshore jurisdictions whose ES laws have come into effect include the Bahamas, Bermuda, British Virgin Islands (BVI), the Cayman Islands, Guernsey, the Isle of Man, Jersey, Mauritius, the Seychelles and the Marshall Islands.

In particular, the idea behind the ES laws is to align the location of economic substance with the jurisdictions where profits are booked. If profits are being booked in an offshore company, it should follow that the business or profit-generating activities giving rise to those profits should be situated in the same jurisdiction. Penalties will apply to entities which breach the requirements, and if they continue to infringe, the entity may be deregistered. However, where an entity is registered as a tax resident in another jurisdiction, the ES laws will not apply.

Activities falling within the ES laws include banking, distribution and service centres, finance and leasing, fund management, headquarter businesses, holding companies, insurance, intellectual property holdings and shipping. For each of these activities, minimum core income generating activities (CIGA) are required to be undertaken in the jurisdiction of incorporation, with the level of activity required being a function of the nature of the activity undertaken.

In the context of investment funds, with its tested regulatory framework and familiarity with investors generally, the Cayman Islands (and to a lesser extent the BVI) has long been seen in Asia as a preferred tax neutral jurisdiction. Structuring through these jurisdictions allows investment returns to be efficiently distributed to investors so that they may report investment returns in their respective jurisdictions of domicile.

In this regard, Cayman Islands investment funds, including their investment special purpose vehicles (SPVs), are excluded from the ES laws. This means that typical Cayman Islands limited partnership funds, the general partners (GPs) of those funds and Cayman investment SPVs established by the funds, should fall outside the scope of the new rules. However, fund management activities remain in scope, which means that Cayman fund managers will be required to meet the CIGA requirements.

Funds beware

A fund management business is defined as "the business of managing securities as set out in paragraph 3 of Schedule 2 to the Securities Investment Business Law (2015 Revision) [SIBL] carried on by a relevant entity licensed or otherwise authorised to conduct business under that Law for an investment fund". 'Managing securities' means managing securities belonging to another person in circumstances involving the exercise of discretion.

Whilst most Cayman Island fund managers are not licensed under the SIBL, under the SIBL (2019 Revision) Act, fund managers will need to register for a licence by January 15 2020. Having said that, the impact on fund managers will vary depending on the operating model and fund type.

For hedge funds, if discretion for making investments is exercised at the level of the onshore investment advisor – for example by a licensed investment advisor based in Hong Kong SAR – instead of at the level of the Cayman Island fund manager, which would typically be the case, then technically the fund manager should not be regarded as conducting a fund management business subject to the ES laws. Conversely, for private equity, real estate and private credit funds, if the discretionary investment decision powers are exercised at the Cayman Island fund manager level, then the ES laws would apply. The upshot of this is that such funds may need to consider shifting their fund management activities to the GP, so as to fall within the investment fund exclusion.

As already mentioned, SPVs established by Cayman Island investment funds should fall outside the scope of the ES laws. Although the ES laws and guidance do not specify the level of ownership required, on a strict reading of the rules, even if the fund invests in a minority stake in a Cayman SPV, the SPV should still be regarded as being part of the investment fund.

As the definition of an investment fund only covers Cayman Island entities, the definition does not extend to BVI companies owned by the fund. While BVI ES requirements will need to be analysed separately, the substance requirements in the BVI for a pure equity holding company should mean that such entities should continue to be able to be used in fund structures.

The upshot of all of this is that fund groups should be able to continue with their Cayman Island platforms, but modifications may need to be made in certain circumstances.

Requirements likely to expand

For companies established on or after January 1 2019 in either the Cayman Islands or BVI, compliance with the substance requirements is mandatory from the time they start conducting the relevant activities. Existing companies as at December 31 2018 had a six-month transition period (that is, until July 1 2019) to comply with the rules.

Starting in 2020, entities will have annual reporting obligations to the Cayman Island and BVI authorities in respect of their compliance with the new rules. There are heavy penalties for failing to satisfy the economic substance test, with a fine for non-compliance of approximately $10,000 applicable to the initial year, and up to $100,000 in subsequent years.

For continuing non-compliance, the entities may also be struck off the Registrar of Companies. This is a good opportunity to revisit the wider fund groups' holding structure and the purpose behind it, as well as the costs and benefits of maintaining such offshore entities.

As a final point, given the development of the global tax environment towards greater transparency and the clamping down on harmful tax practices, economic substance requirements are likely to expand to even more jurisdictions, particularly those which have very low or no taxation. While existing operating structures may still be viable under current laws, management should keep a close eye on new developments and be prepared to make appropriate changes in response to such changes.

Darren Bowdern


Partner, Tax

KPMG China

Hong Kong SAR

Tel: +852 2826 7166

Fax: +852 2845 2588

Darren Bowdern is a partner in KPMG's Hong Kong SAR tax practice. He has more than 25 years' experience of serving institutions in a wide range of industries in Hong Kong SAR and the Asia Pacific region.

Darren heads up the M&A tax practice in Hong Kong SAR. He has been advising on transactions in the Asia Pacific region with respect to tax matters, including due diligence reviews, investment holding structures and advising on cross-border transactions. Many of these projects consist of 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. Darren has extensive experience in working with the mainland Chinese market, including structuring acquisitions of investments in mainland China.

Darren also advises on establishing direct investment, private equity and other investment funds in Hong Kong SAR and advises clients in a wide range of industries.

Darren graduated from the University of Melbourne and is a fellow of the Hong Kong Institute of Certified Public Accountants and a member of the Chartered Accountants Australia and New Zealand.

Johnson Tee


Director, Tax

KPMG China

Hong Kong SAR

Tel: +852 2143 8827

Johnson Tee is a director in the Hong Kong SAR corporate tax practice. Johnson has 17 years of Hong Kong SAR and Malaysian corporate tax experience, performing tax advisory and compliance services for financial institutions and multinational corporations with a particular focus on asset management clients.

Johnson has a wide range of experience in the establishment and structuring of offshore funds, advising on operating protocols for funds, assistance with applying for treaty benefits and advising on the structuring of management fees and carried interest.

Johnson graduated with a bachelor's degree in business from Monash University (Australia) and is a member of the CPA Australia.

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