The regime will create a new type of business, based on a Limited Partnership but created with modern funds’ needs in mind and governed by new rules.
The LPF announcement
In his 2019-20 budget speech, Hong Kong Financial Secretary Chan Po-mo announced that Hong Kong would establish a limited partnership regime for funds (LPF) to facilitate industry development, maintain market integrity and preserve investor protections. This development could transform how private equity funds registered outside Hong Kong do business.
Given the strength of the private equity business in Asia, it’s surprising at first that there wasn’t already some provision in one of the region’s economic hubs for private equity funds. Lacking local options, most funds active in the region have chosen to register as Exempted Limited Partnerships in the Cayman Islands.
The major alternative to the Caymans has been the Singapore Limited Partnership, established in 2009, and Singapore has continued to be a leader in this area — creating opportunities for businesses via Variable Capital Companies, introduced in 2018, for instance.
If Asian businesses have historically registered in the Cayman Islands, what drove the change?
The Cayman Islands were traditionally a location where businesses could be registered at will. But in 2018, that changed. A combination of new laws — The International Tax Co-operation (Economic Substance) Law, 20181 and The International Tax Co-operation (Economic Substance) (Prescribed Dates) Regulations, 2018, collectively referred to as the Initial Law — established an economic substance requirement for entities registered in the Cayman Islands.
The new Cayman law is part of a global movement based on global OECD Base Erosion and Profit Sharing standards, and requirements like this are being implemented by all OECD-compliant jurisdictions that charge no or only nominal tax.
Thus, the appeal of onshore structures has risen considerably and Hong Kong’s new regime can partly be seen as a response to this.
How does the new regime differ from an ordinary Limited Partnership?
The Hong Kong Limited Partnership Ordinance (LPO) dates the the end of the nineteenth century, predating the private equity fund industry, and is designed to meet the needs of small organizations of professionals, not of trusts, for which the prescribed structures are to unwieldy and restrictive.
Here’s how Limited Partnerships for Funds work.
Partners
An LPF is a “fund”, defined as a “collective investment scheme” by the securities and Futures Ordinance, used to manage investments for the benefit of its investors. Under the proposals, LPFs will constitute at least two partners, of whom one will be a Limited Partner and one a General Partner. Limited Partners’ liabilities in the trust are limited by their contributions, while General Partners have full liability.
Crucially, this need not be personal liability. Partners need not be natural persons, and the range of entities permitted to be GPs is much broader and more flexible than the original proposal in the Consultation Paper suggests. Initially, the plan was to allow only private companies limited by shares incorporated in Hong Kong to be GPs. The revision allows fund sponsors to choose among a range of structures with varying degrees of tax opacity.
Managers
The fund would be required to hire an investment manager, who must be over 18 and resident in Hong Kong or a corporation registered in Hong Kong. The investment manager will take care of the day-to-day investment management activities for the fund, and must be licensed by the Hong Kong Securities and Futures Commission of Hong Kong. Not all funds currently operating from Hong Kong have such licensing, and some may decline the new structure because of this licensing requirement.
Custody
The proposed regime will require the GM to ensure that there is appropriate custody for the assets of the LPF. Currently, there are no detailed requirements, such as a requirement to appoint an appropriate custodian, which is usual in the private equity context. The likelihood is that such details will be added at a later date, and the trust and custody arrangements required for an LPF will be formalized along lines already familiar to the Hong Kong trust and custody sector.
Registration
LPFs would be required to register with the Registrar of Companies (RoC), which would serve as registrar and maintain and publish an LPF register. For an LPF’s registration to remain valid, the GP would have to file an annual return with the RoC, and would also be required to inform the RoC within a specified timeframe of any changes in the registration particulars. LPF financial statements will be audited by an independent auditor.
Record-keeping
The GP or investment manager would be responsible for records relating to the LPF’s operations and transactions, such as beneficial ownership information and audited financial accounts. This would need to be kept at the registered office of the LPF, or at any other place in Hong Kong if the SoC has been made aware. LPF financial accounts would need to be available to all partners and to law enforcement where necessary.
Tax and stamp duty
Tax treatment of LPFs in Hong Kong is not yet cretain. For instance, an LPF that meets the definition fo “Fund” used by the Inland Revenue Ordinance, and with some exemption conditions laid out in the IRO, might be exempt from profits tax in Hong Kong for certain transactions.
An interest in an LPF does not meet the definition of “stock” under the Stamp Duty Ordinance, and thus an instrument used to transfer, contribute or withdraw from an LPF is not likely to be subject to Stamp Duty. In-kind capital contributions in relation to the transfer of dutiable assets, however, would be subject to stamp duty.
In general, taxation on LPFs is expected to be the same as for Limited Partnerships.
AML/CFT requirements
AN LPF will be required to appoint a “responsible person” to carry out Anti-Money Laundering and Counter-Terrorist Financing (AML/CFT) functions. The responsible person can be a person or corporation that is an “authorized institution”, a “licensed corporation”, an “accounting professional”, or a “legal professional”. It’s possible that these definitions will be tightened up later, but presently they are broad. The responsible person would be required to conduct preventative AML/CFT measures, such as due diligence, and the name and identification number of the responsible person would need to be declared to the RoC.
Safe harbour activities for LPs
The liabilities of LPs are limited by their commitments to the LPF. While the LPs d not have management rights over the LPF or control over the underlying assets it holds, they do have the right to participate in certain safe harbour activities. These are expected to include serving on a board or committee of the LPF, participating in decisions concerning admission or withdrawal of partners, and changing the investment scope of the LPF.
Enforcement
While we still don’t know exactly what form this will take, the RoC will be granted sufficient enforcement powers to oversee compliance with registration, annual return filing and other requirements. In particular, the RoC will have the power to deregister LPFs under certain circumstances.
Winding up
LPFs will be wound up either according to a partners’ agreement, or by the courts.
Conclusion
The proposal is currently expected to be introduced into the Legislative Council in the first half of 2020. Limited Liability Partnerships will provide Hong Kong and regional funds with the capacity to register and operate closer to home, in the heart of the Asian financial markets and according to a set of rules created to be as supportive as possible while maintaining probity. It seems likely that the new Hong Kong regime will prove attractive to many funds which until recently relied on the Caymans for a base of operations, though licensing requirements may deter some. There is also some concern over the propensity of overseas investors to prefer fund structures they are familiar with, which may be partly allayed by tightly integrating the fund regime into the existing financial structure.