Leading market participants believe Hong Kong's status as a regional fund management centre remains in question, following a new twist in the ongoing saga over the tax exempt status of offshore funds. This issue is of particular interest to hedge funds, which may face taxes for doing business in Hong Kong.

The threat of taxation has been one factor driving many hedge fund start-ups to go to Singapore instead. On December 31, 2004 the Financial Services and Treasury Bureau (FSTB) issued its long-awaited second consultation paper on this topic.

This came in response to the comments it received on its first consultation paper (issued January 14, 2004), which was heavily criticized by the industry for its unrealistic approach. Industry participants are currently reviewing the revised approach and have till January 31 to submit their responses.

Most participants agree that while the new approach is an improvement, it still does not provide a workable solution. "The exemption scope is too narrow. The government has not listened to the industry," says Florence Chan, tax partner at Ernst & Young. "In its current form, the revised approach will not work to reinforce Hong Kong's status as an international fund management centre, and may in fact discourage fund managers from locating in Hong Kong at all."

Experts say that many offshore funds, including the several unauthorized hedge funds in Hong Kong, will not qualify for exemptions under the new proposals. Participants in the hedge fund industry say that the uncertainty over the tax status of offshore funds in Hong Kong has been discouraging start-ups as well as overseas funds looking to set up an Asian presence from setting up in Hong Kong - to the benefit of rival Singapore, with its clearer tax regime, smooth licensing process and proactive government.

"The new consultation paper is a definite improvement on the first paper, which proposed an 80% non-residency test and placed too much burden on fund managers and brokers to monitor the beneficial ownership of Hong Kong residents in the fund," says Florence Yip, tax partner at PricewaterhouseCoopers. "The government has made clear its intention to exempt offshore funds from tax. The speediest solution is for us to suggest improvements within the new guidelines given by the government and work towards a compromise."

The revised approach has two basic components: the exemption provision which sets out the criteria for an offshore fund that can seek profit tax exemption, and the deeming provision, which seeks to prevent round tripping - the practice where local funds disguise themselves as offshore funds to avoid tax. Industry experts say the scope of the exemption provision, which applies only to section 20AA brokers and fund managers, needs to be widened and clarified.

To qualify under Section 20AA fund managers cannot be associates of an offshore fund and must be independent of it. "In many cases, for example through the use of founder or management shares, fund managers control the offshore fund, making them associates," says a Simmons & Simmons paper.

For hedge fund managers, it is common practice to invest their own money in the fund too, hardly making them independent. Various suggestions to address this are arising.

E&Y's China suggests the government either drop the 20AA requirement, or relax its interpretation. PwC's Yip suggests the government should perhaps use an economic rather than legal definition of control, or alternatively apply the exemption to all SFC licensed offshore funds.

Another concern with the revised approach is that it only includes tax exemptions for profits from Hong Kong securities transactions. "This only covers shares traded through the Hong Kong stock exchange, and doesn't cover other types of gains such as forex, distressed debt transactions and gains from interest income," notes Yip, who will seek to urge the government to widen the scope of trading included in the exemption.

The government's biggest fear with granting profits tax exemption for offshore funds is that local entities will use it as a loophole to escape its taxes. The new proposal puts forward a deeming provision in an attempt to combat this.

Under the new rule, if a Hong Kong resident and his or her associates hold more than a 30% beneficial interest in an offshore fund, they will be taxed on the Hong Kong trading profits of that fund. Industry participants have objected to this criterion on various grounds.

E&Y's Chan says the deeming provision is too wide and should apply only to resident corporations rather than resident individuals. PwC's Yip says that 30% threshold is too low, and that a level of 50% or more should be applied as this is the level for economic control.

Most point out that there are a series of practical difficulties with implementing the deeming provision. Often a genuine conglomerate company may not be aware which of its associates were invested in common offshore funds, and whether combined ownership levels reached above 30%.

Another bone of contention is identifying who would be responsible for determining how much of the fund's transactions are in Hong Kong securities. Yip at PwC points out, however, that the deeming provision should be a second priority.

"Our focus should be on clarifying the offshore fund exemption without further delay," he concludes. "It is imperative to Hong Kong's success as an international fund management centre."