Hong KongÆs government has long fancied the territory as AsiaÆs most important centre for asset management. But a longstanding threat of taxing offshore fundsÆ profits made on trading domestic securities has hindered this effort.

This week, that threat was removed when the Inland Revenue Department agreed to exempt offshore funds and the Legislative Council passed the Revenue (Profits Tax Exemption for Offshore Funds) Bill.

Fund managers and lawyers representing the industry praise this decision and say it removes a key barrier to attracting international investment managers, particularly hedge funds, from setting up shop.

ôProvided certain conditions are met,ö says a report from PricewaterhouseCoopers, ôoffshore funds with Hong Kong fund managers and investment advisors may now confidently state that they are not subject to tax in Hong Kong on profits derived in Hong Kong.ö

Rory Gallaher, partner at Deacons, says fund management groups from America and Europe looking to open shop in Asia weighed the possibility of being taxed in Hong Kong. ôSome of them went to Singapore because of it,ö he says. ôNow there is little reason not to set up in Hong Kong.ö

Tax became an issue with the rise of hedge funds. The governmentÆs position has been to treat a Hong Kong-based agent trading on behalf of a non-resident as that investorÆs place of business. Therefore offshore funds were exposed to Hong Kong tax if they traded through a domestic fund manager. Inland Revenue never actually sought to tax overseas investors because it understood that mutual funds and segregated accounts were ôinvestingö rather than ôspeculatingö.

Hedge funds û which short, use derivatives, take on leverage, and usually have much higher turnover û were viewed as ôspeculatingö, particularly in the aftermath of currency traders attacking the Hong Kong currency in 1998. So in 2000, Inland Revenue issued tax returns to any Hong Kong-based fund manager that was registered for stock borrowing.

What the government failed to grasp was that offshore investors were being taxed twice û in Hong Kong on profits from local trades, and at the portfolio level in their home country. The industry argued that this tax was undermining the governmentÆs efforts to make Hong Kong the regionÆs premier site for international asset management.

The government took these arguments seriously, but had a counterargument: wouldnÆt exempting offshore fund managers then allow rich people in Hong Kong to evade or avoid tax by investing via offshore structures?

This was the sticking point. The government has indicated its interest in closing the matter but it has taken nearly six years. In 2003, then-financial secretary Antony Leung expressed the intention to exempt offshore funds from profits tax. But it took another three years to finally realize this goal, and it became a sore point in the industry.

ôItÆs been a consuming project for four years,ö says Christophe Lee, chairman of the Hong Kong chapter of the Association of Investment Management and Research, which has served as a voice for the hedge-fund industry. ôIt only really got going last summer when Inland Revenue finally agreed to meet with us.ö

According to PwC, non-residents (including corporations, trusts or partnerships) are exempt from Hong Kong profits tax on certain types of transactions backdated to April, 1996. This includes transactions in securities, futures contracts, forex contracts, making deposits, foreign currencies and exchange-traded commodities. The non-resident must not, however, carry on any other business in Hong Kong.

Some issues remain for start-up hedge funds, in which the portfolio managers are often the same people as the directors on the fundÆs board. Because the exemption is only for offshore funds, these start-ups remain exposed to profits tax. Lawyers anticipate these funds will seek to build a majority of directors from people located outside Hong Kong, in order to classify the fundÆs principals as non-resident.

Lee says AIMR will work with the government to ensure the law is implemented in a practical way but notes that the legislative framework seems clear. With the licensing process for hedge funds also having improved of late, Lee says AIMR has no outstanding issues with Hong Kong regulators.