Hong Kong's future as a regional hub for the funds management industry hangs in balance as the government reviews comments on its proposals to clarify the tax status of offshore funds.

The uncertainty over the tax treatment was highlighted in 2001 when profit tax returns were issued to several of Hong Kong's offshore funds. Although none are believed to have actually paid the tax - and the government has stated its intention to clarify the law to exempt offshore funds - the ensuing uncertainty has encouraged several new funds to locate their operations in Singapore.

"We warmly welcome the government's intention to encourage the development of the fund management industry in Hong Kong by exempting offshore funds from tax," says George Long, head of the Hong Kong chapter of AIMA (Alternative Investment Management Association). "However we feel the mechanisms under the current proposal are very cumbersome and may have unintended negative consequences."

Moreover, executives worry that if the proposals are adopted in their current form, Hong Kong will cease to be an attractive hub for the mutual funds industry. Responding to the government consultation paper, PricewaterhouseCoopers says, "Implementation of the proposal as drafted . . .will possibly drive fund managers away from Hong Kong to other jurisdictions in Asia, as well as cause overseas investors to redeem existing investments in offshore-managed Hong Kong funds."

In the consultation paper issued by the Financial Services and Treasury Bureau (FSTB) on January 14, the government proposed that offshore funds in Hong Kong will be exempt from tax so long as at least 80% of the fund's beneficial investors are made up of non-Hong Kong residents. In addition, it requires that the fund and its investors do not carry out any other business in Hong Kong.

However, most industry participants feel that the non-resident ownership requirements are impractical.

"The government does not provide any definition of what a Hong Kong resident is, nor has residency ever been used as a criteria for the basis of taxation in Hong Kong," says Florence Yip, partner at PwC.

In addition, the administrative difficulties and costs involved for brokers and investment advisors in complying with the record keeping requirements would be enormous and potentially prohibitive. In many cases it is difficult to identify the tax residency of a funds ultimate beneficial owners. Grey areas occur when a fund is owned by a listed corporation or when a private bank aggregates the accounts of its clients to make an investment in a fund.

There is also concern that the proposal discriminates against Hong Kong investors who might be excluded from access to good quality investment products managed in Hong Kong.

"Under the current proposals the best way for an offshore fund to ensure certainty of its tax exemption status would be refuse any investment from Hong Kong resident investors," says Robert Grome, partner at PwC.

The new proposals may also deter offshore investors from investing in Hong Kong-based offshore funds because of the complicated forms they would be required to fill in and the added requirement of certifying that they have no additional business in Hong Kong. Moreover, investors would always run the risk that the fund would be subject to tax should the Hong Kong resident ownership would cross the 20% threshold due to issues beyond the control of the fund manager, such as redemptions or change of residency of an investor.

The government's focus on the non-resident ownership as a tax exemption criteria is based on the fear of "round tripping", the practice where local funds disguise themselves as offshore funds to avoid taxes.

Unfortunately, the proposal may in fact encourage round tripping, prompting Hong Kong investors to invest via offshore managed funds. AIMA argues that this will only reduce the value of assets managed in Hong Kong.

The organization suggests the round tripping abuse would be most likely to occur where a fund and its manager are pawns of an investor who would otherwise pay profits tax on his trading activities. AIMA therefore suggests the government exempt offshore funds from profit tax on the condition that the fund's managers and its associates own less than 50% of the fund.

PwC suggested similar solutions to the government's round tripping concern, but took a very strong line in its response to the government's proposal arguing that a blanket profit tax exemption for genuine offshore funds is necessary to ensure Hong Kong has a more attractive tax legislation for offshore funds than its regional rivals.

It no secret that Singapore has been laying out the red carpet for fund management companies, not just in terms of tax incentives, but also perks such as rent and staff salary subsidies and a streamlined approval process. The Singapore government has also been known to make investments in offshore funds looking to set up within its borders.

"There is a lot at stake here, for Hong Kong funds management industry and the for the knock effects on Hong Kong's economy," says Grome at PwC. "The right solution is more important than a quick solution."