The appeal of Singapore – and even Hong Kong – as private equity fund domiciles could get a boost from an unexpected source.

Historically, private equity fund managers have favoured offshore domiciles for their funds. Anecdotally, 90% or more of private equity funds investing in Asia are based in the Cayman Islands, according to fund advisers and lawyers. But the OECD is now demanding a higher threshold of ‘domestic economic substance’ in such offshore centres. This could badly tarnish their appeal.

“There's been a lot of discussion and thoughts behind fund domiciliation and whether the Cayman Islands remains the default and preferred choice for structuring private funds,” said Ho Han Ming, a investment funds and private equity partner of law firm Sidley Austin in Singapore.

Ho Han Ming

The Cayman Islands and British Virgin Islands have already introduced domestic substance legislation. Essentially, if a private equity fund is domiciled there, its managers and executives may now have to live there too.

While the Cayman Islands’ new rules do not cover investment funds, general partners (GPs) of Cayman funds who also participate in fund management could be recognised as relevant entities. But Florence Yip, the Asia Pacific tax leader for asset & wealth management at PwC, said that whether the new rules capture these entities is still uncertain.

Smaller fund managers could suffer under the new rules, as they will now have set up an office, hire employees, directors and senior management to make sure it generates its core income in the Cayman Islands and not anywhere else if it wants to continue to avail of.

“Under the economic substance requirements and recent guideline no. 2 issued by the Cayman Islands authorities [on April 30]…a Cayman fund manager which is not a tax resident elsewhere has to comply with the economic substance requirement,” said Yip.

That’s not going to be easy; the Cayman Islands for example only had 63,000 residents at the end of 2017, according to its Economics and Statistics Office. But compliance with the new regime will not be as simple as adding a staff member or two, argued Yip.

“If the European Union wants tax transparency, and if they want commercial substance, it will be difficult for many Cayman Islands funds to have commercial substance if what they probably have are one or two Cayman directors of a GP while everything else is run outside of Cayman,” she said.

Yip acknowledged that although new economic substance rules of different offshore jurisdictions are similar, each comes with slightly different definitions.

To date the impact has been limited. A professional at an international private equity firm told AsianInvestor the push for more transparency in the Cayman Islands hadn’t caused any major problems for his investors or increased the tax they pay.

But starting from as early as July this year, relevant entities covered by the new rules will need to be compliant and by December 2020 a full reporting to the Cayman authority [The Tax Information Authority] will be required.

“In terms of risk planning, you don't want to be left in a situation where you either have to have economic substance in the Cayman Islands, which would be expensive and counterproductive, or not have another home to go to,” said John Levack, vice chairman of Hong Kong Venture Capital and Private Equity Association.

SHIFTING CONDITIONS

Lawyers and tax experts said it's currently impossible to gauge the final requirements of this new regulatory oversight.

There is “no clarity on the final form of requirements or compliance, in order to demonstrate adequate economic substance in the jurisdictions where you establish the fund,” said Ho.

John Levack, HKVCA

 

But one likely impact is that is fund managers faced with these extra compliance costs become more open to looking at alternative domiciles, particuiarly onshore jurisdictions that still offer competitive tax rates.

Hong Kong could potentially be one, given its station as the financial gateway to China. And financial secretary Paul Chan has expressed his desire to make the territory a hub for private equity. But Levack said that it will have to do much more to raise its appeal to private equity managers.

The city's recently-introduced open-ended fund structure hasn’t been as popular as hoped and its upcoming limited partnership regime lacks both legal precedents and tax certainty.

“There is potentially an opportunity for Hong Kong, if firms are forced to alter their legal structures, where Hong Kong’s new rules might allow the alignment of legal and economic substance in the location where many of the senior team members are resident,” said Levack.

Singapore looks better placed to attract fund managers moving away from offshore jurisdictions. the city state has the track record of its 10-year limited partnership regime, while the tax benefits of its new VCC [Variable Capital Company] structure could be adapted to private equity funds.

Fund managers setting up a VCC in Singapore are eligible for exemption from withholding tax and a 10% concessionary tax rate under the Financial Sector Incentive, subject to regulatory approval. The structure is expected to be available by the end of this year.

“There's strong interest in Singapore versus Hong Kong for a variety of reasons, including familiarity with the operational mechanics and legislative concepts similar to corresponding structures in the Cayman Islands. In short, from a fund’s perspective, it [the VCC framework] works,” said Ho.

In addition to the tax benefits offered to VCCs, Ho noted that the licensing regime is relatively progressive: The Monetary Authority of Singapore allows fund managers to apply for different tiers of licence with varying requirements, depending on what type of investor they are targeting.

Having said that, there’s no guarantee that the VCC regime will turn out to be as handy as it sounds.

“The shift is there, from offshore to onshore fund domiciles but where funds eventually gravitate globally, for now at least, it does seem to point towards Asia,” said Ho.