Investors often set up their investment structure in offshore jurisdictions such as the British Virgin Islands and Cayman Islands. Whether they are limited partnerships or companies with different share classes, these structures rely heavily on Hong Kong-based affiliates for support in management and investment decision-making, among other key business functions.
This trend is particularly noticeable in relation to cryptocurrency and other virtual assets, robo-trading, online assets evaluation/screening and other digital-oriented investment businesses. Typically, the offshore entity carries on business by way of a fully automated system, while its Hong Kong affiliate provides technical support, such as upkeep and adjustment of its proprietary software, and is remunerated on a cost-plus basis.
The key SFC licensing and Hong Kong profits tax and transfer pricing implications regarding these offshore and onshore operations are highlighted below.
The licensing regime under the Securities and Future Ordinance (Cap. 571) is activity-based. A company that carries on a "regulated activity" in Hong Kong, regardless of whether it is incorporated in Hong Kong or elsewhere, has to obtain a license from the Securities and Futures Commission ("SFC") unless an exemption applies.
An offshore entity without operations in Hong Kong will not be treated as carrying on regulated activities in Hong Kong so long as (i) it does not hold itself as carrying on regulated activities in Hong Kong or (ii) its services are not actively marketed to the public in Hong Kong.
With regards to software/online platforms, SFC takes the view that it will not regulate platforms that only provide general advice on asset allocation among different asset classes without providing advice concerning specific investment products. However, when business activities involve providing order execution services and/or financial advice via an online environment using algorithms and other technology tools, it will likely attract licensing and regulation under Type 1 "dealing in securities" and Type 4 "advising on securities" regulated activities. Type 9 "asset management" may also be relevant if the automated platform is given full discretion in terms of investment decision-making.
Several licensing exemptions are available. For example, the offshore entity is exempt from licensing if the trading order execution is carried out by another person who is licensed for Type 1 activities. Another relevant exemption would be the provision of advisory services on an intragroup basis. So for instance, advising on securities, being a Type 4 regulated activity, is exempt from licensing so long as the advice is provided to its 100%-parent, subsidiaries or fellow subsidiaries. This intragroup exemption is particularly relevant to single-shareholder family offices.
HK tax issues
Where an offshore entity and a Hong Kong entity are under common control, or where one is wholly-owned or controlled by the other, the remuneration received by the Hong Kong entity in return for the services it renders to the offshore entity will be subject to transfer pricing considerations. As such, where a Hong Kong entity provides services or technical support to the affiliated offshore entity, the local entity's remuneration will have to be made on an "arm's length" basis, such that its profits are not artificially depressed to lower its tax burden in Hong Kong. This will prevent the entity from falling foul of the transfer pricing requirements of Hong Kong.
In respect of the trading profits of the offshore entity itself, Hong Kong applies the territoriality principle of taxation: only profits arising in or derived from Hong Kong from a trade, profession or business carried on in Hong Kong are subject to profits tax. Accordingly, while the Hong Kong entity's service fees are subject to profits tax (being sourced from activities rendered in Hong Kong), the trading or investment profits may or may not be subject to profits tax depending on the application of the territoriality "source" test. Whether certain profits or gains in a particular case are chargeable to profits tax has to be considered on the basis of its individual facts and circumstances. The existing laws concerning profits tax are equally applicable to transactions involving virtual assets, including the general exemption of capital gains from taxation.
Following recent legislative amendments, privately-offered onshore and offshore investment funds operating in Hong Kong can enjoy profits tax exemption for their transactions in qualifying assets, provided they meet certain criteria. However, it appears that digital assets, which are not considered "securities", may not be treated as qualifying assets. Therefore, relevant crypto funds may find themselves assessable for profits tax. Nevertheless, this does not affect the territoriality principle of taxation: the exemption is not relevant where profits are considered to be sourced offshore or arise from the sale of capital assets.
Given the rapid evolution and increasing digitalisation of the trading/asset management space, investors should consult with legal experts in the area when considering the structure of their investment activities. This will enable them to avoid hefty legal and financial complications.