Imagine a scenario in which a Hong Kong-based hedge fund manager
establishes and appoints an offshore management company to provide
investment management services for its fund. On one hand, the
fund's structure ensures a clear operational base. But at
another level, key governance procedures are often neglected. These
tasks include maintaining a certain number of offshore directors,
opening and maintaining a bank account, holding regular board
meetings in the offshore jurisdiction, and keeping a balance of
Such neglect could come at a steep price and expose the fund
manager to tax liabilities in the manager's onshore
jurisdiction. This is especially true in today's environment,
in which regulators and tax authorities everywhere are taking a
closer look at the substance of offshore management companies in
relation to corporate governance.
By substance, we mean maintaining a proper operational structure
that keeps the fund manager's operations outside of the tax
framework of the onshore entity. In other words, the offshore
company should be a real, living, breathing entity and not a mere
Hong Kong-based managers are no doubt aware of this increased
scrutiny, as over the past few years, the Inland Revenue Department
(IRD) has been delving into this very matter. The IRD is increasing
its investigations for the same reasons regulators everywhere
looking more closely at offshore fund management structures
– to consider what activities being provided by investment
managers are to be taxed in Hong Kong.
How to mitigate risk
So, how does a Hong Kong investment manager minimise its
exposure to tax risk? Merely setting up a fund manager in an
offshore jurisdiction such as the Cayman Islands is not a
sufficient structure to ensure tax compliance and minimise the
risk. Regulators have highlighted the risk of the approach.
First, ongoing questions from tax authorities point to concerns
about central management and control issues regarding the fund, as
well as the need to properly demonstrate that there is real
substance to the offshore business structure. Some of the questions
that the Hong Kong-based asset manager should look to address
include: Can the asset manager show trade activity being reviewed,
approved or ratified offshore? Does the offshore management company
have dedicated directors or employees based in the offshore
jurisdiction? Can the manager show payments being processed
Additionally, tax authorities must be satisfied that the
directors of the Cayman fund manager are located offshore and that
the board consists of a majority of non-onshore directors. There
should also be proof that the board meets regularly and does so in
the offshore jurisdiction in which the management company is
established or a jurisdiction other than the onshore
The directors should also operate independently and not simply
rubber-stamp decisions of the executives in the onshore
Other pertinent considerations include whether the Cayman fund
manager has had regular involvement in the fund's management
and in the realisation of the fund's investment objective,
policies and strategy. Questions regarding where and by whom
agreements of the Cayman fund manager are executed are also looked
into and whether the offshore directors of the Cayman fund manager
are regularly reviewing reports and actively monitoring the
Good corporate governance helps minimize tax
These inquiries represent only a fraction of the facts which, if
considered thoughtfully, would mitigate the risk of tax liability
being assessed on income earned by the offshore Cayman fund
Hong Kong-based fund managers should take other precautionary
steps to ensure that their Cayman fund manager is operating with
the required level of offshore substance so as not to attract tax
In addition, managers must ensure that the flow of fees earned
from the offshore fund truly represent what is noted in the
underlying agreements between the Cayman fund manager and its
An imperative to getting the substance right
With governments around the world casting their tax nets far and
wide, it's an opportune time for Hong Kong fund managers to
carefully assess their offshore structures and ensure that there is
substance to them.
Not addressing the corporate governance and operations of the
offshore management company is a far riskier proposal today than it
ever was. The good news is, there's no need to run this risk.
Asset managers have plenty of opportunities to step up their
guidance and oversight and ensure they use their Cayman structures
to achieve operational efficiency, meet compliance requirements and
avoid unnecessary tax liabilities.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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