Background

In 2013 the FSDC published its research paper entitled "Developing Hong Kong as a Capital Formation Centre for Real Estate Investment Trusts" ("2013 FSDC Research Paper").³ Since that time there have, amongst other initiatives, been multiple helpful changes to the Code on Real Estate Investment Trusts ("REIT Code") and other regulations applicable to H-REITs. These have included expanding the approved types and combinations of investments that can be undertaken by H-REITs and also enabling greater cross-investment by other types of regulated funds in Hong Kong into H-REITs.⁴

The 2021 FSDC Research Paper was prepared following the formation by the FSDC of a Working Group comprising industry experts including from Baker McKenzie to revisit the 2013 FSDC Research Paper, and identifies six core policy recommendations to bring about further growth in the H-REIT market. We explore the recommendations in more depth below.

In Depth

Recommendation 1: Refining the REITs value proposition

The FSDC has noted that the existing H-REIT regime already provides flexibility regarding the nature of assets that can be listed as a REIT along with enabling listings using multiple currencies. It is suggested that some of these important, positive advantages of the H-REIT regime compared to those of other markets need to be more strongly emphasised in a consolidated manner. Specific areas for potential focus include the following.

1. Hong Kong is welcoming of various asset types to list as REITs.

Whilst an H-REIT is required by the REIT Code to "primarily invest in real estate", there is no restriction as to the type of industry to which the real estate must belong, or the underlying purposes for which the property is used. A recent example of this diversification capacity is the listing of SF REIT, which is the first logistics-related H-REIT to be listed in Hong Kong.

2. Hong Kong's simple and low tax regime benefits REITs.

There is an incorrect perception that H-REITs are significantly disadvantaged from a tax perspective compared to some leading markets - when the terms could actually be preferential in certain circumstances. The Hong Kong tax system provides for an exemption for certain profits for H-REITs and there is no value-added tax (VAT). Investors, whether local or foreign, aren't subject to taxes on capital gains or dividend income derived from investing in H-REITs.

3. Dual Currency trading is available for REITs.

Dual currency trading is already facilitated under the Dual Tranche, Dual Counter (DTDC) model introduced by the SEHK in 2011.⁵ This model allows issuers to list two tranches of shares and ETFs in different trading currencies and would enable an H-REIT to also be listed, for example, in RMB in addition to HKD thereby enabling direct access to a significant offshore RMB liquidity pool.

Recommendation 2: Tapping into cross-boundary investor base

Reflecting the role that Hong Kong plays as a gateway to investment in, and from, Mainland China ("Mainland"), the FSDC has made several recommendations as to how this important function can benefit H-REITs further. Those recommendations include the following.

1. Stock Connect Schemes.

H-REITs are not currently included as eligible securities under the Stock Connect schemes. It is proposed that H-REITs and also Mainland REITs (C-REITs),⁶ should be included thereby ultimately allowing for two-way investment in each market. International capital seeking to increase their stake in Mainland assets, particularly in infrastructure sectors, will be granted such access conveniently; while Mainland investors looking to diversify their global allocation can leverage the platform to invest in regional and global real estate assets through Hong Kong. Such a move would further establish both Hong Kong and the Mainland as a regional REIT hub and facilitate the efficient matching of real-estate assets and cross-boundary capital. In the event that an "ETF Connect" scheme is introduced in the future, REIT ETFs could also be included as eligible securities.

2. Introduce market making.

In order to increase trading liquidity, a market making function for H-REITs could also be introduced. Whilst market making is currently available for REIT ETFs listed on the SEHK or for options traded on an H-REIT, no such capacity exists for the H-REIT units. Such an arrangement could potentially result in build-up of liquidity and formation of a critical trading mass enabling an H-REIT to thrive on its own on a fast-growing trajectory.

Recommendation 3: Diversifying REITs product offerings

The FSDC proposes several ways in which the existing H-REIT sector can be expanded in a similar manner to that seen in other competitive markets. The suggestions include the following:

1. The promotion of H-REITs as a competitive structure for listing real estate assets in various additional industry categories including healthcare, logistics parks and infrastructure. The SFC is encouraged by the FSDC to consider providing guidance and clarity on the regulatory implications for such listings.
2. Encouraging H-REIT related product innovations in order to provide additional liquidity and cater to different trading needs. These could include additional REIT ETF products which could enable future hybrid combined cross-boundary H-REIT / C-REIT ETFs or REIT futures such as those found in Singapore could also be considered and explored.

Recommendation 4: Exploring tax and financial incentives

The FSDC notes that H-REITs already enjoy a strongly competitive position from the tax perspective as they can benefit from a profits tax exemption in addition to there being no tax on capital gain and dividend income. However, there are still areas that the FSDC suggests could be improved to better differentiate H-REITs from listed property companies. These include providing tax incentives in the following areas:

• Property taxes on REITs (which apply on rental income received from Hong Kong properties whilst a special purpose vehicle ("SPV") holding the property will generally be exempted from property taxes).
• Profits tax on asset holding SPV's (which unlike the H-REITs for which they are established to hold assets like hotels, recreational parks or serviced apartments are currently subject to profits tax).
• Tax for transfer of properties acquired by REITs.
• Stamp duty on trading REITs.

Recommendation 5: Implementing regulatory enhancements expeditiously

In its 2013 Research Paper, the FSDC noted that there were two key regulatory difficulties that impacted the capacity of H-REITs to engage in takeover and merger transactions. Those were:

• Absence of "squeeze-out" provisions facilitating takeover of a REIT (i.e. an ability to compulsorily acquire the units of minority shareholders making it extremely difficult to obtain complete ownership); and
• Non-availability of a "scheme of arrangement" in the privatisation of a REIT (i.e. no ability, subject to certain approval thresholds, to implement a binding scheme of arrangement on all shareholders including those who object).

The FSDC notes that as yet, no solution to these issues has been implemented and that an expeditious implementation of suitable regulatory enhancements would be welcomed by market participants. As potential options, the FSDC has suggested that the SFC could issue a Practice Note to ensure that minority unitholders are provided the same level of protection as shareholders in listed companies and the same takeover / privatisation tools for Hong Kong listed companies should be available to H-REITs to provide a level playing field. Clear guidance is also requested on the applicability of law-based privatisation for REITs adopting a stapled structure in the future.

Recommendation 6: Stepping up market promotion and regulatory communication

The FSDC has noted that with a refreshed H-REITs value proposition, expanded investor base and product basket, a revised approach could be taken to promoting and raising awareness of H-REITs. The suggested methods by which this could be achieved include the following.

1. International Promotion.

The regional and international promotion of H-REITs should be given more emphasis to establish Hong Kong as the regional go-to market. Events like a "REITs day" could be considered to bring the promotion of the H-REIT concepts closer to investors in other markets.

2. Targeted Marketing by Investor Type.

More targeted marketing could be explored with differentiated strategies for varying investor types to raise awareness of H-REITs and understanding of their unique characteristics. It is envisaged that institutional investors seeking yield, whilst also wanting to minimise risk exposure, could find the risk return profile of an H-REIT to be of particular appeal and H-REITs should be highlighted amongst other investment types in Hong Kong.

3. Swift and Transparent Regulatory Communication

It has been suggested that certain service level commitments from regulators would be highly appreciated by market players. Example measures include the implementation for market players of a hotline and enquiry email (similar to the one established to answer REIT comments and enquiries for market participants and the public), and potentially shortening the processing time for application approvals. Whilst recent efforts by the SFC to provide regulatory clarity are noted, further efforts to provide continuous regulatory clarity for professional service providers such as REIT sponsors and managers regarding compliance and operational matters are also suggested as being helpful.

Conclusion

The 2021 FSDC Research Paper contains important recommendations the successful implementation of which will, in many cases, require detailed guidance to be issued by the Hong Kong regulators, preparation of legislation to be considered and passed by the Legislative Council or cross-border multi-agency cooperation. We will continue to monitor for further developments considering or adapting these recommendations for the H-REIT regime.

To discuss how our experience with H-REITs can assist you, or if you have any questions on any of the matters above, please do not hesitate to liaise with your usual contact at Baker McKenzie or the lawyers listed in this Alert.

1 https://www.fsdc.org.hk/media/ilqeyuzp/20210518_fsdc-releases-report-on-revitalising-reits-market_en.pdf

2 Please refer to our earlier client alerts on this topic for more information available at: https://insightplus.bakermckenzie.com/bm/real-estate_1/hong-kong-new-subsidy-for-listing-of-h-reits

3 https://www.fsdc.org.hk/en/press-publications/developing-hong-kong-as-a-capital-formation-centre-for-real-estate-investment-trusts

4 Please refer to our earlier client alerts on this topic for more information available at: https://insightplus.bakermckenzie.com/bm/financial-institutions_1/hong-kong-client-alert-sfc-commences-consultation-on-proposed-amendments-to-the-hong-kong-reit-code

5 https://www.hkex.com.hk/Global/Exchange/FAQ/Featured/RMB-Readiness-and-Services/Dual-Tranche-DualCounter-Model?sc_lang=en

6 Please refer to our earlier alerts for more information on this topic available at: https://insightplus.bakermckenzie.com/bm/real-estate_1/china-reits-stock-exchanges-and-csrc-commence-review-of-first-batch-of-prc-infrastructure-reits; and https://insightplus.bakermckenzie.com/bm/real-estate_1/china-csrc-publishes-formal-rules-on-prc-infrastructure-reits