Regulatory Hot Issues - PwC · the Fundamental Review of the Trading Book (“FRTB”). Based on expectations that the EU and other major jurisdictions might postpone the effective

4th Edition September 2019

Regulatory

Hot Issues

Regulatory Hot Issues

Executive

Summary

The guidelines issued by regulators in the last six months

have contributed to the strengthening of Hong Kong financial

services sector.

In this fourth edition of Regulatory Hot Issues, we have

covered the following key developments:

Environmental, Social and Governance (“ESG”) Regulations

With the growing awareness and concerns around climate change, Hong Kong

regulators and the stock exchange have been pushing to develop and enhance

environmental, social and governance regulations.

• In May 2019, the Hong Kong Monetary Authority (“HKMA”) unveiled three sets

of measures to support and promote Hong Kong’s green finance development

• In April 2019, the Securities and Futures Commission (“SFC”) provided guidance

to management companies of SFC-authorised unit trusts and mutual funds on

enhanced disclosures for SFC-authorised green or ESG funds

• In May 2019, the Stock Exchange of Hong Kong (“HKSE”) issued a consultation

to support and improve issuers’ governance and disclosure of ESG activities and

metrics.

Interest Rate Benchmark Reform

In July 2017, the United Kingdom (“UK”) Financial Conduct Authority announced that

it would no longer compel Panel Banks to participate in the LIBOR submission

process after the end of 2021.

In March 2019, the HKMA issued the circular to request authorised institutions (“AIs”)

to prepare for the interest rate benchmark reform being pursued under the auspices

of the Financial Stability Board (“FSB”). Many challenges remain to be addressed by

continuing LIBOR transition efforts. International and cross-market coordination will

continue to be crucial in driving progress.


Economic Substance Laws

The Cayman Islands introduced an economic substance law effective

from 1 January 2019, requiring certain legal entities to maintain a level

of economic substance. Many of the private equity firms and hedge

funds active in Hong Kong, which locate their investment funds and

their fund management entity in the Cayman Islands, will be required to

demonstrate economic substance in the Cayman Islands.

Culture and Ethics

Culture and ethics continue to be centerpiece in regulations. The HKMA has

issued a number of regulatory guidance, including:

• The “Supervision for Bank Culture” circular in December 2018;

• A consultation on the “Guideline on a Sound Remuneration System” in

May 2019 to clarify that, in addition to promoting effective risk

management, remuneration systems should contribute to acceptable

staff behaviour; and

• A letter encouraging AIs to adopt and implement the Ethical Framework

issued by the Privacy Commissioner for Personal Data.

Insurance Regulatory Reform Updates

The Insurance Authority (“IA”) has continued publishing new guidelines for

authorised insurers and licensed insurance intermediaries as it transitions into its

role as the sole regulator of insurance intermediaries in Hong Kong from 23

September 2019. In the last six months, regulatory guidance has been issued with

respect of:

• Sale of long term insurance policies;

• Enterprise risk management;

• Qualifying deferred annuity policy; and

• Other areas such as the IA’s power to impose pecuniary penalty, “fit and proper”

criteria and continuing professional development.

The IA has also turned its sights onto another regulatory hot issue: cybersecurity. In

June 2019, it published the Guideline on Cyber Security (GL20) that sets out the

minimum standards for cybersecurity.


Branch Transfer Pricing

The enactment of the Inland Revenue (Amendment) (No. 6) Ordinance

2018 in relation to base erosion and profit shifting and transfer pricing

can potentially have dramatic effect on bank branches in terms of

attribution of assets and capital for tax purposes, which may differ from

those shown in the branch accounts. Furthermore, the Inland Revenue

Department (“IRD”) has introduced guidance requiring more extensive

transfer pricing documentation.

Consultation on new Market Risk Capital Requirements

The HKMA is currently conducting a consultation on the new requirements

in relation to market risk capital charge calculations, or commonly known as

the Fundamental Review of the Trading Book (“FRTB”). Based on

expectations that the EU and other major jurisdictions might postpone the

effective date of the new requirements, Hong Kong could be a front runner

on regulations in this area based on the timetable proposed in the

consultation paper.

The impact of the proposed FRTB rules on capital requirements is pending

the outcome of the quantitative impact study to be conducted by the HKMA.

However, similar impact assessments done by other regulatory and industry

bodies suggest that capital requirements will likely be higher as a result of

the implementation of similar rules.

It is also worth highlighting that the September 2019 was a landmark month for Hong Kong financial

services regulations. Aside from the updates on insurance regulations and market risk capital

requirements, and progress in the LIBOR Reform, the Financial Action Task Force and Asia/Pacific

Group published the Mutual Evaluation Report on Hong Kong’s anti-money laundering and counter-

terrorist financing regime, assessing it to be compliance and effective overall. This makes it the first

jurisdiction in the Asia-Pacific region to have achieved an overall compliant result. The report also

provides recommendations for further work which will help focus efforts over the coming few years.

Regulatory Hot Issues 5

It can become difficult to keep track of

regulatory updates when new

regulations and guidelines are issued on

a piecemeal basis almost everyday.

“Regulatory Hot Issues” aims to provide

you with a recap on some of the most

pertinent areas that are challenging

financial institutions. This publication will

be released periodically as a reminder of

key regulatory updates impacting the

financial services industry.

The 4th edition touches on a range of

trending topics that the Hong Kong

regulators are focused on for 2019,

including environmental, social and

governance regulations, interest rate

benchmark reform, economic substance

laws, and culture and ethics.

Objective of this publication

Table of

contents

Environmental, Social and

Governance Regulations

6

Interest Rate Benchmark Reform 8

Economic Substance Laws 10

Culture and Ethics 12

Insurance Regulatory Reform

Updates

15

Branch Transfer Pricing 19

Capital Requirements Update 21

Your PwC Contact 22


Environmental,

Social and Governance

Regulations

Driven by the Paris Agreement on climate change, there has been a renewed interest globally in

integrating environmental, social and governance (“ESG”) factors in the financial industry.

This global trend is gaining momentum in Hong Kong. To address the growing investor demand

and develop a standard for ESG investment practices, major financial regulators in Hong Kong

have recently announced measures focused on green finance:

The SFC to launch a central database of Green

or ESG funds by end of 2019

In April 2019, the SFC provided guidance to

management companies of SFC-authorised unit trusts

and mutual funds on enhanced disclosures for SFC-

authorised green or ESG funds

In line with the existing requirements set out in the Unit

Trust Code, a Green or ESG fund should invest primarily

in investments to reflect the particular green or ESG

investment focus which the fund represents.

For an existing SFC-authorised fund to be classified as a

Green or ESG fund, managers should review the fund’s

offering documents in view of the requirements set out in

the circular, and make the necessary updates and

revisions no later than 31 December 2019.

In March 2019, the SFC engaged PwC to launch a

survey on integrating ESG factors in asset management

as part of its Strategic Framework for Green Finance.

The HKMA’s measures on sustainable banking

and green finance

In May 2019, the HKMA unveiled three sets of

measures to support and promote Hong Kong’s green

finance development:

1) Green and Sustainable Banking

• Phase I: develop a common framework to

assess the “Greenness Baseline” of individual

banks;

• Phase II: engage the industry and other relevant

stakeholders in a consultation on the supervisory

expectation or requirement on Green and

Sustainable Banking; and

• Phase III: after setting the targets, implement,

monitor and evaluate banks’ progress.

2) Responsible Investment

• The HKMA will adopt a principle that priority can

be given to Green and ESG investments if the

long term return is comparable to other

investments on a risk-adjusted basis.

3) Centre for Green Finance

• HKMA will establish the Centre for Green

Finance under its Infrastructure Financing

Facilitation Office, which will serve as a platform

for technical support and experience sharing for

the green development of the Hong Kong

banking and finance industry.


Hong Kong Stock Exchange (“HKSE”)

consults on introducing climate related issues disclosures

On 17 May 2019, HKSE launched a consultation on ESG matters to support

and improve issuers’ governance and disclosure of ESG activities and

metrics. The consultation closed on 19 July 2019.

Key proposals of the consultation include:

• Disclosure requirement of significant climate-related issues that have

impacted and may impact the issuer;

• Amending the “Environmental” key performance indicators to require

disclosure of relevant targets; and

• Introducing mandatory disclosure requirements in the ESG Reporting

Guide to include a board statement setting out the board’s consideration

of ESG issues and applications of relevant reporting principles and

boundaries in the ESG report.

Conclusion

There is a clear regulatory focus on ESG and green

finance. Given the impending results of an SFC

survey of the asset management industry together

with the increased interest and awareness of

investors, we expect the HKMA and the SFC to issue

more guidelines in this area. The financial services

industry in Hong Kong will need to build relevant

knowledge and capabilities to meet regulatory and

investor expectations on ESG investment practices

and products.


Interest Rate

Benchmark Reform

The end of LIBOR, entry of New RFRs

In July 2017, the UK Financial Conduct Authority

announced that it would no longer compel Panel Banks

to participate in the LIBOR submission process after the

end of 2021. As a result of this announcement, market

participants have begun the process of preparing for the

cessation of LIBOR and transitioning to replacement

benchmark rates. Regulators and industry bodies have

proposed and agreed on new risk-free rates (“RFRs”) to

replace LIBOR rates.

LIBOR is currently the benchmark for over US$350

trillion in financial contracts worldwide, the impact of the

transition from LIBOR will be far-reaching for financial

services firms, businesses and customers alike. The

transition remains a fundamental issue confronting

financial markets. Regulators in both the United States

and Europe have expressed the view that the

discontinuation of LIBOR is a virtual certainty, and that

market participants should plan accordingly.

Key impacted businesses and functions include capital

markets, commercial lending, retail banking and wealth

management, investment management, insurance,

market infrastructure and corporate treasury.

Both LIBOR and HIBOR are used extensively

in the Hong Kong banking industry

In March this year, the HKMA issued the circular to

request AIs to prepare for the transition associated with

the interest rate benchmark reform being pursued

under the auspices of the FSB.

As an FSB member, Hong Kong is obliged to follow the

recommendation to identify an alternative reference

rate or RFR to the Hong Kong Interbank Offered Rate

(“HIBOR”). The RFR should be nearly risk-free and

should serve as a fall-back for HIBOR.

In this regard, the Treasury Market Association has

proposed to adopt the Hong Kong Dollar Overnight

Index Average as the RFR and is consulting with

industry stakeholders this year.

The HKMA considers it important that AIs should start

to make preparation for the transition to RFRs in case

the need to fall back on such RFRs arises.

The preparatory work should cover the following

elements:

• Regular quantification and monitoring of

affected exposures;

• identification and evaluation of key risks

arising from the reform under different

scenarios, including but not limited to a

LIBOR discontinuation scenario;

• Formulation of an action plan to prudently

manage the risks identified; and

• Close monitoring of the developments of the

benchmark reform, both in Hong Kong and

internationally, and updating the scenarios

and action plan as appropriate.

The boards of directors of locally incorporated

AIs and the head/regional offices of AIs

incorporated overseas should provide oversight

of the process and be kept informed of the

progress of the preparatory work.

Preparation for the transition to RFRs

”Interest rate benchmark reform is complex,

but it is something too important for any market

participant to ignore”

Howard Lee, Deputy Chief Executive, HKMA

30th May 2019


9

Considerable challenges remain ahead to be addressed by continuing LIBOR transition efforts.

International and cross-market coordination will continue to be crucial in driving progress.

Market participants should continue to closely monitor developments concerning interest rate

benchmark reform while considering implications for their own transition planning.

Multidimensional risk

The move from LIBOR to other reference rates could affect three drivers of

profitability: revenue, expense, and cost of capital. By using a different reference

rate, firms will need to recalculate valuations and rethink pricing. A transition plan

will require changes to hedging and risk management to adjust for the different

methodologies underlying LIBOR and alternatives rates. The gains from investing

and costs from debt will shift. As a result, a firm’s revenues and expenses will also

change, altering their cost of capital.

The effects are not exclusively financial. Firms may have to revisit accounting and

tax treatments. They will also want to reduce product, legal, market, credit, and

operational risks by revamping the full range of business functions— from strategy

and financial management to accounting and contract management. How effectively

firms manage through the transition has consequences for customer, conduct,

brand and reputational risks.

Ambiguity

Regulators and central banks are not defining how the LIBOR transition should take

place. Rather, they are collaborating with the industry, including trade associations,

in plotting a way forward. To an extent, companies must create their own roadmaps

while facing unclear timelines before LIBOR rate-setting ends in December 2021.

Companies need to determine which alternative benchmark(s) they will use and

when the cutovers will take place across the front and back office. They also need

to rely on untested legal and contractual language on topics such as fallback terms

and trigger events. With regulators issuing few, if any, hard mandates, financial

firms will likely make different operational changes and follow different strategies

and timelines. The lack of industry uniformity may slow or disrupt the transition.

Whatever path a firm chooses, it will need to find a way to work with multiple

benchmarks for the foreseeable future.

Complexity

LIBOR is giving way to five alternative RFRs that differ by region, currency, tenor,

and basis. SOFR, overseen by the Federal Reserve Bank of New York, and

SARON, administered by Zurich-based SIX Exchange, are secured rates, while

SONIA (Bank of England), ESTER (European Central Bank), and TONAR (Bank of

Japan) are unsecured. Some of these are already in use; others are in the process

of being introduced.

LIBOR differs significantly from the alternative RFRs, making the transition

especially complicated. LIBOR reflects a degree of bank credit risk; some of the

RFRs do not. LIBOR is a forward-looking term rate with a range of seven maturities

up to a year, whereas the RFRs are backward-looking overnight rates. A significant

challenge still exists in the development of forward-looking term rates based on

overnight RFRs.

Most market participants need to switch to the new rates across the full range of

financial products. They also need to coordinate changes to settlement, accounting,

cash management, and other critical operations with thousands of customers and

vendors – and they may not all be ready on the same schedule.

The Challenges

Ongoing monitoring of developments


Economic

Substance Laws

The Cayman Islands ranks first globally among offshore

hedge fund domiciles, and is the fifth largest financial

services centre in the world. It is home to almost 80% of

offshore hedge funds globally. According to the Cayman

Islands Registrar of Exempted Limited Partnerships, the

number of registered exempted limited partnerships*

registered in the Cayman Islands increased by 68%

between 2014 and 2018.

The Cayman Islands’ popularity is explained by many

factors, including a stable government, pro-business

policies and an advanced legal system, along with many

tax-free incentives with minimal financial regulation and

oversight.

* one of the typical vehicles for private equity funds domiciled in the

Cayman Islands

Economic Substance

The Cayman Islands introduced an economic substance

law effective from 1 January 2019 requiring certain legal

entities to maintain a level of economic substance in the

Cayman Islands. This will affect all “relevant entities” that

carry on “relevant activities”.

According to the law and guidance, a “relevant entity” that

carries on a “relevant activity” is required to satisfy the

economic substance (“ES”) test.

Non-compliance with the ES Law would lead to financial

penalties and the entities may also be struck off. There

may also be spontaneous exchange of information with

tax authorities of other jurisdictions.

To satisfy the ES test, the relevant entity must have the following in the Cayman Islands for each relevant

activity:

“Relevant entity” includes:

• A company, other than a domestic company, that is

incorporated under the Companies Law (2018 Revision);

or a limited liability company registered under the Limited

Liability Companies Law (2018 Revision);

• A limited liability partnership that is registered in

accordance with the Limited Liability Partnership Law

2017;

• a company that is incorporated outside of the Islands and

registered under the Companies Law (2018 Revision);

but does not include an investment fund or an entity that is

tax resident outside the Islands.

“Relevant activity” includes:

but does not include investment fund business.

• Headquarters business

• Holding company business

• Insurance business

• Intellectual property

business; or

• Shipping business

• Banking business

• Distribution and service

centre business

• Financing and leasing

business

• Fund management

business

Adequate

operating

expenditure

Adequate no. of

full-time

employees or

other personnel

Conducts core

income generating

activities

Appropriately

directed /

managed

Adequate

physical

presence


Depending on the nature of the business, a company and related individual should apply for one or more

Regulated Activity licence(s) to conduct the proposed regulated activities:

Type of Regulated Activities

Type 1 Dealing in securities

Type 2 Dealing in futures contracts

Type 3 Leveraged foreign exchange trading

Type 4 Advising on securities

Type 5 Advising on futures contracts

Type 6 Advising on corporate finance

Type 7 Providing automated trading services

Type 8 Securities margin financing

Type 9 Asset management

Type 10 Providing credit rating services

Type 11 Dealing or advising in over-the-counter (“OTC”) derivative products

Note: Not yet in operation

Type 12 Providing clearing agency services for OTC derivatives transactions

Note: The new Type 12, Part 1, Schedule 5 added by the Securities and Futures (Amendment) Ordinance 2014

came into operation on 1 September 2016, in so far as it relates to paragraph (c) of the new definition of

excluded services in Part 2 of Schedule 5.

Implications for Hong Kong entities

Many of the private equity firms and hedge funds active in

Hong Kong, from pan-regional firms to small cap China

players, locate their investment funds and their fund

management entity in the Cayman Islands. This tried and

tested formula is now under threat. Planned regulatory

reforms will require fund management entities to

demonstrate economic substance in the Cayman Islands:

either they accumulate local resources capable of

running a fund or they relocate elsewhere.

While further changes to the law and guidance may

follow, the April guidelines suggest asset managers may

have to rethink the structures that underpin their

business, and do so by the end of 2019. Hong Kong is

one of the most realistic options for Asia-based private

equity firms to relocate their fund management business.

Licencing requirements in Hong Kong

For asset managers who want to relocate or plan to

establish their asset and wealth management business in

Hong Kong, fulfilling the licensing requirements under the

Securities and Futures Ordinance (“SFO”) is essential

prior to the commencement of any regulated activities in

Hong Kong.

Some key considerations for the asset managers to

consider in terms of applying a licence from the SFC

include:

• Assess the business activities as to whether they will

trigger the licensing requirements under the SFO;

• Be aware of licence exemptions, including incidental

exemption;

• Understand all the licensing application requirements

under the SFC Licensing Handbook;

• Identify which type of regulated activities will be

subject to the licensing requirements and be aware

of licence exemptions, including incidental

exemption;

• Appoint responsible officers and licensed

representatives who can meet the fit and proper

criteria and / or competency requirements as

promulgated by the SFC;

• Identify application forms, supplementary schedules

and supporting documentation that are required to be

submitted to the SFC;

• Be aware of ongoing regulatory developments that

have a bearing on their licence application; and

• Have a complete picture of ongoing regulatory

obligations once a SFC licence has been obtained.

In Hong Kong, most of the hedge fund managers are

licensed with the SFC, whereas the private equity

managers are not. Under the SFC licensing

requirements and with the current development of the

ES Law, the existing unlicensed managers or new

entrants should carefully revisit their regulatory

compliance position.


In December 2018, the HKMA issued the “Supervision for Bank Culture” circular. 30 AIs were required to submit a self-

assessment of their governance arrangements, policies and procedures relevant to corporate culture. All other AIs are

expected to reflect on their own insights, lessons learnt and issues encountered in their culture enhancement initiatives.

Following on from this, the HKMA issued a consultation on the Guideline on a Sound Remuneration System in May 2019.

The proposed changes were made to further clarify that, in addition to promoting effective risk management, remuneration

systems should contribute to acceptable staff behaviour. These changes emphasise the following expectations.

12

Culture

and Ethics

Banking Culture

Governance

• Adequate board oversight of

remuneration policies, systems and

related control processes. This

includes ensuring that the

remuneration system is appropriate

and consistent with the Bank’s

culture, risk appetite and control

environment.

Remuneration

structure

• Fixed and variable incentive-based

remuneration should have regard to

the employees’ seniority, role and

activities.

Alignment of

remuneration pay-

outs to the time

horizon of risks

• Variable incentives should be paid in

a manner that aligns long-term value

creation and the time horizons of

relevant risks.

• Deferral period for a proportional

element of the variable incentive

payments should be implemented to

ensure employee performance is

measured for a sufficient period of

time before payment. In principle,

this should be for a period of not less

than 3 years.

Performance

measurement

for variable

remuneration

• Award of variable remuneration

should depend on pre-determined

and assessable financial and non-

financial criteria.

• Overall variable remuneration should

take into account performance over a

longer term.

• To enforce desirable employee

behaviour consistent with the risk

management framework and

corporate values, communication

should be made to employees on

how behaviours can affect their

remuneration.

• Risk personnel independent of the

business should be actively involved

in the process of design and

implementation of policies.

• In the event of misconduct, incentives

should be adjusted in a proportional

manner to the outcome. This may

include employees beyond those who

were directly responsible for the

misconduct.

• Regular analysis and monitoring on

mechanisms used to prevent and

address misconduct


These changes are consistent with the conclusions drawn

by the Royal Commission into Misconduct in the Banking,

Superannuation and Financial Services in Australia. In

particular, Commissioner Hayne observed that “in almost

every case, the conduct in issue was driven not only by

the relevant entity’s pursuit of profit but also by individuals’

pursuit of gain, whether in the form of remuneration for the

individual or profit for the individual’s business.”

The Australian Prudential Regulatory Authority’s 2019 key

priorities includes the strengthening of the remuneration

prudential framework. This is primarily focused on better

aligning remuneration and prudent risk management

outcomes whilst maintaining long term financial

soundness. Similarly, we expect this to be a continued

focus for the HKMA and the industry as they continue to

assess the appropriateness of different incentive schemes

Ethical Accountability Framework for

collection and use of personal data in

Fintech development

The Privacy Commissioner for Personal Data (“PCPD”)

has issued an Ethical Accountability Framework

(“Ethical Framework”) for the collection and use of

personal data in 2018. The HKMA also published a

letter encouraging authorised institutions (“AIs”) to adopt

and implement the Ethical Framework, due to AIs‘

increasing reliance of data obtained via massive

collection and the use of customer data on the online

platform or through their Fintech products.

The Ethical Framework suggests organisations adopt a

broader view of data governance, including where non-

personal data may also impact an individual. The

traditional consent-based approach is the foundation

upon which future governance approaches will be built.

The key concepts introduced by the Ethical Framework

and covered in this article are:

1. Enhanced data stewardship;

2. Enhanced data stewardship accountability elements;

3. Data stewardship values;

4. Ethical Data Impact Assessments (“EDIAs”); and

5. Process oversight model.

Enhanced Data Stewardship

Data stewards need to consider the interests of all

parties and use data in ways that create maximum

benefits while minimizing risks to those involved. The

banks also need to understand and evaluate advanced

data processing activities and their positive and

negative impacts on all parties

Enhanced Data Stewardship Accountability

Elements

PCPD worked with 20 Hong Kong organisations and

drafted the ‘Enhanced Elements’, which call for

organisations to:

• Define data-stewardship values that are condensed

to guiding principles and then translated into

organisational policies and processes for ethical data

processing;

• Use an ethics by design process to translate their

data-stewardship values into their data analytics and

data-use design processes;

• Use an internal review process that assesses

whether EDIAs have been conducted with integrity

and competency;

• Be transparent about processes and where possible

enhance societal, groups of individual or individual

interests; and

• Stand ready to demonstrate the soundness of

internal processes to the regulatory agencies that

have authority over advanced data processing

activities.



• The Beneficial value has to do not only with benefits

but also with risks. Advanced data-processing

activities should provide benefits and values to users

of the products or service; and

• The Fair value has to do with the concept that

advanced data-processing activities, including

decision-making, are impartial and not solely for self-

interested purposes.

The Process Oversight Model (“Process Model”)

The Process Model looks at how an organisation has

translated its ethical values into principles and policies

and into and “Ethics by design” program. It considers

how well-established internal review processes, such as

EDIAs and effective individual accountability system,

have been implemented. The Process Model consists of

seven sections:

1. Accountability for the oversight process;

2. Translation of organisation values into principles

and polices;

3. Translation of organisational values into an “ethics

by design” program;

4. Use of the EDIA;

5. Review according to an internal process;

6. Accountability to the individual; and

7. Transparency of process.

The Process Model is designed to address the ethics

part of data stewardship and assumes other internal

oversight processes exist to address core elements of

privacy programs.

Ethical Data Impact Assessment (“EDIA")

The EDIA is a process that looks at the full range of

rights and interests of all parties in a data processing

activity to achieve an outcome when advanced data

analytics may impact people in a significant manner, or

when data-enabled decisions are being made without

the intervention of people. If the processing is less

complex and organisations would like to identify issues

at the early stage of development life-cycle, a Privacy

Impact Assessment (“PIA”) can be used. However, when

the data uses are most complex, under either a third

party or an in-house solution, an assessment like EDIA

that weighs the risks and benefits may be more

appropriate in addition to a PIA.

The EDIA is broader in scope than the typical PIA. For

example, all data are considered in EDIA and not just

personal data. The data in aggregate, non-identifiable

form that may be outside the scope of PDPO will be

covered by EDIA. EDIA is an enhancement to the

organisation’s privacy management program and can

improve compliance with the Personal Data (Privacy)

Ordinance (“PDPO”).

The Model EDIA consists of four sections:

• Purpose of the activity;

• A full understanding of the data, its use and parties

involved;

• Impact to parties and in particular individuals; and

• Whether an appropriate balance of benefits and

mitigated risks supports the data-processing activity.

Data stewardship values

The PCPD defined the following three data stewardship

values that data stewards were expected to follow:

• The Respectful value has to do with the context in

which the data originated, in which the data will be

used and in which advanced data processing

activities occur, including in which decisions will be

made;

Going Forward

Organisations will continue to face challenges in

personal data protection when developing Fintech

products and services. Merely having the mind-set

to conduct operations to meet the minimum

regulatory requirements may not be sufficient

going forward. Organisations should be held to a

higher ethical standards in order to meet all

stakeholder’s expectation in collecting, using and

processing personal data.



Updates

Regulatory Reform

Insurance

Since our last publication six months ago, the Insurance Authority (“IA”) has published twelve new guidelines for

authorised insurers and licensed insurance intermediaries. Some of these new guidelines were issued as part of the

IA’s takeover of its role as the sole regulator of the insurance intermediaries in Hong Kong with effect from 23

September 2019.

Guidelines on the sale of long term insurance policies

On 17 September 2019, the IA has issued six guidelines (“GL”) to authorised insurers (“insurers”) and licensed

insurance intermediaries (“intermediaries”) in relation to the sale of long term insurance policies, namely GL25 to

GL30. The tables below and on the next page set out the key matters regarding these guidelines:

Guideline on Offering of Gifts

(GL25)

Guideline on Sale of

Investment-linked Assurance

Scheme Products (GL26)

Guideline on Long Term

Insurance Policy Replacement

(GL27)

• It provides guidance on certain

restrictions on the use of gifts and

rebates which insurers and

intermediaries should follow when

marketing, promoting or distributing

insurance products classified as

long term business.

• Insurers and intermediaries should

not directly offer gifts to customers.

A gift may be offered only if the gift

would not distract the customer from

making an informed decision on

whether or not to purchase the

product.

• Premium rebates and commission

rebates should not be offered or

paid unless such rebates are

recorded under the insurance

contract.

• It supplements the Guideline on

Underwriting Class C Business

(GL15) by including detailed

requirements on the sales process

for investment-linked assurance

scheme products to ensure fair

treatment of policyholders and

potential policyholders.

• An adequate suitability assessment

will need to be performed and will

cover:

(i) Financial Needs Analysis (“FNA”),

(ii) Risk Profile Questionnaire,

(iii) Important Facts Statements, and

(iv) applicant’s declarations.

The GL provides detailed guidelines

on the implementation of these

assessments.

• Insurers are required to conduct

audio-recorded post-sale

confirmation call or point-of-sale

audio recordings, regardless of the

distribution channel used.

• Insurers and intermediaries are

required to take all reasonable steps

to ascertain whether the customer is

purchasing the life insurance policy

as a policy replacement, including

whether the customer is funding, or

intends to fund the purchase of the

new life insurance policy using the

cash value of the existing life

insurance policy, or using savings

from reducing the premium payable

under the existing life insurance

policy.

• An intermediary should provide

advice to the customer on whether

the purchase of the new life

insurance policy is in the customer’s

best interests.

• Policyholders are required to

complete and sign “Important Facts

Statement – Policy Replacement”,

which aims to help them understand

the factors to be considered and the

risks associated with the policy

replacement.


Guideline on Benefit

Illustrations for Long Term

Insurance Policies (GL28)

Guideline on Cooling-off

Period (GL29)

Guideline on Financial

Needs Analysis (Gl30)

• It sets out the standard

requirements for insurers regarding

benefit illustration documents to be

provided to potential policyholders

or existing policyholders.

• Benefit illustration documents

include point-of-sale benefit

illustrations, supplementary

illustrations and inforce re-projection

illustrations. Inforce re-projection

illustrations should be provided on

an annual basis after the policy

issuance.

• Policyholders are required to sign a

declaration on the benefit illustration

documents at the point-of-sale.

Digital signatures or other similar

signature verification technology

may be accepted.

• This defines the relevant

requirements for cooling-off period

included in life insurance policies.

• These requirements include (i) how

the cooling-off period is to be drawn

to the attention of the policyholders,

(ii) the basis for determining the

commencement of the cooling-off

period, (iii) policyholders’ rights to

cancel during the cooling-off period,

and (iv) delivery of cooling-off

notices.

• The cooling-off terms should be

stated in (i) the application form; (ii)

a reminder included in the insurance

policy; and (iii) the Cooling-off

Notice.

• It sets out the minimum standards

and practices for insurers regarding

the FNA and outlines the information

that should normally be collected

during the FNA process.

• A FNA must be conducted for all

policies under Class A and Class C

unless exempted under this

guideline. This is to be performed

before making a recommendation to

the policyholder.

• The completed FNA form will be

deemed to be valid for 12 months

unless there are material changes.

• The intermediaries must document

the information provided by the

policyholder during the FNA

process, which include the factors

considered, the recommendations

made and the reasons for such

recommendations.

ERM

Framework

GovernanceERM

Business

Activities

ORSA

Review

And

Monitoring

Risk

Appetite

Statement

An organisational structure should be

established for risk management,

including a risk committee, senior

management and personnel

responsible for risk function. The

responsible personnel should be

qualified individuals with clear roles

and responsibilities.

Regular review of the ERM framework and ORSA to

should be conducted to validate that the ERM framework

remains fit for purpose.

ERM

An ERM framework should be established to ensure

that relevant material risks are managed within an

insurer’s risk appetite, including formal risk

identification and quantification processes.

The ERM framework should be embedded

in the insurer’s business activities. Insurers

should develop and maintain risk

management policies in business areas

in which risk is actively taken or

transferred, as well as policies to cover

other risks such as conduct, cyber, data

quality and internal controls.

The ORSA should assess the

insurer’s risk profile and evaluate the

effectiveness and adequacy of its risk

management, including the quality

and adequacy of available capital.

This assessment should be

performed at least annually.

Guideline on Enterprise Risk Management (GL21)

The risk-based capital regime for Hong Kong’s insurance industry comprises three key components, commonly known

as the “Three Pillars”. This new GL sets out the Pillar 2 requirements that provide the impetus for insurers to (i) put in

place a robust system of risk governance, (ii) proactively identify and assess their risk exposure, (iii) maintain sufficient

capital to cover risks not captured or not adequately captured under the Pillar, and (iv) develop and enhance risk

management techniques in monitoring and managing these risk exposures.

This guideline sets out the ERM standards that insurers are expected to have in place and the general guiding

principles which the IA uses in assessing the effectiveness of an insurer’s ERM framework and Own Risk and

Solvency Assessment (“ORSA”).

The risk appetite statement should (i)

define the insurer’s risk capacity and

give clear guidance on operational

management; and (ii) contain both

qualitative and quantitative measures

that take into consideration relevant

risks and their interdependencies.


Guideline on Qualifying Deferred Annuity

Policy (GL19)

This new guideline sets out (i) the criteria that the IA will

consider when certifying whether a deferred annuity

insurance policy is to be recognised as a qualifying

deferred annuity policy (“QDAP”); (ii) the process for

obtaining such certification; and (iii) the ongoing

requirements which insurers have to comply for

promotion, arrangement and administration of QDAP.

Under sections of 26N to 26U of the Inland Revenue

Ordinance (Cap. 112), a certain amount of the premium

paid for QDAP is eligible for tax reduction under salaries

tax and tax under personal assessment.

The IA has published a list of QDAPs on its website.

Other guidelines to be comply by licensed

insurance intermediaries

Three new guidelines for intermediaries were

published in July and August 2019. These include:

• Guideline on exercising power to impose

pecuniary penalty in respect of regulated persons

under the Insurance Ordinance (Cap. 41) (GL22);

• Guideline on “Fit and Proper” criteria for licensed

insurance intermediaries under the Insurance

Ordinance (Cap. 41) (GL23); and

• Guideline on continuing professional

development for licensed insurance

intermediaries (GL24).

Consultations were carried out for these guidelines in

late 2018. There were no significant changes between

the consultation drafts and the final guidelines in

terms of the regulatory requirements.


Cybersecurity

18

Insurance &

Cybersecurity Strategy &

Framework

• Cybersecurity strategy and framework

with reference to industry standard

should be established and endorsed by

the Board of the insurer

• The cybersecurity framework should be

reviewed and updated regularly, and

when there is significant changes

Governance

• The Board should hold overall

responsibility for cybersecurity controls

and ensure accountability within the

insurer.

• The Board should establish a defined

risk appetite and tolerance limit on

cyber risks

Risk Identification, Assessment & Control

• Insurers should identify cyber risks and conduct assessment

on the effectiveness of mitigating measures to manage cyber

risks within the risk appetite and tolerance limit

• Cyber risk mitigation processes should be regularly reviewed

and assessed when there are significant changes to the

organisational / operational structure

Continuous Monitoring

• Systematic monitoring process for early detection of

cybersecurity incidents should be established, including

network monitoring, security testing, internal and external

audit

• All elements of the cybersecurity framework should be

tested at least annually with combination of different

methodologies, such as vulnerability assessment,

scenario-based testing and penetration testing.

Information Sharing & Training

• Insurers should gather and analyse relevant cyber risk

information and participate in cyber threat information

sharing groups.

• Cybersecurity awareness training should be provided to all

system users, taking into account the type and level of

cyber risk that the insurers may face

Insurance Authority Guideline on Cybersecurity (“GL20”)

Cybersecurity is always one of top concerns of organisations, especially for financial institutions that process important

business operations and customer data digitally and via online channels. In response to this risk, the Insurance

Authority published GL20, the Guideline on Cybersecurity (“the Guideline”) in June 2019. The Guideline sets the

minimum standard for cybersecurity that applies to all authorised insurers in Hong Kong, and authorised insurers are

expected to comply the Guideline from 1 January 2020.

The Guideline covers the following key areas:

Response & Recovery

• Incident response plan should be

developed, covering different

scenarios of cybersecurity incidents

• Incident response drill should be

performed at least annually

• Relevant incident should be reported

to the Insurance Authority as soon as

practicable, and no later than 72

hours after detection


Branch

Transfer Pricing

The enactment of the base erosion and profit shifting

(“BEPS”) and transfer pricing (“TP”) Ordinance (Inland

Revenue (Amendment) (No. 6) Ordinance 2018, or the

“BEPS and TP Ordinance”) in July 2018 introduced a

number of new TP requirements on Hong Kong

companies and the branches of non-resident companies.

It has also introduced a requirement for a branch to be

taxed as if it was a “separate and distinct legal entity” and

for transactions or dealings with either head office, other

branches or affiliated companies to be done on an arm’s

length basis.

While the general approach for attributing profits to

branches in Hong Kong for tax purposes extends to any

non-resident company with a permanent establishment in

Hong Kong, the impact of these new rules, and

application of the separate entity concept, will be

particularly acute for bank branches as bank branches

often have very significant tax deductions on interest.

The key effects of the new rules on bank branches will be

as follows:

Ownership of financial assets

Attribution of capital

A branch and head office are part of the same legal entity. This means that, at least from a purely legal point of

view, there is not a distinction between an asset of the branch versus an asset of the entity as a whole. Up until

the introduction of the BEPS and TP Ordinance, it was common practice to rely on the branch accounts as a

starting point for preparing the tax return.

However, going forward, while taxpayers may be guided by the accounting treatment, assets should ultimately be

attributed to a Hong Kong branch if the Key Entrepreneurial Risk Taking (“KERT”) functions take place in Hong

Kong. This can potentially lead to different outcomes than those shown in the branch accounts and may require

groups to prepare a separate tax balance sheet and P&L for the branch.

Typically, a bank branch in Hong Kong is not directly subjected to the Hong Kong regulatory capital requirements

as the HKMA will defer to the home country regulator. However, for tax purposes, it will now be necessary for a

bank branch to determine a hypothetical amount of capital. An arm’s length amount of capital is that which a

bank branch would reasonably be expected to have if it were a locally incorporated bank with the same credit

rating as head office, and subject to regulatory supervision in Hong Kong.

The hypothesised capital structure of the permanent establishment (“PE”) in turn drives the amount of tax

deductible interest expense recognised in the PE. A tax return adjustment may then be required to recognise the

difference in the interest expense recognised in the financial statements from the notional amount calculated

under the hypothesised capital structure. This is referred to as the Capital Attribution Tax Adjustment (“CATA”)

calculation, which in effect is a form of thin capitalisation adjustment made to branches that do not have an arm’s

length amount of non-deductible equity capital.

1

2


Guidance on performing the CATA calculation for

capital attribution

In their guidance, the IRD sets out five steps for bank

branches performing a CATA calculation:

Key takeaway

The application of the new branch profit attribution rules is

complex and will require a level of judgement from

taxpayers. These changes will have an impact on the Hong

Kong branches of foreign banks which may include:

• Possible recharacterisation of where assets and risks are

recognised for tax purposes;

• The need to prepare a separate balance sheet and profit

and loss statement for tax purposes which may be

different to the regulatory branch accounts;

• Effective thin capitalisation rules that may result in

interest expense adjustments (i.e. CATA) in the tax return

for branches; and

• Additional documentation requirement to support the tax

return filing position of Hong Kong bank branches.

With the new rules applying for accounting periods ending

on or after 1 April 2019, time is running out to assess the

impact – in particular as the analysis will need to be done

before year end for tax provision purposes.

Step 1: Attribute the assets to the PE in

accordance with a functional analysis to identify

the KERT functions. Broadly speaking, KERT

functions are those performed by the people in the

organisation who make decisions leading to the

assumption of, and ongoing management of, risk. A

separate balance sheet and P&L may be needed if

the KERT functions are not aligned with the booking

of financial assets in the accounts.

Step 2: Risk-weight the assets. To determine the

capital required by a locally incorporated bank, it is

first important to identify the Risk Weighted Assets

(“RWA”) of the branch. If the regimes of other

jurisdictions are shown to be broadly comparable to

HKMA rules, the home country regulatory regimes

may apply.

Step 3: Determine the Equity Capital. Typically, the

level of equity capital held by a bank is measured by

looking at the Common Equity Tier 1 to RWA ratio.

Benchmarking an arm’s length amount of equity

capital is important as no tax deduction for the

funding of such capital is available.

Step 4: Determine the Loan Capital. While equity

capital may not be tax deductible, it may be possible

to obtain a deduction on Additional Tier 1, and Tier 2

capital that is typically interest bearing, as long as the

allocation can be supported as being at arm’s length

by reference to third party comparables and such

interest meets Hong Kong tax deductibility rules.

Step 5: Determine the CATA to be made. Once an

arm’s length amount of equity and loan capital that

can be attributed to the Hong Kong Branch is

determined, the CATA is calculated so that the

correct interest deduction is taken in the tax return.

The key challenge in this step is to determine which

of the interest bearing funding of the branch should

be replaced by the hypothetical capital determined

under steps 3 and 4 and the deduction of any other

non-interest related items that may also be displaced

by the new equity (e.g. foreign exchange losses, loan

arrangement fees etc.).

Documentation

The IRD’s guidance specifies that TP

documentation is expected for all Hong Kong

PEs. This documentation would be over and

above what is required in the Transfer Pricing

Masterfile and Local File (if these are required).

Additional supplementary documentation to be

prepared by taxpayers as follows:

• A functional analysis detailing the KERT

functions;

• An internal policy document, setting out the

basis and support used to determine an

appropriate standalone entity capital ratio;

and

• Detailed calculations and schedules

supporting the allocation of interest expense

and capital and the amounts of disallowable

interest.

The above information should be prepared prior

to the due date for filing the tax return in order to

meet the “reasonable efforts test” outlined in the

BEPS and TP Ordinance. Having

documentation may result in reduced penalties,

which can be reduced to nil if the taxpayer can

“prove” they have taken reasonable efforts

determining an arm’s length amount.


Capital RequirementUpdates

Consultation on new Market Risk Capital Requirements

The HKMA is currently inviting comments on the

consultation paper (CP 19.01) on the new market risk

capital charge calculation requirements, commonly

known as “Fundamental Review of the Trading Book”

(“FRTB”), until 30 September 2019. The proposed FRTB

rules are broadly consistent with the Basel Committee’s

(“BCBS”) framework, except for a few key differences in

respect of the conditions for the use of the internal

models approach ("IMA”). This includes the requirement

that at least 30% of the aggregate market risk capital

charge have to be based on IMA calculations (instead of

10% under BCBS standards).

The consultative paper proposes that the new standards

are effective as of January 1, 2022, which is in line with

the BCBS timeline. However, Hong Kong could be a front

runner compared to other jurisdictions – the European

Union, for instance, will implement the global FRTB

standards incrementally by following a phase-in

approach.

The HKMA also intends to run a quantitative impact study

(“QIS”) for locally incorporated banks to assess the

potential quantitative impact of the revised market risk

capital charge computation. Apart from the quantitative

results, this QIS may help identify whether there are any

banks that are not yet ready for the implementation.

The BCBS estimated the impact of the new market risk

regime to increase capital requirements by 22%,

according to their quantitative study conducted in January

2019. However, a more recent assessment conducted by

the International Swaps and Derivatives Association

(“ISDA”) suggests that the impact of market risk rule

changes on capital requirements is more than three times

larger than estimated by the BCBS. Both of these studies

suggest that the FRTB in Hong Kong will increase market

risk capital requirements as of 2022, with the ISDA study

showing that the requirements could be even higher than

previously estimated in the BCBS study.

Amid these mixed results in the global impact studies, the

planned quantitative impact study in Hong Kong will be

useful for locally incorporated banks to assess the

projected impact of the new rules on their individual

capital requirements.


Your PwC

Contact

Matthew Phillips

Mainland China and Hong Kong

Financial Services Leader

[email protected]

mailto:[email protected]

This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.

© 2019 PricewaterhouseCoopers. All rights reserved. In this document, PwC refers to the Hong Kong member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. PMS-000550

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Regulatory Hot Issues - PwC · the Fundamental Review of the Trading Book (“FRTB”). Based on expectations that the EU and other major jurisdictions might postpone the effective