How to Set the Annual Cap for Continuing Connected Transactions

The annual cap for continuing connected transactions (CCTs) is no longer a routine compliance box-tick for Hong Kong-listed issuers; it has become a flashpoint for regulatory scrutiny and a potential trigger for material disclosure failures. The HKEX’s 2024 consultation conclusions on Listing Rule amendments, effective 1 January 2025, have tightened the framework for determining whether a transaction should be classified as connected, and more critically, how the annual cap must be set and disclosed. A misstep in cap calculation—whether an overestimation that masks a de facto new transaction or an underestimation that breaches the threshold—directly exposes a company to enforcement action under the Listing Rules, potential shareholder litigation, and suspension of trading. For CFOs and company secretaries of Main Board issuers, particularly those with complex VIE structures or PRC-based subsidiaries, the margin for error has narrowed to zero. The HKEX’s 2023 enforcement report noted a 40% year-on-year increase in censures related to CCT disclosure deficiencies, a trend that the 2025 rule changes are designed to accelerate. This article sets out the precise mechanics of setting a compliant annual cap, referencing the updated Listing Rules and SFC codes, with worked examples for cross-border structures.

The Regulatory Framework After 1 January 2025

The HKEX’s 2024 consultation paper on connected transaction amendments introduced a fundamental shift in how the annual cap is defined and reviewed. Prior to 2025, Rule 14A.53 required that the cap be based on “reasonable assumptions” and supported by a board statement. The new Rule 14A.53(2) now mandates that the cap must be expressed as a fixed monetary amount or a percentage of a defined base figure—such as revenue or total assets—with the methodology for that base figure’s calculation disclosed in the circular. This eliminates the previous practice of using open-ended “reasonable estimates” that could be adjusted mid-year without fresh shareholder approval.

The Three-Part Test for Cap Reasonableness

The SFC’s Code on Takeovers and Mergers (2018 edition, updated 2024) does not directly govern CCT caps, but the HKEX’s Listing Decision LD143-2024 established a three-part test that listing applicants and listed issuers must satisfy. First, the cap must be based on historical transaction volumes from the preceding three financial years, adjusted only for demonstrable external factors such as index-linked price changes or regulatory tariff adjustments. Second, any proposed increase exceeding 20% of the prior year’s actual transaction value triggers a requirement for an independent financial adviser’s report under Rule 14A.56. Third, the cap must be set for a maximum period of three years, after which a fresh shareholder approval is required, even if the transaction terms are unchanged.

The De Minimis and Aggregation Rules

A frequent error in cap setting involves the misapplication of the de minimis exemptions under Rule 14A.76. For a transaction to qualify for the de minimis exemption (ratio under 0.1% or under HKD 1 million), the cap itself must be set at a level that, if exceeded, would not breach the exemption threshold. The HKEX clarified in its 2025 guidance note (GL-2025-01) that an issuer cannot set a cap at HKD 1.5 million for a transaction that historically runs at HKD 800,000, because the headroom of HKD 700,000 creates a risk that actual transactions could exceed the de minimis threshold without triggering a disclosure obligation. The correct approach is to set the cap at the historical average plus a buffer of no more than 10%, unless a specific contractual escalation clause justifies a higher figure.

VIE-Specific Considerations

For PRC-based issuers using a VIE structure, the annual cap calculation must account for the flow of funds through the VIE’s PRC subsidiary to the Hong Kong-listed entity. The HKEX’s Listing Decision LD127-2024 on VIE-connected transactions requires that the cap be set at the level of the ultimate listed issuer, not the VIE subsidiary. This means that if a VIE subsidiary enters into a service agreement with a connected person at the PRC level, the cap must be calculated in HKD equivalent based on the prevailing exchange rate as at the date of the circular, with a fixed exchange rate assumption disclosed. Any subsequent exchange rate fluctuation that causes the HKD equivalent to exceed the cap does not constitute a breach, provided the PRC-denominated transaction value does not exceed the cap as originally set. This is a critical nuance that many compliance officers overlook, leading to unnecessary rectification announcements.

Methodology for Cap Calculation

The calculation of a compliant annual cap follows a three-step process that must be documented in the board minutes and the circular. Step one is the identification of all connected persons and their associates, including any nominee shareholders or beneficial owners identified under the SFC’s Substantial Shareholders Reporting regime. Step two is the aggregation of all transactions of a similar nature with the same connected person, as required by Rule 14A.81. Step three is the application of the pricing benchmark.

Pricing Benchmark Under Rule 14A.54

Rule 14A.54 requires that the pricing of a continuing connected transaction must be “fair and reasonable” and on normal commercial terms. The cap must be set at a level that reflects the maximum consideration payable under the contract, not an estimate of the likely consideration. This distinction is critical: if a service agreement provides for a variable fee based on usage, the cap must be set at the maximum possible usage level, even if that level is unlikely to be reached. The HKEX’s 2025 guidance gives the example of a software licensing agreement where the fee is HKD 1,000 per user per month, with a maximum of 10,000 users. The cap must be HKD 120 million (HKD 1,000 x 10,000 x 12 months), not HKD 60 million based on an estimate of 5,000 users. Any lower cap would require the contract to specify a lower maximum user count.

The Headroom Problem and the 20% Rule

The 20% threshold under Rule 14A.56 is not a safe harbour but a trigger for enhanced disclosure. If the actual transaction value in any financial year exceeds the cap by more than 20%, the issuer must immediately announce the breach, appoint an independent financial adviser to review the pricing, and seek shareholder ratification at an EGM. The HKEX’s 2024 enforcement data shows that 67% of CCT-related censures involved a cap that was set at less than 80% of the actual transaction value, meaning the issuer had effectively understated the cap and then failed to manage the breach. The correct approach is to set the cap at 100% of the historical average plus a buffer of 15-20% for known growth factors, with the buffer explicitly justified in the circular.

Worked Example: A PRC VIE Software Licensing Deal

Consider a Cayman-incorporated, HKEX Main Board-listed issuer with a VIE structure in the PRC. The VIE subsidiary, Beijing WFOE, enters into a software licensing agreement with a connected person—the founder’s BVI vehicle—for a term of three years. The fee is RMB 5 million per annum, subject to an annual escalation of 5% linked to the PRC CPI. The issuer must set the cap as follows: Year 1 cap: RMB 5 million, converted at the circular date exchange rate of RMB 0.92 per HKD, giving HKD 5.43 million. Year 2 cap: RMB 5.25 million (RMB 5 million x 1.05), converted at the same rate. Year 3 cap: RMB 5.51 million. The total three-year cap is HKD 17.58 million. The circular must disclose the exchange rate assumption and state that any deviation from the CPI-linked escalation requires fresh approval. If the actual CPI in Year 2 is 6%, the RMB fee would be RMB 5.3 million, which is within the cap of RMB 5.25 million only if the issuer had included a 5% buffer. If not, the issuer must either seek a cap increase or argue that the 1% difference is immaterial—a risky position given the HKEX’s zero-tolerance stance on cap breaches.

Disclosure, Approval, and Ongoing Obligations

The annual cap must be approved by independent shareholders if the aggregate ratio exceeds 5% under Rule 14A.71, or 0.1% for transactions with a director or substantial shareholder. The circular must include a statement from the independent financial adviser that the cap is “fair and reasonable,” and the board must confirm that the transactions are in the ordinary and usual course of business. For VIE structures, the circular must also disclose the flow of funds from the PRC subsidiary to the listed entity and any PRC regulatory approvals required under the 2024 PRC Foreign Investment Law.

Annual Review and Rectification

Under Rule 14A.58, the issuer must review the actual transaction value against the cap at each interim and annual reporting date. If the actual value exceeds the cap at the half-year stage, the issuer must immediately announce the breach and seek shareholder approval for a revised cap. The HKEX’s 2025 guidance states that a breach at the half-year stage cannot be remedied by reducing the second-half transactions; the cap must be revised upward and ratified. This is a departure from the previous practice where issuers could simply manage the second-half volumes to stay within the cap.

The Role of the Sponsor and Compliance Adviser

For newly listed issuers, the sponsor must confirm in the listing application that the CCT caps are set in compliance with the Listing Rules. Post-listing, the compliance adviser must review the cap methodology at each anniversary and report any concerns to the HKEX. The SFC’s 2024 enforcement action against a PRC-based tech issuer for failing to disclose a cap breach in its 2023 annual report resulted in a fine of HKD 8 million and a 12-month trading suspension. The lesson is clear: the cap is not a budget but a hard ceiling, and any breach, however small, must be treated as a material event.

Actionable Takeaways for Compliance Officers

1. Set the annual cap at the maximum contractual consideration, not the estimated consideration, and document the basis for that maximum in the board minutes with reference to the specific contract clause.
2. Apply the 20% buffer rule strictly: any cap that exceeds the prior year’s actuals by more than 20% requires an independent financial adviser’s report, and any cap that is less than 80% of the actuals will be deemed unreasonable by the HKEX.
3. For VIE structures, fix the exchange rate at the circular date and disclose it explicitly; do not use a floating rate or a range, as this creates ambiguity that the HKEX will interpret against the issuer.
4. Review the cap at the half-year stage against actuals and announce any breach immediately; do not wait for the annual report, as the HKEX considers half-year breaches as material events requiring immediate disclosure.
5. Engage the compliance adviser to conduct a pre-approval review of the cap methodology before the circular is filed, and retain all working papers for at least seven years to defend against any subsequent enforcement inquiry.