On 29 January 2021, the Inland Revenue (Amendment) (Tax Concessions for Carried Interest) Bill 2021 was gazetted to amend the Inland Revenue Ordinance (IRO) and introduce concessionary tax treatment on eligible carried interest received by, or accrued to, qualifying recipients. In particular, the bill includes a 0 percent profits tax rate on eligible carried interest and excludes 100 percent of eligible carried interest from employment income for calculation of salaries tax. This is a long-awaited development, and key to the development of the Hong Kong asset and wealth management industry.
The bill will be subject to the scrutiny and approval of the Legislative Council before it is enacted. Once enacted, the tax concession treatment will apply to eligible carried interest received by or accrued to a qualifying person or a qualifying employee on or after 1 April 2020, from year of assessment 2020/21 onwards. While carried interest received or accrued from 1 January to 31 March 2020 may fall within the 2020/21 basis period, it would not be eligible for the carried interest tax concession.
This article provides an introduction to the key definitions in the bill, together with our observations and insights.
Qualifying carried interest payer
Qualifying carried interest payer is defined to be:
- a “fund” as defined under the unified tax exemption regime for funds (UTE) of the IRO and certified by the Hong Kong Monetary Authority (HKMA);
- an associated corporation, or an associated partnership, of a certified investment fund that is a corporation or a partnership; or
- a specified entity defined to mean “The Innovation and Technology Venture Fund Corporation” (ITVFC) incorporated under the Companies Ordinance.
In the case of a non-resident fund, an authorized local representative must be appointed who will be responsible for providing the necessary particulars and information to the Inland Revenue Department (IRD) and HKMA.
Carried interest eligible for the tax concession would only apply to sums paid by a certified investment fund or ITVFC. The carried interest tax concession would therefore not include any carried interest paid out from a non-certified fund where a carried interest recipient has not provided any investment management services.
Eligible carried interest
Eligible carried interest is defined to mean a sum received by, or accrued to, a person by way of profit-related return (subject to a hurdle rate as stipulated in governing agreement) from the provision of investment management services by the person for a certified investment fund or ITVFC.
The bill defines “hurdle rate” to mean a preferred rate of return on investments in a certified investment fund (or a specific entity) that is stipulated in the agreement governing the operation of the fund or entity. In practice, however, some funds may not have hurdle rates, and thus there may not be specific disclosures in their limited partnership agreements. Where relevant, this requirement would need to be reflected or updated accordingly in the fund documentation.
“Profit-related return” requires the following conditions to be met:
- the sum is to be, or may be, received or accrued only if (a) there are profits for a period on the investments, or on particular investments, made for the fund or entity; or (b) there are profits arising from a disposal of investment made for the fund or entity;
- the sum that is to be, or may be, received or accrued is variable by reference to those profits;
- the returns to external investors of the fund or entity are also determined by reference to those profits; and
- significant risk test on anti-avoidance measure to exclude management fees disguised as eligible carried interest.
The detailed rules of condition 4 above are extensive. Such anti-avoidance provision is to exclude management fees potentially disguised as eligible carried interest for tax avoidance purposes. Carried interest arrangements should therefore be clearly articulated and documented as appropriate.
Qualifying carried interest recipients
Qualifying carried interest recipients are defined to mean the following persons providing investment management services to a certified investment fund or a specified entity in Hong Kong, or arranging such services to be carried out in Hong Kong:
- a corporation licensed under Part V of the Securities and Futures Ordinance to carry on, or an authorized financial institution registered under that part for carrying on, a business in any regulated activity as defined by Part 1 of Schedule 5 of that ordinance;
- a person (meaning natural person, corporation, partnership, trustee, whether incorporated or unincorporated, or body of persons), who does not fall within (1) above, providing investment management services in Hong Kong to a certified investment fund that is a “qualified investment fund” defined in the IRO or a specified entity, or arranging such services to be carried out in Hong Kong; and
- an individual deriving assessable income from the employment with the qualifying persons referred to in paragraphs (1) and (2) above or their associated corporation or associated partnership by providing investment management services in Hong Kong to the certified investment funds or the specified entity on behalf of the qualifying persons.
The term “investment management services” include:
- seeking funds for the fund or entity from external investors or potential external investors;
- researching and advising on potential investments to be made for the fund or entity;
- acquiring, managing or disposing of property or investments for the fund or entity; and
- acting for the fund or entity with a view to assisting an entity in which the fund or entity has made an investment to raise funds.
The concessionary tax treatment would be ring-fenced to eligible carried interest arising from qualifying transactions in private companies only. These are transactions in:
- shares, stocks, debentures, loan stocks, funds, bonds, or notes of, or issued by, a private company specified under Schedule 16C to the IRO;
- shares or comparable interests of a special purpose entity (SPE) or interposed SPE solely holding and administering one or more investee private companies;
- shares, stocks, debentures, loan stocks, funds, bonds, or notes of, or issued by an investee private company held by an SPE or interposed SPE from (2); and
- incidental to the carrying out of the qualifying transactions from (1) to (3), subject to a 5 percent threshold.
The bill provides that the carried interest tax concession would only apply on profits arising from investments earned from transactions in private companies, where those profits are exempt from profits tax in accordance with the UTE. It is unclear whether funds need to rely on the UTE in order to qualify for the carried interest tax concession on those transactions, notwithstanding that they may still be exempt from profits tax by other means such as deriving non-Hong Kong sourced income or not carrying on business in Hong Kong.
Carried interest from hedging transactions may also be eligible for the tax concession, subject to conditions.
Substantial activities requirements
Qualifying carried interest recipient has to meet the substantial activities requirements for each year of assessment for the period from the date when the qualifying carried interest recipient begins to perform investment management services directly or indirectly to the certified investment fund or a specified entity, to the date when the carried interest is received or accrued to the qualifying recipient:
- average of two or more full-time employees in Hong Kong who carry out the investment management services; and
- HK$2 million or more operating expenditure incurred in Hong Kong for the provision of investment management services.
HKMA’s certification and ongoing monitoring mechanism
Funds need to go through an application and certification process with HKMA before it is eligible for the carried interest tax concession regime. In the year of carried interest distribution, an external auditor needs to verify the satisfaction of relevant substantial activities requirements and the requirements of eligible carried interest.
The IRD may seek advice from HKMA to ascertain:
- whether a service constitutes an investment management service;
- whether a sum has been received by, or accrued to, a person by way of profit-related return so that it may be eligible carried interest;
- whether an entity is, and has remained, a certified investment fund; and
- any other matter that the IRD commissioner considers appropriate in relation to the claim.
Further, it is pertinent to note that qualifying carried interest recipients and payers (e.g. certified investment fund and its associated corporation or partnership) of eligible carried interest are required to retain records for up to seven years from the date of payment or accrual of eligible carried interest. While this is in line with the general record keeping requirements under the Limited Partnership Fund Ordinance and the IRO, this may not necessarily be the case for record keeping of funds incorporated in other jurisdictions (in particular for post dissolution period), and care should therefore be taken into consideration on this requirement.
We understand that the HKMA is expected to hold wider industry consultation for the carried interest certification and on-going monitoring mechanism. We encourage industry participants to actively participate in the consultation to ensure the implementation of the carried interest tax concession is practical.
Definition of SPE under the UTE
We would also like to highlight a notable change to the current UTE rules. Under the current UTE regime, SPEs of an investment fund are restricted to invest in private companies only, and not in public securities and other asset classes that the investment fund is allowed to directly invest in.
To address the industry’s concerns on the above restriction, the bill also provides that a SPE can invest in the full range of asset classes as the investment fund under Schedule 16C of the UTE, and tax exemption can equally apply to the gain derived by the SPE. As such, investment funds (including hedge funds) should be able to use SPEs to hold listed and marketable securities going forward, without jeopardizing the tax exemption status under the UTE.
Over the past few years, the industry has lobbied for clarity and certainty on the tax treatment of carried interest. This carried interest tax concessions bill is a big step towards alleviating the industry’s concerns on the taxation of carried interest, and ensures Hong Kong remains an attractive and competitive location for fund managers. The carried interest tax concession follows the various measures the government has already implemented to bolster Hong Kong’s position as a leading international asset and wealth management center, including the UTE, the open-ended fund company regime, and the limited partnership fund regime. We expect the industry would be eager to see the fruition of a practical carried interest tax concession.
This article is contributed by Rex Ho, Partner – Hong Kong Asset and Wealth Management Tax Leader, and Eric Gong, Senior Manager, Tax Services, PwC Hong Kong