The Hong Kong Institute of CPAs issued a submission to the Financial Services and the Treasury Bureau (FSTB) on a proposal to provide a tax concession on carried interest. While the Institute is supportive of the general direction to offer a tax concession, the submission raises certain technical issues and points for clarification. 

Eligible funds

The Institute calls for clarification if the requirements for profits tax exemption under sections 20AN and 20AO of the Inland Revenue Ordinance is a prerequisite for enjoying the preferential treatment for carried interest.

What is carried interest?

The proposal makes reference to the definition of “carried interest” in the United Kingdom with suitable modifications. Following the U.K.’s approach, carried interest means a sum which is received or accrued to the persons concerned by way of profit-related return. It is proposed that the “profit-related return” is defined to encompass three conditions: (i) the carried interest must arise only if the validated fund is making profits, (ii) the carried interest paid would vary substantially by reference to the profits; and (iii) return to external investors is also determined by reference to the same profits.

It appears that these conditions could be problematic for carried interest paid under the United States model (i.e. on a deal-by-deal basis). Therefore, the Institute recommends a wider definition of “carried interest.”

Is carried interest capital or revenue in nature?

If the holding period is long enough, carried interest in part or in full could be regarded as capital in nature in both the U.K. and U.S. Hence, lower tax rates for capital gains may apply. However, carried interest recipients in Hong Kong would be subject to profits tax or salaries tax based on the entire amount received as no part of it would be considered as capital in nature.

As capital gains are not taxable for profits tax, the preferential regime could be even more attractive if the government would agree to treating the carried interest as capital in nature by reference to the holding period.

Qualifying transactions

The Institute recommends that what constitute “qualifying transactions” should be clearly explained in the legislation.

Qualified carried interest recipients

The FSTB proposed that individuals providing investment management services to eligible funds in Hong Kong who derive assessable income from the employment with the qualifying person could enjoy the concessionary tax rate. However, other employees, such as the chief financial officer, legal counsel, head of investor relations, could also be the carried interest recipients. Moreover, some investment advisors may need to travel overseas to handle projects. Therefore, the government may consider expanding the scope of the qualified carried interest recipients.

Tax loss

The FSTB proposed that tax loss of the carried interest recipient would not be eligible for carry forward. However, if the highly competitive rate is not set at zero, it is necessary to allow tax loss be carried forward to offset against future taxable profits.

Tax rate differential

The management fee and carried interest payable to the investment manager will be subject to profits tax at normal tax rates and the concessionary rate respectively. Hence, there is a tax differential. While it is common for management fees to be set at 2 percent of the fund’s assets under management, the Inland Revenue Department (IRD) expects that fees are charged at an arm’s length basis. To this end, would the IRD agree 2 percent as the deemed arm’s length amount? Clear guidance on what would be considered as an acceptable arm’s length basis would avoid unnecessary disputes.

Concessionary tax rate

Setting the concessionary tax rate at zero would make the preferential tax regime very attractive. However, there is a minimum tax rate requirement under the Base Erosion and Profit Shifting 2.0 initiative. Though most investment managers would not hit the €750 million threshold, consideration should still be given to avoid potential tax leakage in rare cases.

Substantial activity requirements

The substantial activity requirements of (i) hiring of at least two investment professionals and (ii) a minimum of HK$3 million local spending are friendly to the investment managers.  Yet, the government should ensure that this preferential tax regime would not be considered as a harmful tax practice by the Organization for Economic Cooperation and Development.

Accounting standards

Many existing funds use Cayman structures and prepare their accounts under U.S. Generally Accepted Accounting Principles (GAAP).  Yet, the IRD only accepts accounts prepared under Hong Kong Financial Reporting Standards. GAAP conversion is time consuming and cumbersome. How can this be streamlined?

Timing difference on recognition

Expense and income recognition in the hands of the fund and the investment manager are governed by two sets of accounting standards. Timing difference for the two parties may occur. The Institute calls for clarification on the acceptable tax treatments on the amounts recognized in the two parties’ accounts.

The role of auditors

Under the FSTB’s proposal, auditors have a role to play to report that the carried interest payers are validated funds and the carried interest recipients satisfy the substantial activity requirements.  However, it is unclear to us what the exact reporting requirements are, e.g. level of assurance and therefore the Institute sought clarification on the same.

This article is contributed by William Chan, Chairman of the Institute’s Taxation Faculty Executive Committee and Partner, Grant Thornton, and Eric Chiang, Deputy Director, Advocacy and Practice Development at the Institute