As part of its ongoing objective of strengthening Hong Kong's position as an asset management center and, in particular, a center for private equity, in August, 2020, the Hong Kong Government launched a proposal to provide a tax concession for carried interest earned from Hong Kong private equity funds. Though the proposal does not specify the rate of profits tax on carried interest, the Hong Kong Government has indicated that it intends for the rate to be "highly competitive".
Historical Tax Treatment of Carried Interest
The private equity industry views carried interest as "sweat equity", earned not through the contribution of financial capital as is the case with limited partners but through the contribution of intellectual capital and energy. As such, the private equity industry considers carried interest earned as a capital gain, no different in substance than the earnings of limited partners who contributed financial capital.
The Inland Revenue Department ("IRD") however, has traditionally viewed carried interest as an incentive reward which supplements management fees for the provision of management services. Consequently, for Hong Kong private equity funds (i.e. funds managed day-to-day from Hong Kong), arrangements have typically been made for the recipient of the carried interest, normally the general partner, to receive the carried interest outside of Hong Kong and thus, outside the ambit of Hong Kong profits tax. However, these arrangements have been subject to 2 risks.
First, there has been a risk that the IRD would take issue with the characterization that the general partner was carrying on a business outside of Hong Kong. If the general partner were to be regarded as carrying on a business in Hong Kong, the general partner might be subject to Hong Kong profits tax on the basis that the carried interest arose in or was derived from that business in Hong Kong.
Secondly, even if the general partner were regarded as carrying on its business outside Hong Kong, there has been a risk that the IRD could challenge the arrangements for carried interest on transfer pricing grounds, arguing that the true economic risk and effort lay not with the general partner but with the adviser responsible for day-to-day management in Hong Kong. On this basis, the IRD could treat the Hong Kong adviser as the recipient of the carried interest and assess profits tax accordingly. This risk has been particularly pronounced with the recent global emphasis on base erosion and profits shifting ("BEPS") and the introduction in Hong Kong of BEPS legislation.
New Proposal on Carried Interest
While the Inland Revenue Ordinance has been amended over time to exempt Hong Kong private equity funds from Hong Kong profits tax (or at least to reduce the liability of such Hong Kong private equity funds for Hong Kong profits tax), until this proposal, the Hong Kong Government had made no effort to provide tax relief to Hong Kong private equity fund sponsors.
Under the proposal, carried interest must qualify as such and, assuming this is the case, will be taxed at a preferential concessionary rate if 3 conditions are satisfied: (i) the recipient of the carried interest must be an eligible entity, (ii) the carried interest must be derived from the provision of investment management services in Hong Kong, and (iii) the management services must be provided to an eligible fund validated by the Hong Kong Monetary Authority ("HKMA").
Qualifying Carried Interest
Under the proposal, carried interest may qualify for the concessionary tax rate if it meets 3 conditions:
- Fund Eligible for Tax Relief - The carried interest must be distributed by a fund which meets the criteria for a "fund" under the private funds tax exemption ("Unified Funds Exemption") under the Inland Revenue Ordinance ("IRO"), s. 20AM.
- Tax Exempt Private Equity Investments - The carried interest must arise from private equity transactions, meaning transactions in shares, stocks, debentures, loan stocks, funds, bonds or notes of a private company or transactions incidental thereto. On this basis, it may be that carried interest from public equity private investment ("PIPE") transactions will not be eligible. Similarly, it may be that carry from exits from the listing of portfolio investments may not be eligible. Finally, it may be that carried interest from exits of certain investments in private companies holding Hong Kong real estate may not be eligible.
- Profit Based Return - The carried interest must be received or accrued by way of a profit-related return, meaning that it must arise only if the distributing fund is making a profit, the carried interest must vary substantially by reference to profits made and returns to external investors must also be determined by such profits made. It follows from this requirement that management fees calculated on capital commitments will not qualify for concessionary relief.
Deemed Qualifying Carried Interest
Though it is unclear, it appears that, notwithstanding the foregoing, as a bright line test, a sum paid out of the profits derived from qualifying transactions of a fund will qualify as carried interest if the sum arises after all, or substantially all, of the fund's investments have been repaid to investors and each external investor has received a preferred return at an annual rate of 6% compound interest. The bright line test appears to presuppose a whole fund approach to carried interest. There is no similar bright line for carried interest on a deal-by-deal basis.
IRD Guidance on Fund Eligibility
There are a number of issues in respect of whether a Hong Kong private equity fund, particularly a newly launched fund, will qualify for the Unified Funds Exemption and the IRD has issued a Departmental Interpretation and Practice Note (DIPN 61 - Profits Tax Exemption for Funds) to provide guidance on its approach to resolving these issues. These same considerations will need to be applied in the context of the carried interest concession.
Eligible Recipients of Carried Interest
To be an eligible recipient of carried interest, a person must meet 2 criteria. First, the person must fall within an eligible category and secondly, the person must have, in the opinion of the Commissioner of Inland Revenue, substantial activities in Hong Kong.
In the former regard, the following persons may be eligible:
- a corporation licensed or registered by the Securities and Futures Commission ("SFC") for any regulated activity, including Type 1 (dealing in securities), Type 4 (advising on securities) and Type 9 (asset management)
- a person providing investment management services in Hong Kong to a "qualified investment fund", meaning a fund that is eligible for exemption under the Unified Funds Exemption where there is no SFC licensed or registered person arranging or carrying out transactions
- an individual deriving assessable income from employment with the persons above by providing investment management services on behalf of his or her employer.
Unlicensed Recipient of Carried Interest
It is notable that in respect of a person providing investment management services in Hong Kong who is not licensed by the SFC, the proposal requires that the services be provided to a "qualified investment fund" under the Unified Funds Exemption. This is because to be a qualified investment fund, the Unified Funds Exemption caps carried interest receivable by the fund sponsor and its associates at 30%, requires a minimum of 4 investors and requires that outside capital commitments exceed 90% of capital commitments.
Substantial Activities Requirement for Recipient of Carried Interest
In respect of substantial activities, the Commissioner of Inland Revenue must be satisfied that:
- there is an adequate number of qualified full-time employees in Hong Kong including not less than 2 investment professionals (or 1 investment professional and 1 related professional in legal, compliance or finance)
- there is adequate operating expenditure in Hong Kong and in this regard, there must be not less than HK$3 million in expenditure incurred in Hong Kong.
Though the proposal does not specify, presumably the HK$3 million expenditure is a minimum annual outlay which can comprise salaries for the investment professionals.
Carried Interest Earned from Investment Management Services
To qualify for the concessionary rate, the recipient of the carried interest must earn the carried interest from investment management services in Hong Kong to a fund. For this purpose, "investment management services" includes:
- Capital raising - seeking funds for the purposes of the fund from participants or potential participants
- Deal Sourcing - researching potential investments to be made for the purposes of the fund
- Deal Execution - acquiring, managing or disposing of property for the purposes of the fund
- Investment Banking - acting for the purposes of the fund with a view to assisting a portfolio company (i.e. an entity in which the fund has made an investment) to raise funds
HKMA Private Equity Fund Validation
Under the proposal, the Hong Kong private equity fund to whom the investment management services are provided to earn carried interest must be validated by the HKMA both on an initial and on an ongoing basis to establish that the fund focuses on private equity investment strategies and that the fund meets economic substance requirements.
For the initial validation, the HKMA will require the fund's formation documents including the offering document and a structure chart. For the ongoing validation, the HKMA will require an external auditor to examine expenditures and human resources and may conduct a site visit.
It is unclear whether a recipient of carried interest will be denied concessionary relief in entirety if at any time the fund fails to meet HKMA validation requirements.
The proposal does not provide for an appeal mechanism in the event that a taxpayer wishes to challenge a position taken by the HKMA. In the absence of such a mechanism, it would appear that short of judicial review, the HKMA would have broad and absolute discretion to deny concessionary relief on the basis of its own interpretation of tax legislation after a fund has been structured with the tax concession in mind. It is not clear whether the HKMA is well positioned for this role given its lack of institutional track record in both private equity and tax matters.
Under the proposal, the concessionary tax rate for carried interest will apply to the net carried interest after deducting eligible expenses. However, any loss will not be eligible to be set-off against any assessable profits.
It is unclear what happens if carried interest which has been distributed is subject to clawback as is common in funds which provide for deal-by-deal carried interest.
The proposed carried interest tax concession for Hong Kong private equity fund sponsors is expected to be introduced as legislation as soon as possible taking into account feedback received. The proposal provides that the legislation will be retroactive to April, 2020.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.