An Overview of the Hong Kong Tax Concession for Carried Interest

The Inland Revenue (Amendment) (Tax Concessions for Carried Interest) Bill 2021 was gazetted on Jan. 29, 2021. The long-awaited bill sets forth the legislative framework for granting concessionary tax treatment to carried interest received by or accrued to fund managers and their employees. The bill is in line with the proposals put forward by the Government in its August 2020 consultation paper, and by the Legislative Council Panel on Financial Affairs (LegCo Panel) in its January 2021 discussion paper.

Form of tax concession

The bill introduces a tax concession in respect of carried interest distributed by private equity funds whose investment management activities are carried out in Hong Kong. Net eligible carried interest received by or accrued to qualifying fund managers, and remuneration paid by qualifying fund managers to their employees for work performed in securing the eligible carried interest received or accrued will not be subject to profits or salaries tax.

Effective date

Subject to the passage of the bill, the concessionary tax treatment will take retrospective effect in respect of eligible carried interest received by or accrued to qualifying carried interest recipients on or after April 1, 2020. However, the concession will not apply to carried interest accrued before April 1, 2020, even if it is only received after April 1, 2020.

Qualifying carried interest recipients

Both fund managers and employees may benefit from the tax concession. Under the bill, fund managers may qualify for the tax concession if they:

(1) carry out investment management services (which include seeking funds, researching and advising on potential investments, and acquiring, disposing and managing assets), or arrange for such services to be carried out, for a fund in Hong Kong, from the day they start providing such services to the fund, to the day when they receive the carried interest from the fund applicable period);

(2) do not partially carry on investment management services for the fund through a permanent establishment (including a branch, management, other place of business or agent who habitually exercises a general authority to negotiate and conclude contracts on behalf of the fund manager) which they may have outside of Hong Kong; and

(3) fulfil the following “substantial activity requirements” during the entirety of the Applicable Period:

• have, on average, an “adequate” number of full-time employees in Hong Kong who carry out investment management services for the fund, which must, in any event, not be less than two during each year of assessment falling within the Applicable Period; and
• incur in Hong Kong an “adequate” amount of operating expenditure in providing investment management services to the fund, which must, in any event, not be less than HKD 2 million during each year of assessment falling within the Applicable Period.

The bill however does not elaborate on how adequacy is to be determined for the purposes of determining whether the substantial activity requirements are satisfied.

As for employees, under the bill, they will qualify for the concession if they are employed by a qualifying fund manager, or an associated corporation or partnership of a qualifying fund manager who carries on a business in Hong Kong. The employee himself must provide investment management services in Hong Kong in order to qualify for the tax concession. The salaries tax concession also only applies to the extent that the amount received by the employee is paid out of eligible carried interest that is exempt from profits tax under the concession.

Conditions to qualifying for the tax concession

In order for carried interest payments to qualify for the concessionary tax treatment, the following conditions must be satisfied:

(1) The carried interest must be paid by a qualifying payer.
The carried interest must be paid by one of the following entities (qualifying payers):

• a fund that has been certified by the Hong Kong Monetary Authority (HKMA) as being in compliance with the criteria for certification published by the HKMA (a “certified investment fund”);
• an associated corporation or partnership of a “certified investment fund”; or
• the Innovation and Technology Venture Fund Corporation established by the Hong Kong Government.

Based on the Government’s and LegCo Panel’s earlier consultation and discussion papers, it is expected that the HKMA will only certify a fund if it is satisfied, on the application of the fund (or in the case of a non-resident fund, its local authorized representative), that:

• the fund is focused on private equity investment strategies; and
• the fund manager engaged by the fund will fulfill the relevant “substantial activity requirements” outlined above.

In making its determination, the HKMA will likely have regard to, amongst other things, the fund’s formation documents, the type of investments which the fund makes, the fund’s historical local expenditure, the budget of the fund structure, and the fund’s historical and estimated local hire. The HKMA may also prescribe other criteria that must be fulfilled before it will certify a fund as a “certified investment fund.” Certification will be done through issuing the relevant fund a letter of certification.

(2) The carried interest must be profit-linked.
The carried interest must be remuneration which is, under the terms of the agreement governing the operation of the fund, linked to those profits generated by the fund by reference to which the returns of external investors are determined, and subject to fulfillment of the hurdle rate stipulated in the agreement. The tax concession would therefore not apply to base advisory or management fees which the fund manager or its employees are entitled to receive regardless of the performance of the fund.

In addition, to the extent there is no significant risk that the amount would not be received or accrued, such amount would not be regarded as eligible carried interest. Any risk that the amount would be prevented from being received or accrued (whether by reason of insolvency or otherwise) will be ignored.

(3) The carried interest must arise from tax-exempted qualifying transactions.
The tax concession is limited to carried interest distributed in respect of transactions that meet both the following criteria:

• the transaction is one in the shares, stocks, debentures, loan stocks, bonds or notes of, or issued by, a private company, or a special purpose entity (SPE) or interposed SPE that holds and administers one or more private companies and no other assets of a class specified in Schedule 16C to the Inland Revenue Ordinance (IRO), or is incidental to the carrying out of such transactions (provided such incidental transactions do not exceed 5% of total trading receipts); and
• profits earned from the transaction are tax-exempt under the unified funds exemption as provided for in section 20AN or 20AO of the IRO which is targeted at collective investment schemes and their special purpose entities.

Note: Under the funds exemption in the IRO, profits derived by funds from transactions in assets of a class specified in Schedule 16C (including securities; shares, stocks, debentures, loan stocks, bonds or notes of, or issued by, a private company; futures contracts; foreign exchange contracts; certain deposits and certificates of deposits; foreign currencies; exchange traded commodities, and OTC derivative products) are exempt from profits tax, subject to the fund satisfying other conditions in the IRO. Notably however, investments in private companies that directly or indirectly hold more than 10% of their assets in Hong Kong immoveable property are excluded. The bill provides that carried interest distributed in respect of transactions in SPEs or interposed SPEs may only qualify for the tax concession if the SPE or interposed SPE only holds and administers one or more private companies, and no other assets of a class specified in Schedule 16C.

The tax concession is accordingly restricted to carried interest distributed in respect of private equity transactions that are exempt from tax under the funds exemption. Certain conditions may need to be satisfied in order for the funds exemption to apply, including conditions as to the number of investors in the fund if the fund manager is not an entity licensed with the Hong Kong Securities and Futures Commission, the period for which the investment must be held, etc.

As a side note, we note that for the purposes of the funds tax exemption, the bill expands the classes of assets that may be held and/or administered by an SPE, on behalf of a fund which owns the entity, without disqualifying the SPE from the funds exemption. An SPE may now hold and administer any class of assets specified in Schedule 16C (and not just shares and other interests in private companies). For the purposes of the carried interest tax concession however, it will only be available in respect of carried interest earned from transactions in SPEs which hold and administer shares and other interests in private companies only (i.e., to the exclusion of the other classes of assets specified in Schedule 16C, which are specifically carved out).

Ongoing requirements

The bill contains detailed information and record retention requirements. Qualifying fund managers must, for instance, provide information relating to any eligible carried interest which they receive, and details regarding employees who receive eligible carried interest, to the IRD in their returns or in any other manner prescribed by the IRD, and retain sufficient records to enable the accuracy and completeness of payments or accruals of carried interest to be ascertained for a seven-year period. Qualifying payers are also subject to similar record retention requirements. Failure by qualifying payers to do so may render carried interest which they pay ineligible for the tax concession.

In addition, the IRD is expressly empowered to seek advice from the HKMA in order to ascertain whether an activity constitutes an investment management service, whether a sum may be eligible carried interest, whether an entity is a certified investment fund, and any other matter which the IRD considers appropriate in relation to a tax concession claim.

Calculation of net eligible carried interest and treatment of losses

For profits tax purposes, a concessionary tax rate of 0% will apply to net eligible carried interest received or accrued, calculated after deducting any relevant outgoing and expenses and depreciation allowances, and adding back balancing charges.

If the fund manager incurs a loss in respect of eligible carried interest, such associated loss would not be available for set off against any assessable profits of the fund manager (e.g., assessable management fee income) for the current or for any subsequent years of assessment.

Anti-avoidance

The bill includes a new specific anti-avoidance provision which applies to arrangements that have as one of their main purposes the obtaining of a tax benefit under the carried interest tax concession, whether for the person or for any other person. The drafting of this provision is vague, and at present, there is little guidance as to the types of arrangements that may be caught, in particular, whether a carried interest compensation scheme introduced to take advantage of the tax concession would fall within the scope of the anti-avoidance rule. As drafted, the provision only provides that arrangements put in place to disguise as eligible carried interest a management fee that a person receives or accrues would be regarded as “ arrangements to obtain a tax benefit,” such that the concessionary tax treatment could be denied in such cases.

Way forward

Subject to the passage of the bill, the tax concession will take retrospective effect in respect of eligible carried interest accrued from 1 April 2020. As such, relevant funds and fund managers should be prepared for the new tax concession regime with an understanding of the scope, eligibility requirements and application procedures.

Notably, for the tax concession to apply, taxpayers could be subject to the scrutiny of both the IRD and HKMA, for the initial HKMA certification and for compliance with the ongoing requirements discussed above. Moreover, the IRD is expressly authorized to seek advice from the HKMA in respect of any matter relevant to a person’s entitlement to the tax concession.

Due to the complexity of the legislative framework, fund managers may need to work closely with their legal advisers in structuring and setting up funds in light of the new regime. Fund managers and relevant employees should also take care to ensure that employment terms are appropriately drafted and relevant documentation is maintained to establish the nexus between payments to employees and the carried interest, so that payments are eligible for the tax concession from a salaries tax perspective. Fund managers should also work closely with their legal advisers to better secure the relevant certification from the HKMA, whilst ensuring proper control is placed over the nature and extent of the information supplied.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Steven Sieker is a tax partner and Managing Partner for Baker McKenzie’s China and Hong Kong offices. Pierre Chan is a partner, Carrie Liu is a Special Counsel and Michael Olesnicky is an Of Counsel.

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