As long awaited by the Hong Kong private equity funds industry, the Inland Revenue (Amendment) (Tax Concessions for Carried Interest) Ordinance 2021 (the Amendment Ordinance) became law on 7 May 2021. The concessionary tax treatment will take retrospective effect applying to eligible carried interest received by or accrued to qualifying persons on or after 1 April 2020. It should, however, be noted that the tax concessions do not apply to eligible carried interest received by, or accrued to, a qualifying person before 1 April 2020 but falling within the basis period for a year of assessment commencing on or after 1 April 2020.

Background

In recent years, the Hong Kong government has been contemplating and designing measures to further promote and foster the growth of the local investment management industry. Some of these measures have been specifically intended to develop Hong Kong as a premier asset management hub, in particular for private equity, including:

1. Pursuant to the Inland Revenue (Profits Tax Exemption for Funds) (Amendment) Ordinance 2019, since 1 April 2019, privately-offered funds (including private equity funds) may enjoy profits tax exemption for transactions in specified assets, subject to meeting certain conditions; and
2. The limited partnership fund (LPF) regime commenced operation on 31 August 2020, which is substantially comparable with limited partnership regimes in other major jurisdictions for fund formation and therefore meets the operational needs of private equity managers.

Previously, management fees and carried interest, if derived from investment management services rendered in Hong Kong, will be chargeable as service income for profits tax or chargeable employment income for salaries tax, as the case may be, in the hands of the recipient. With a view to attracting more private equity fund managers to operate in Hong Kong, after conducting industry consultations, the Hong Kong government has developed a tax concession regime for carried interest, subject to the fulfilment of certain conditions.

Tax concession regime

The tax concession regime will be administered by the Inland Revenue Department (IRD) together with the Hong Kong Monetary Authority (HKMA). While IRD and HKMA may issue further implementing details, pursuant to the Amendment Ordinance, tax concessions would apply to eligible carried interest arising from qualifying private equity transactions, distributed by a fund which falls within the meaning of “fund” under section 20AM of the Inland Revenue Ordinance (Cap.112) (IRO) (essentially the “fund” should be a collective investment scheme), and received by or accrued to a qualifying person. The fund must be certified by the HKMA (a certified investment fund) before concessionary tax treatment will apply to their eligible carried interest distributions.

Tax concessions also apply where the eligible carried interest is distributed to individuals employed by a qualifying person, or an associated corporation or an associated partnership of a qualifying person, if that associated corporation or partnership carries on a business in Hong Kong, and where those individuals carry out duties of employment by providing investment management services in Hong Kong for or on behalf of the qualifying person.

Although the tax concession regime was initially proposed alongside the new LPF regime, the Amendment Ordinance does not limit the application of tax concessions to LPF only. A non-resident fund may also enjoy the tax concessions, subject to fulfilment of all eligibility criteria and conditions under the Amendment Ordinance and such “non-resident fund” must appoint an authorised local representative to provide the necessary particulars and information to the IRD and the HKMA on behalf of the fund.

Eligible carried interest

In order to differentiate carried interest from management fees and other types of remuneration received by the manager or investment professionals, under the Amendment Ordinance, “eligible carried interest” is defined as a sum received by or accrued to a person by way of profit-related return from the provision of investment management services by the person for a certified investment fund. Such amount must be received or accrued after the payment of a return on investments in the fund subject to the hurdle rate which is a preferred rate of return on investments in the fund as stated in its governing document. Eligible carried interest must vary by reference to profits on the investments or on particular investments made for the purposes of the certified investment fund or profits arising from a disposal of investment for the fund. Further, the returns to external investors of the fund must also be determined by reference to those profits.

It is further provided that, if there is no significant risk that at least a certain amount of the actual sum would not be received by or accrued to the person concerned, then the said amount is not regarded as “eligible carried interest” for the purposes of the Amendment Ordinance. This risk is to be assessed as at the latest of: (a) the time the person enters into an agreement for provision of investment management services for the certified investment fund, (b) the time the person begins to carry out investment management services directly or indirectly for the fund; and (c) the time when a change is made to the agreement referred to in (a) so far as relating to the sums that are to be or may be received by or accrued to the person. These provisions highlight that the carried interest tax concession is intended to apply or benefit payments that shall be received or accrue only upon profits from private equity investments and which carry risks and uncertainty. The tax concession is not intended to apply to management fees or other services income which remain subject to profits tax if received by a manager carrying on business in Hong Kong. The Amendment Ordinance also sets out an anti-avoidance provision to disapply the tax concessionary treatment if the Commissioner of Inland Revenue is satisfied that the main purpose or one of the main purposes of an arrangement is to obtain a tax benefit in relation to a liability to pay profits tax or salaries tax under the tax concession regime.

Qualifying transactions

The concessionary tax treatment applies to eligible carried interest arising from profits on investments, profits on particular investments, or profits on a disposal of investment, that are earned from qualifying transactions in private equity only. Qualifying transactions include transactions:

1. In shares, stocks, debentures, loan stocks, funds, bonds or notes of, or issued by, a private company (whether incorporated in or outside Hong Kong and not allowed to issue any invitations to the public to subscribe for any shares or debentures of the company);
2. In shares of, or comparable interests in, a special purpose entity or an interposed special purpose entity which is solely holding (whether directly or indirectly) and administering one or more investee private companies;
3. In shares, stocks, debentures, loan stocks, funds, bonds or notes of, or issued by, an investee private company held by a special purpose entity or interposed special purpose entity at paragraph (b) above; or
4. Incidental to the carrying out of the qualifying transactions at paragraphs (a) to (c) above.

Such qualifying transactions also have to meet all the relevant tax exemption conditions under the profits tax exemption for privately offered funds under sections 20AM to 20AY of the IRO before the eligible carried interest arising from the transactions concerned is eligible for tax concessions.

It is noted in the Legislative Brief of the tax concession regime that, depending on the facts and circumstances, carried interest derived from hedging transactions may be eligible for tax concessions under limited circumstances, if the hedging transaction would form part and parcel of the private equity transaction and the profits on the hedging transaction are embedded in the profits or loss on the private equity transaction for the calculation of carried interest.

Qualifying persons and employees

Under the Amendment Ordinance, the following are qualifying persons who are eligible for the concessionary tax treatment on eligible carried interest received or accrued on investment management services carried out in Hong Kong for certified investment funds:

1. A corporation licensed under Part V of the Securities and Futures Ordinance (Cap.571) or an authorised financial institution registered under that Part for carrying on a business in any regulated activities;
2. Any other person or entity carrying out investment management services in Hong Kong, or arranging such services to be carried out in Hong Kong, for a certified investment fund that is a “qualified investment fund” as defined by section 20AN(6) of IRO (see below); and
3. Employees of the qualifying persons referred to in (a) or (b) above or their associated corporation or partnership, who provide investment management services in Hong Kong to the certified investment funds on behalf of the qualifying persons.

Under section 20AN(6) of the IRO, a qualified investment fund means a fund in relation to which— (a) at all times after the final closing of sale of interests— (i) the number of investors exceeds four; and (ii) the capital commitments made by investors exceed 90% of the aggregate capital commitments; and (b) an agreement governing the operation of the fund provides that not more than 30% of the net proceeds arising out of the transactions of the fund are to be received by the originator and the originator’s associates, after deducting the portion attributable to their capital contributions (which is proportionate to that attributable to the investors’ capital contributions).

The requirement that investment management services must be carried out in Hong Kong or arranged to be carried out in Hong Kong is further to the policy objective to attract more private equity funds to operate in Hong Kong.  At the same time, the Amendment Ordinance sets out rather broadly that “investment management services” include:

1. Seeking funds for the certified investment fund from external investors or potential external investors;
2. Researching and advising on potential investments to be made for the certified investment fund;
3. Acquiring, managing or disposing of property or investments for the certified investment fund; and
4. Acting for the certified investment fund with a view to assisting an entity in which the fund has made an investment to raise funds.

The investment management services performed by the qualifying persons must also not be carried on outside Hong Kong by a permanent establishment i.e. a branch, management or other place of business (but not including an agency, unless the agent has, and habitually exercises, a general authority to negotiate and conclude contracts on behalf of a principal).

In addition, qualifying persons must meet relevant substantial activities requirements during the period from the day on which they begin to carry out investment management services directly or indirectly for a certified investment fund and ending on the day on which eligible carried interest is received by or accrued to them. The qualifying persons must have, in the opinion of the Commissioner of Inland Revenue, an adequate number of qualified full-time employees and operating expenditure incurred in Hong Kong for the relevant years of assessment. In any event, for each year of assessment, these are, as the minimum requirements (i) an average of two or more full-time employees in Hong Kong who carry out the investment management services and have the qualifications necessary for doing so; and (ii) operating expenditure incurred in Hong Kong for the provision of the investment management services of HK$2 million or more.

HKMA certification and ongoing monitoring

To prevent tax abuse, the HKMA will administer a certification scheme and funds will have to go through a certification process before concessionary tax treatment will apply to their eligible carried interest distributions. The HKMA will assess, based on the information provided by the fund, whether the fund makes private equity investment and whether the local employment and local spending requirements of the carried interest recipients are likely to be met. However, there is, as of now, no specific guidance on the criteria that the HKMA will use in assessing funds for certification.

The Amendment Ordinance also provides for a mechanism that the Commissioner of Inland Revenue may, in assessing claims received for concessionary profits tax or salaries tax treatment on eligible carried interest, seek advice from the HKMA on 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 it may be eligible carried interest and whether an entity is, and has remained, a certified investment fund, and any other matter that the Commissioner considers appropriate in relation to the claim.

Attractive tax framework for private equity funds

The Amendment Ordinance is the latest step that further enhances the favourable tax framework for private equity funds.  In addition to the carried interest tax concession regime, the IRO is also amended for allowing special purpose entities established by a fund to hold and administer financial assets of a class specified in Schedule 16C of the IRO, other than investee private companies, and to carry out transactions in such assets, on behalf of the fund, for profits tax exemption purposes.

The tax concession regime for carried interest distributed by eligible private equity funds operating in Hong Kong, alongside the enhancements to the profits tax exemption that was initially introduced in April 2019, offer additional strong incentive and an attractive tax framework for fund operators to establish and operate private equity funds in Hong Kong, while complementing and further enhancing the attractiveness of LPFs as a structuring option for Hong Kong domiciled funds.

Private equity fund sponsors and operators are welcomed to contact us for advice or assistance on eligibility for certification by HKMA, assessing whether qualifying conditions for the carried interest tax concession can be met, or to discuss with us proposed private equity funds to be established or operated in Hong Kong that may qualify under the available tax benefits.

For further details, please get in touch with the author, Vivien Teu (Partner, Hong Kong).