Profits tax exemption for private equity funds in Hong Kong

In recent years, Hong Kong has been stepping up on its efforts to become a leading asset and wealth management hub in Asia. Following the introduction of the unified funds tax exemption in early 2019 and the launch of the limited partnership fund regime in August 2020 (please see our previous article), a tax concession scheme for carried interest will be implemented later this year.

The proposed concession will address general partners and fund/investment managers’ concerns on the tax exposure relating to their performance fee, or commonly known as “carried interest”. Since May 2016, the Inland Revenue Department of Hong Kong has professed a robust position to tax, subject to relevant exemptions, carried interest received by fund executives of offshore funds by way of either salaries tax (applicable to employment income) or profits tax (applicable to service income). That means distributions from the general partners or the carried interest limited partners that are deemed as performance-based income (instead of genuine investment returns) can be subject to profits tax at 16.5%, or to salaries tax at a rate of up to 17%.

The Carried Interest Concession Bill

Against this background, the Inland Revenue (Amendment) (Tax Concessions for Carried Interest) Bill 2021 (the “Bill”) was gazetted on 29 January 2021 to offer concessions for carried interest. Below are some key features of the Bill:

  • Tax Concession Rate – At the time of public consultations launched in 2020, the initial plan of the government was to offer a “highly competitive rate” which is compatible with the global standard. The Bill now confirms that eligible carried interest will be fully exempted, thereby rendering payments of carried interest in practice tax neutral in Hong Kong.
  • Eligible Carried Interest – Eligible carried interest must be a “profit-related return” and subject to a hurdle rate. “Profit-related return” encompasses three conditions, namely (i) it arises only if underlying investments generate a profit; (ii) the amount of which varies by reference to the profits; and (iii) returns to investors are determined by reference to the same profits. Concession will therefore not apply to advisory or management fees or remuneration that a fund executive is entitled to receive regardless of the performance of the fund.
  • Eligible Payer – Payer of the carried interest must be a certified fund (broadly defined to be a collective investment scheme managed by a professional manager, e.g. a fund managed by a general partner or fund manager). To be certified by Hong Kong Monetary Authority, the fund must satisfy the substance requirements (see below). In addition, The Innovation and Technology Venture Fund Corporation established by the government under the Innovation and Technology Venture Fund Scheme will also be eligible for the tax concession.
  • Qualifying Transactions – In line with the overall objective to attract fund executives and operation in Hong Kong, the concessionary tax treatment will be ring-fenced to eligible carried interest arising from “qualifying transactions” in private equity only. Qualifying transactions include transactions in shares, stocks, debentures, loan stocks, funds, bonds or notes of, or issued by a private company. Shares or comparable interests of a special purpose entity or interposed special purpose entity which is solely holding one or more investee private companies are also covered. Transactions incidental to the above-mentioned qualifying transactions (” incidental transactions “) will also qualify, provided that the trading receipts from incidental transactions do not exceed 5% of the total trading receipts from qualifying transactions and incidental transactions.
  • Carried Interest Recipients – Qualifying recipients of the carried interest include: (i) corporations licensed by the Securities and Futures Commission to carry on a regulated activity; (ii) persons carrying out investment management services in Hong Kong for a certified investment fund, which is a qualified investment fund [1] ; and (iii) individuals deriving assessable income from the employment with the qualifying persons in (i) or (ii) by providing investment management services in Hong Kong to the certified investment funds on behalf of the qualifying persons, as long as, in each case, the qualifying recipient provides “investment management services” to a certified investment fund in Hong Kong, or arranges such services to be carried out in Hong Kong.
  • Substance Requirement/ HKMA Certification – Qualifying carried interest recipients must have (i) an average of at least two employees in Hong Kong carrying out investment management services; and (ii) at least HK$2 million of operating expenditure incurred in Hong Kong in each relevant year of assessment. Funds need to apply to the Hong Kong Monetary Authority for a one-off certification, based on whether they make private equity investments and are likely to meet the local employment and spending requirements referred to above.

More to Come

Hong Kong has recently proposed to legislate for a re-domiciliation scheme for foreign funds to migrate to Hong Kong as open-ended fund companies or limited partnership funds. In connection with such corporate migration, the government will subsidise the migrating entities for 70% of the expenses paid to local professional service providers (e.g. lawyers, tax advisors, and fund administrators), subject to a cap of HK$1 million.

With all the legal and regulatory benefits mentioned above, Hong Kong is well-positioned to propel itself as one of the best fund management destinations in Asia.

[1] Fund that has more than 4 investors who contribute >90% of the fund’s capital, and the fund originator (e.g. GP) is entitled to not more than 30% of the fund’s proceeds.

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