Hong Kong: Proposed Tax Concession For Carried Interest Issued By Private Equity Fund In Hong Kong

Introduction

As announced in the 2020/2021 budget speech, the Financial Secretary proposed a tax concession for carried interest in Hong Kong. The Financial Services and Treasury Bureau (FSTB) has recently launched consultation seeking views on its proposal on the said tax concession (the "Proposal") whilst the consultation period ended on 4 September 2020. To allow you to evaluate the benefits of the proposed tax concession, we highlight the details of the Proposal below.

The Proposal

There are three key points in the Proposal. First, the tax concession rate is described to be "highly competitive" although not specified in the Proposal. Next, the tax concession will take retrospective effect from the year of assessment commencing on 1 April 2020. Third, there is a prescribed set of eligibility criteria for the proposed tax concession, which are divided into three main heads: the fund itself, the relevant carried interest subject to the tax concession, and the carry recipient.

The fund

The proposed tax concession will apply to carried interest paid by private equity funds that qualify for the Unified Fund Tax Exemption (the "UFE"), namely those that fall within the definition of "fund" in section 20AM of the Inland Revenue Ordinance (Cap. 112, the "IRO"). In this connection, it is noteworthy that such a definition closely replicates that of "collective investment scheme" in the Securities and Futures Ordinance (Cap. 571, the "SFO"), albeit with certain modifications. Separately, validation of the fund by the Hong Kong Monetary Authority (the "HKMA") is required, and an external auditor has to be engaged to fulfil the requirements in relation to the ongoing monitoring of the carry distributions. Further, an authorised local representative must be appointed to provide the HKMA and the Inland Revenue Department with the necessary communications on the particulars of the carry distributions.

The carried interest

To qualify for the tax concession outlined in the Proposal, the carried interest has to be a profit-related return which 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) the return to external investors is also determined by reference to the same profits. Separately, it is also proposed to include as carried interest a sum paid out of the profits derived from "qualifying transactions" under the UFE provided that all or substantially all the investments in the fund should have been repaid to external investors first with each external investor having received an annual rate of at least 6% compound interest. It is only when these conditions are satisfied that the carried interest will qualify. As to what is meant by "qualifying transactions" under the UFE, Part 1 of Schedule 16C to the IRO provides that they include transactions in e.g. securities, shares in a private company, future contracts, etc. Finally, the carried interest has to be derived from the provision of "investment management services" in Hong Kong to a validated fund, which include (i) seeking funds for the purposes of the validated fund from participants or potential participants; (ii) researching potential investments to be made for the purposes of the validated fund; (iii) acquiring, managing or disposing of property for the purposes of the validated fund; and (iv) acting for the purposes of the validated fund with a view to assisting an entity in which the fund has made an investment to raise funds.

The recipient

The proposed tax concession is only available to persons providing investment management services to a validated fund in Hong Kong, or those who arrange such services to be carried out in Hong Kong. There are three major classes of such persons: first, licensed corporations and authorised institutions that are licensed or registered under the SFO; second, entities providing or arranging for such services to a "qualified investment fund" as defined under IRO section 20AN(6); and third, individuals deriving assessable income from employment with these two preceding categories of entities/persons where he/she provides investment management services to the validated funds.

Additionally, the carry recipients have to fulfil certain substantial activities requirements. There must be no less than two investment professionals employed in Hong Kong (or alternatively, one investment professional and one related professional in finance, legal, or compliance). Moreover, there must have been at least HK$3 million local expenditure incurred in Hong Kong for the year of assessment. These ensure that talents and operations of the funds are retained locally.

Foresight

The aforesaid details of the Proposal may be subject to further change depending on the industry views. We expect that the Proposal may help easing the market concern and will increase Hong Kong's attractiveness for private equity funds in general.

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.