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Introduction and summary
As part of a longstanding Government policy to attract private equity (“PE”) and investment fund operations to Hong Kong, the Inland Revenue (Amendment) (Tax Concessions for Carried Interest) Bill 2021 (the “Bill”) was gazetted on 29 January of this year. If it is, as currently expected, enacted, it would in effect exempt qualifying carried interest from profits tax and salaries tax by taxing such receipts at 0%, thereby rendering payments of carried interest in practice tax neutral in Hong Kong. As with other tax concessions offered in Hong Kong, however, the carried interest exemption is subject to extensive anti-avoidance and local substance conditions.
Who is eligible?
The carried interest exemption operates at both the salaries tax and the profits tax level. In practice, what that means is that an eligible Hong Kong resident company or other entity receiving carried interest payments – generally, with a view of allocating or otherwise distributing such payments to investment professionals – will not pay any Hong Kong profits tax on the carried interest receipt. Similarly, any individual investment professional receiving carried interest either directly from an offshore vehicle or from a Hong Kong resident vehicle exempt from profits tax as a result of the concession, will likewise be exempt from salaries tax on so much of his taxable income as relates to carried interest. In other words, the flow of qualifying carried interest in Hong Kong will be totally exempt from tax, and fund professional who receive carried interest, whilst remaining taxable on their other income from employment, will not pay any Hong Kong tax on their carry.
What are the main conditions for carried interest to be exempt from tax?
1. The carried interest must be ‘eligible carried interest’. That means that it must be carried interest in the strict sense of the term having:
a. A profit related return, which means that:
i. The carried interest only arises if the underlying investments generate a profit – it cannot be guaranteed; AND
ii. The carried interest varies as a function of the profits; AND
iii. Returns to external investors are determined by reference to the same profits.
b. Subject to a hurdle rate.
It is important to note, therefore, that salaries, bonuses, and other perquisites or contractual payments due that are independent from the performance of the underlying investments are not eligible for the concession.
2. The entity distributing the carried interest must be a ‘qualified payer’, which means either:
a. a certified investment fund; OR
b. a company or partnership associated with a certified investment fund; OR
c. the Innovation and Technology Venture Fund Corporation (“IVTF”).
In practice, the certified investment fund requirement is the most relevant. A fund, in this context means a bona-fide widely held collective investment scheme that is certified by the Hong Kong Monetary Authority. To be so certified, the fund must be: (1) a PE fund; (2) have a minimum of two full-time employees in Hong Kong carrying on investment management services; and (3) incur operating expenditure of not less than HK$2 million in Hong Kong. These are substance requirements; the policy behind the concession is to encourage PE funds to set up a physical presence in Hong Kong. It will, however, be apparent that these substance requirements are relatively modest.
3. The carried interest must arise only from ‘qualifying transactions’ that one would expect a PE fund in the ordinary course to make, notably transactions in: securities issued by private companies (and transactions incidental thereto provided that they do not contribute more than five per cent to trading receipts) and certain special purpose vehicles (“SPV”) interposed as holding vehicles for the investee private companies. Note that for a transaction in an SPV to be a qualifying transaction it cannot hold assets other than the aforementioned private company securities.
4. The ‘qualifying transactions’ noted above must in any event be tax-exempt qualifying transactions compliant with the tax incentive for investment funds in ss.20AM – 20AY of the Inland Revenue Ordinance (“IRO”). This is a potentially restrictive condition. In summary, the profits of certain collective investment schemes derived from qualifying transactions are exempt from profits tax under a separate tax concession for funds. For carried interest to qualify for the concession, the underlying investments from which the carried interest is distributed must also comply with the same conditions governing exemption from tax for investment funds. Simply put, the carried interest must arise from transactions that are (or would be exempt) from profits tax by virtue of the said tax concession for investment funds. Generally, such transactions will be either transactions effected in or through Hong Kong, or the relevant fund is a widely-held fund.
5. The Hong Kong Inland Revenue Department (“IRD”) will not grant the benefit of the concession to an arrangement the main purpose or one of the main purposes of which is to obtain a tax benefit. This is the principal specific anti-avoidance provision applicable to the carried interest tax concession code. In practice, most bona fide PE funds should not be caught by it.
Which entities will be eligible for the profits tax concession?
Hong Kong has a territorial tax code: profits tax is charged on the Hong Kong source profits of a trade, profession or business carried on in Hong Kong. That means that in practice carried interest received by a company or other entity in Hong Kong may be in any event exempt from tax by virtue of not being sourced in Hong Kong (e.g., by virtue of having been generated by operations or transactions effected exclusively outside of Hong Kong).
If, however, a company or other entity wishes to rely on the concession, it must be a ‘qualifying person’, which means that it:
- is a corporation licensed under Part V of the Securities and Futures Ordinance to carry on, or an authorised financial intuition registered under that Part for carrying on, a business in any regulated activity as defined by Part 1 of Schedule 5 of the Ordinance; OR
- carries out investment management services in Hong Kong, or arranges for such services to be carried out in Hong Kong, for a certified investment fund that is a qualified investment fund as defined in s.20AN(6) of the IRO; OR
- carries out investment management services in Hong Kong, or arranges for such services to be carried out in Hong Kong, for the IVTF.
Which employees will be eligible for the salaries tax concession?
Salaries tax is usually charged on income and other emoluments from employment – i.e., sums that are paid as a reward for past, present, or future services in employment, or otherwise for acting as an employee. In certain cases, carried interest may in any event be exempt from salaries tax because it has the character of a genuine co-investment by the employee, and is not, therefore, a reward for services in employment. That said, the concession for salaries tax would put the salaries tax position of ‘qualifying employees’ beyond doubt.
A qualifying employee is an individual employed:
- by a qualifying person, as defined above; OR
- by an associate of a qualifying person, provided that it carries on a business in Hong Kong; AND
- in each case carries out the duties of his employment by providing investment management services in Hong Kong for or on behalf of the qualifying person.
‘Investment management services’ are defined narrowly, which means that employees who are commercially fundamental, such as office managers or human resources directors, would fall outside the scope of the exemption because they do not strictly speaking render investment management services in the ordinary course of their employment.
It bears repeating that only the portion of the qualifying employee’s income that is qualifying carried interest will be exempt from salaries tax.
From when will the concession apply?
It is currently envisaged that the Bill will once enacted have retrospective effect, applying to carried interest from 1 April 2020 (i.e., the year of assessment 2020/21 onwards).
How can Deacons help?
We are highly experienced in advising investment funds on optimal fiscal structuring for all aspects of Hong Kong tax, including profits tax, salaries tax, and stamp duty, and in the resolution of tax disputes. The draft legislation governing the carried interest concession is highly complex, and in places restrictive. We are ready to advise on its application once it is enacted, and, should a given arrangement fall outside the scope of the carried interest exemption, we can propose alternative structuring models with a view to in any event achieving a similar tax-neutral outcome.
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