In recent years, private equity (PE) funds are gaining popularity amongst investors and have become a key impetus to the growth of asset and wealth management business. PE funds play a pivotal role in channeling capital, talents and expertise into corporations, especially pre-initial public offering (IPO) companies and unicorns. Management fees and carried interest are commonly structured as a distribution to fund executives through limited partnership arrangements, and the related tax treatment is one of the major considerations dominating the selection of jurisdiction for fund domiciliation and day-to-day management.
Current tax treatment
Under the Hong Kong Inland Revenue Department’s (IRD) prevailing practice, if a fund executive provides services in Hong Kong, management fees and carried interest from the limited partnership would be chargeable to salaries and taxed as employment income or profits tax as service income if the distributions are not genuine investment returns. The IRD will apply the general anti-avoidance provisions to counteract any tax benefits obtained and will charge fees derived from the provision of management services in Hong Kong.
The Inland Revenue (Amendment) (Tax Concessions for Carried Interest) Bill 2021
On Jan. 29, 2021, the Inland Revenue (Amendment) (Tax Concessions for Carried Interest) Bill 2021 (TCCI) was published in the Gazette. The Hong Kong Legislative Council passed TCCI into law on April 28, 2021. TCCI provides tax concessions for carried interest distributed by eligible PE funds operating in Hong Kong. Under TCCI, qualifying carried interest recipients are eligible for zero percent profits tax rate on net eligible carried interest after deducting any relevant depreciation and outgoing expenses. Remuneration for related employees paid out of the eligible carried interest received by a qualifying recipient is excluded from the salaries tax calculation at a rate of one hundred percent.
TCCI applies retrospectively to eligible carried interest amounts received or accrued by qualifying recipients on or after April 1, 2020.
The eligibility criteria for the tax concession are outlined below:
The concessionary tax treatments are confined to eligible carried interest arising from profits on investments, on particular investments, or on a disposal of investments that are earned from qualifying transactions in relation to PE funds only. This includes the following:
- Shares, stocks, debentures, loan stocks, funds, bonds, or notes of, or issued by, a private company specified under Schedule 16C to the Inland Revenue Ordinance (IRO).
- Shares or comparable interests of a special purpose entity (SPE) or interposed SPE that only holds and administers one or more investee private companies.
- Shares, stocks, debentures, loan stocks, funds, bonds, or notes of, or issued by an investee private company held by an SPE or an interposed SPE from item 2 above.
- Transactions incidental to the carrying out of the above qualifying transactions, subject to a 5% threshold.
The profits arising from the above in-scope transactions should meet all the relevant tax exemption conditions under the Unified Tax Exemption (UTE) for the Funds Regime in the IRO before the carried interest is eligible for the tax benefits.
Subject to the facts and circumstances, certain hedging transactions forming part of the PE transaction and the relevant profits that are embedded in the profit or loss on the PE transaction for the calculation of eligible carried interest may also qualify.
Qualifying carried interest
TCCI defines “eligible carried interest” as a sum received by, or accrued to, a person by way of a profit-related return1 subject to a hurdle rate which is a preferred rate of return on investments in the fund which is stipulated in the agreement governing the operation of the fund.
Qualifying carried interest payer
Qualifying carried interest payer includes certified investment funds and the Innovation and Technology Venture Fund Corporation (ITVFC). A certified investment fund is a fund that falls within the definition of ‘fund’ under IRO section 20AM and certified by the Hong Kong Monetary Authority. For a non-resident fund, an authorized local representative must also be appointed.
Qualifying carried interest recipient
Qualifying carried interest recipient includes the following persons who provide investment management services (e.g., fundraising, research and advising on potential investments, and acquiring, managing or disposing of property or investments). The carried interest must be paid by a qualifying carried interest payer in Hong Kong or must arrange for the relevant services to be carried out in Hong Kong:
- A corporation or an authorized financial institution licensed/registered under the Securities and Futures Ordinance; and
- A person (including a natural person, corporation, partnership, trustee, whether incorporated or unincorporated, or body of persons), other than (1) above, carrying out investment management services, or arranging such services to be carried out in Hong Kong, for a certified investment fund which is a “qualified investment fund” defined under the UTE regime or ITVFC.
For each year of assessment for the period from the date when the qualifying carried interest recipient begins to perform investment management services to the date when the carried interest is received or accrued, it is subject to the following substantial activities requirements: