Carried interest: Safe in Hong Kong?

In Hong Kong, absolute certainty that carried interest will escape local taxation comes at a price – and for global private equity firms especially, it might not be worth paying.

The territory has embarked on a policy blitz in recent years to woo managers as part of efforts to solidify its position as Asia’s preeminent asset management hub. A fund-level profits tax exemption was introduced so that private equity firms can carry out meaningful activities locally without becoming liable for tax, while an updated limited partnership ordinance gives managers the option of domiciling funds in Hong Kong.

A 0% levy on carried interest was the third arrow in the quiver, and a key weapon in the battle against fast-rising private equity insurgent Singapore. In many respects, Hong Kong is playing catch-up with its neighbor. Carried interest was different. While Singapore doesn’t impose a tax on the share of profits managers receive from funds, neither does it offer definitive clarity on the issue.

But initial satisfaction with the new legislation when it became law earlier this year was followed by a sinking feeling – all-too-familiar to many industry participants – when draft guidelines were introduced outlining how managers could qualify for the concession. They are far enough from what was expected to make some advisors declare the system unworkable.

“I’m hoping this isn’t another great idea that is poorly implemented,” says Darren Bowdern, a partner in the Hong Kong tax practice at KPMG. “With the application process as it stands and the level of detail required, based on discussions I’ve had with my clients, no one would be willing to apply for the concession. It needs to be a lot more light-touch.”

Nothing has been finalized. The draft guidelines were circulated as part of a soft consultation and sources on the regulatory side say they have heard the industry’s feedback and plan on making changes – soon. Private equity investors are not only waiting to see how much ground the government is willing to give. They are also concerned about the role the inland revenue department (IRD), known for its aggressive approach to the asset class, will play in vetting applicants.

Sense of déjà vu

If all this seems disturbingly familiar, then it should. Five years ago, IRD published practice notes relating to the profits tax exemption. Advisors said the guidelines were so limiting, managers wouldn’t bother bringing operations onshore to take advantage of the regime; Hong Kong would remain a sub-advisor location with key decisions taken offshore.

In the same notes, IRD announced it would turn years of assumed practice on its head and tax carried interest as income rather than capital gain, or 16.5% rather than 0%. No other private equity center globally had taken such an emphatic stance. It triggered fierce lobbying, and ultimately, the concession that has created the current implementation furor.

While the tax exemption issue was resolved with the introduction of a unified regime that treats onshore and offshore funds equally, it could hardly be described as a private equity triumph. Rather, the discrepancy was identified by the EU under the BEPS initiative designed to root out misuse of low-tax jurisdictions. Hong Kong changed its stance to avoid getting blacklisted as non-compliant. The situation should not be interpreted as IRD softening its line, several industry participants say.

“IRD at a functionary level has a bad track record in terms of making stuff up rather than doing what it is supposed to do in line with policies set by the government,” according to one. Others are more charitable, highlighting the inherent conflict jurisdictions face while trying simultaneously to minimize leakage and promote market development.

Vetting applicants for a tax concession represents a departure from the norm for Hong Kong. Self-assessment is the typical approach, including for the unified fund-level profits tax exemption. Taxpayers simply submit supplementary documentation alongside their annual filings. There is always the possibility of an audit, at which point more detail would be required.

“Self-assessment under the unified fund exemption regime was well received because it’s convenient. IRD can ask questions – it can ask the fund to justify why it qualifies for the exemption – but there is no requirement under law for them to apply for verification,” says Rex Ho, Asia Pacific financial services tax leader at PwC. “They are taking a more stringent approach on carried interest.”

Apparently, getting IRD sign-off necessitated having a gatekeeper to check that applications are valid, and the Hong Kong Monetary Authority (HKMA) agreed to step up. Qualification is contingent on investments meeting specific criteria – for the time being, credit funds and fund-of-funds are excluded – and the manager having sufficient local economic substance. This means employing at least two people in Hong Kong and spending no less than HK$2 million ($258,000).

Pain points

Industry concerns with the validation system are twofold. First, applications must include a significant amount of information. While it was thought that a copy of a fund private placement memorandum (PPM) might suffice, the draft guidelines ask for: the name of each company the fund has invested in; the business registration numbers of the special purpose vehicles (SPVs) involved; and the dates of acquisition and disposal.

“A lot of this information may not even be shared with investors in the funds,” says Anthony Lau, a partner at Deloitte. “It is difficult for fund managers to disclose so much confidential information while also adhering to the confidentiality agreements they have in place as fiduciaries.”

In the absence of similar gatekeeper systems in other jurisdictions, Hong Kong studied the disclosure requirements for Singapore’s preferential tax regimes, according to the regulatory source. While local substance is a must, the amount of information requested on funds is far lower than that proposed by Hong Kong. That said, Singapore’s position on carried interest amounts to don’t ask, don’t tell.

From an internal administrative perspective, smaller private equity firms should be able to accommodate the proposed system. It involves Hong Kong entities applying on behalf of local employees and submitting details of relevant funds to which these individuals have exposure. For a manager with few offices, simple fund structures, and a relatively high headcount concentration in Hong Kong, the concession could be desirable and achievable.

Global private managers are another matter entirely. A senior executive in Hong Kong may have interests in dozens of funds under a global carried interest pool arrangement. Adopting a highly unorthodox disclosure regime for the sake of a relatively small percentage of a global workforce is hardly an attractive prospect.

“It could be difficult for global firms if the process is not simplified,” says Bonnie Lo, a partner at NewQuest Capital Partners and chair of the Hong Kong Venture Capital & Private Equity Association’s (HKVCA) technical committee. “There might be two senior people in Hong Kong who qualify for the concession and have exposure to lots of global funds that have nothing to do with Hong Kong. How can you expect the firms to go through this vetting process and disclose all that information?”

The industry’s second concern involves IRD. Investors and advisors were encouraged by HKMA’s appointment as gatekeeper specifically because of a longstanding discomfort with the tax authority’s approach to private equity. Yet the guidelines link the carried interest concession to the unified fund exemption regime – they refer to the same qualifying conditions – and state that IRD will perform a separate assessment to HKMA.

The overriding fear is what IRD might do with the information and whether it could lead to managers facing additional scrutiny. “The application frontloads a lot of disclosure, essentially assuming there will be carried interest. A lot of managers are unwilling to open the kimono and have the IRD know everything about their business when they could end the year with no carried interest,” says Kher Sheng Lee, co-head of Asia Pacific at the Alternative Investment Management Association (AIMA).

Suggested solutions

The situation is not detrimental to Hong Kong’s prospects as an asset management center in the near term. Rather, Lee describes the draft guidelines as inconsistent with the stated goals of the primary legislation and warns that they could undermine the appeal of the entire tax concessions scheme.

Moreover, there are various potential fixes. Simplifying the validation process by asking for fewer details is one. It is suggested that the government’s desire for the ability to target non-qualifying investments could be satisfied by pushing the information gathering burden on to the auditor, which performs much of this function already.

“It is possible to have a simplified form and then HKMA could rely on the auditor’s report. This is different to providing details directly because auditors are not part of the government. They would provide a summary of what they have reviewed, including whether investments meet the conditions for exemption. Audit reports do not offer details on every investment,” says Lau of Deloitte.

However, he observes that these process changes would not address a bigger concern expressed by his global clients: whether their deals qualify for exemption at all. If a GP operates through a series of local advisory entities, and investment decisions are made through a fund management entity located offshore, profits arising from deals involving the Hong Kong advisor would not need to rely on the unified tax exemption regime and so wouldn’t be eligible for the carried interest concession.

Clarification can help address concerns in other areas. For example, carried interest typically flows from the fund to another offshore holding vehicle and from there to the individuals. The guidance stipulates that carry paid under the exemption must be routed through Hong Kong. This could have implications for the Hong Kong entity’s financial performance.

“They are saying that it must be recognized on the P&L of the Hong Kong entity. There is an ongoing discussion about how and whether carry could be recognized on the profits tax return outside of having to make it income of the qualifying entity,” explains James Ford, a partner at Allen & Overy. “Could there be a separate schedule for carried interest received by entity employees?”

Excluding IRD from verification would be more challenging. The concession is open to certified investment funds as defined in the Inland Revenue Ordinance, which means IRD is ultimately responsible for implementation. A potential compromise solution would be to shift the point at which the tax authority gets involved to later in the process, certainly after the pre-determination phase. However, industry participants are uneasy about predicting the likely outcome.

Political twists

Larger fund managers, who would be most impacted by the guidelines, are waiting to see what happens next. Should they not take advantage of the concession, business may continue as normal – with the existing lack of certainty on tax treatment. PwC’s Ho admits there is some concern that IRD might intensify its scrutiny of GPs operating in Hong Kong without the cover of the concession.

The situation is complicated by the philosophical and political issues woven into its core. Private equity investors insist that carried interest is a capital gain. Granting carry points is compared to granting share options: the initial value is minimal and there is no guarantee of a payout, but any future appreciation is regarded as a personal investment return and doesn’t get taxed.

There are exceptions, notably when junior team members receive carried interest from an unallocated pool, not because they contributed to the GP commitment to the fund. Some private equity firms already report distributions from unallocated pools in returns filed with IRD on the basis that it is a discretionary bonus controlled by the manager.

“If it’s paid as a bonus, then it’s taxable,” says KPMG’s Bowdern. “However, senior deal guys often get carried interest by way of an equity instrument that goes into the fund and then up to a holding vehicle, and distributions are made from that. We don’t tax dividend distributions, we don’t tax partnership distributions, and we don’t tax capital gains.”

IRD reached its contrarian perspective after launching a wave of audits of Hong Kong-based alternative asset managers eight years ago, ostensibly looking for potential transfer pricing violations. Several private equity firms handed over summaries of all carry distributions paid out of their funds. Using hedge funds as a reference point, where performance fees are generally taxed as income, IRD concluded that carried interest constituted a disguised management fee.

Since announcing that it would consider these distributions as a fee for service, the tax authority has challenged numerous managers on the topic. It estimates how much carried interest has been paid out, attributes a portion of this to the Hong Kong team based on size and seniority, and tries to reconcile the total with what is on the local profits tax return. IRD then uses a transfer pricing argument to ask the manager to make up some of the difference, a Hong Kong lawyer explains.

Meanwhile, from a political perspective, the philosophical principles and structural nuances around carried interest tax treatment might carry little weight. Those politicians announced a 30% increase in stamp duty on Hong Kong stock market transactions earlier this year, to take effect from August. Absent a compelling narrative, this could complicate efforts to give PE a tax break.

As one investor puts it, “How do you justify to the man in the street why a Goldman Sachs banker is paying tax on his bonus, but the private equity guy isn’t paying any tax at all on what might appear to be his bonus or remuneration?”

Competitive edge?

Assorted industry participants did not want or expect Hong Kong to offer a 0% concession. AIMA was one of them. “We were happy paying half the topline corporate rate in Hong Kong, about 7.5%. Rather than make it zero for some, it’s better to have some tax and make the policy more inclusive. That would jumpstart Hong Kong’s asset management industry,” says Lee.

A 7.5% rate would still have been lower than in Europe and the US, where the Biden administration has proposed treating carried interest as income instead of capital gain, which would more than double the current 20% levy. This gets short shrift from one pan-regional manager, who asserts it is not a choice between 7.5% or 15% in Hong Kong and 20% in the US, but between Hong Kong and 0% in Singapore. Is that enough to make dealmakers move? “Absolutely,” he says.

However, the same manager also spent five minutes explaining why he thought Hong Kong would do all it could to encourage private equity to stay put, including resolving the carried interest issue.

Tax is one of many reasons why GPs are drawn to the territory, alongside proximity to market, the availability of talent, and the strength of supporting infrastructure. And despite the fraught nature of policymaking, the certainty proposition could yet become a competitive edge. Lee notes that Japan and Singapore are reviewing their positions on carried interest in response to Hong Kong’s stance.

As is fast becoming a mantra for those contributing to the debate on the PE side, it is all about implementation. “The concession is a creative and unique offering – nowhere else has anything similar,” says NewQuest’s Lo. “If it works, it could be attractive for people looking to use Hong Kong as a base.”

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• Topics
• Greater China
• GPs
• Regulation
• Hong Kong (China)
• tax
• HKVCA
• Alternative Investment Management Association (AIMA)
• KPMG
• Deloitte
• PwC