Hong Kong proposes 0% carried interest tax rate

Historically, carried interest has been deemed a capital gain in Hong Kong, so there is no tax at all. However, in 2016, the Inland Revenue Department (IRD) turned this assumption on its head, stating that carried interest received by the investment manager outside of Hong Kong could be targeted under anti-avoidance provisions and taxed as income onshore, at the corporate or individual level.

A paper issued by the Legislative Council this week states that the tax rate for eligible carried interest – which would otherwise be subject to the standard corporate rate of 16.5% – will be zero. Moreover, carried interest will be fully excluded from employment income for salaries tax calculations. Hong Kong’s salaries tax rate is 15-17%. A bill introducing the legislation will be released in late January or early February. The measures will take retrospective effect from April 2020.

Industry participants welcomed the development while cautioning that it will be important to review the detailed rules to determine how they apply to existing carried interest plans. For example, Adam Williams, Greater China PE tax leader at EY, highlighted the need to examine “how the carried interest may flow through the various entities before being received by the final carry recipients.”

In her November policy address, Hong Kong Chief Executive Carrie Lam reaffirmed the territory’s commitment to providing certainty on the tax treatment as part of efforts to consolidate its position as a private equity hub. Three months earlier, the Financial Services & The Treasury Bureau released a consultation paper detailing the qualification criteria. Much of this has been carried forward into the proposed legislation.

Qualification for the tax concession is contingent on having sufficient local economic substance, including at least two investment professionals – or one investment professional and one back office executive – and no less than HK$2 million ($258,000) in annual local expenditure. Funds do not have to be domiciled in Hong Kong, though they must meet certain requirements in terms of size and structure, and local representatives may need to be licensed by the Securities & Futures Commission (SFC).

Hong Kong Monetary Authority (HKMA) will be responsible for validating funds. It will also advise the IRD on situations where there is uncertainty as to whether activities constitute investment management services, payments should be considered as carried interest, or a fund is properly certified.

The Hong Kong Venture Capital and Private Equity Association (HKVCA) responded to the consultation paper with various recommendations. Some of these have been incorporated into the proposal. Changes include a reduction in the minimum spend – the original figure of HK$3 million was thought too high for certain angel and VC funds – and a broadening in the scope of strategies classified as private equity as well as the types of transactions that PE investors participate in.

There is no clarification as to whether concessions would be available to funds that do not take advantage of Hong Kong’s profits tax exemption and to parallel structures used for co-investment. Moreover, while there is no reference to specific numbers in terms of fee and hurdle rates, they remain in the qualification criteria. Fangda Partners questioned in a briefing note whether venture capital funds without hurdle rates would be eligible for concessions.

Providing greater transparency on carried interest tax treatment is the last of several initiatives undertaken by Hong Kong to attract private equity managers. The fund-level tax exemption makes it easier for PE firms to carry out meaningful activities locally without triggering permanent establishment from a taxation perspective. Meanwhile, updated limited partnership legislation was passed into law last year, giving managers the option of domiciling their funds in the territory.

The ultimate objective is to encourage private equity firms to bring every part of the management and investment process – the fund, the fund management entity, the various vehicles used to make downstream investments – onshore. This is seen as being in line with the Organization for Economic Cooperation & Development’s (OECD) ongoing crackdown on investors using jurisdictions purely for the pursuit of favorable tax treatment.

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• Topics
• Greater China
• Regulation
• Hong Kong (China)
• tax