Hong Kong regulation: Carry on

Of the Hong Kong Monetary Authority’s (HKMA) four core functions, three are well-known and reasonably clear-cut: maintaining currency stability, promoting financial system integrity, and managing the Exchange Fund, which is in part a tool used to fulfill functions one and two. HKMA also has the somewhat woolier remit to support Hong Kong’s status as an international financial center.

This last function is the reason why HKMA has played a proactive role in the territory’s three-pillar approach to creating a more conducive environment for private equity. This comprises: a fund-level tax exemption that makes it easier for investors to operate Hong Kong without triggering permanent establishment; an updated limited partnership legislation, so managers can domicile funds locally; and a competitive carried interest tax regime.

The third of these came into focus last week as the Hong Kong government proposed a 0% on eligible carried interest at the corporate level. It also plans to fully exclude carried interest from employment income for salaries tax calculations.

Should the proposals become law – which is expected to happen this year – it will resolve a ruckus that started in 2016 when the Inland Revenue Department (IRD) announced that carry would be treated as income rather than capital gain and taxed accordingly. Previously, Hong Kong fell in line with international norms. Carry was deemed a capital gain and the territory has no capital gains tax.

It remains to be seen how all this plays out. Industry participants welcomed the development, while cautioning that full judgment should be reserved until the full legislation is released.

Moreover, Singapore’s response is worth watching. While the country treats carry as capital gain, which means zero tax, it is officially silent on the issue. Clarity, however, is a selling point in the battle between the two jurisdictions to become Asia’s preeminent private equity hub. As one fund formation lawyer put it recently: “If Hong Kong provided certainty on carried interest in conjunction with the new limited partnership law that in my view could be the killer app.”

The qualification criteria outlined in the proposal are much as expected. Accessing the tax concession is contingent on having sufficient local economic substance, including at least two investment professionals and no less than HK$2 million ($258,000) in annual local expenditure. Various recommendations were taken on board in terms of and broadening the scope of strategies classified as private equity as well as the types of transactions that PE investors participate in.

Arguably the most interesting aspect is the responsibilities that will be thrust on HKMA. Funds must apply to the regulator for certification and it will decide whether investments and local substance requirements are likely to be met. HKMA 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.

HKMA’s involvement will likely be welcomed by the private equity industry. After all, the carried interest debate stems from what some would describe as a fundamental misunderstanding on the part of the IRD. This arose during audits of Hong Kong-based alternative asset managers that targeted transfer pricing violations over management fees. The hedge fund model – which features performance fees that are taxed as income – was applied to private equity. Confusion reigned.

The redesignation of carry as capital gain emerged as part of practice notes relating to the fund-level tax exemption. These notes made the exemption unworkable for many private equity investors; the surprise move on carry only added to industry frustrations.

The IRD’s stance on certain issues is not mendacious, rather it illustrates an agency that – perhaps through no fault of its own – sees the world through the prism of local politics. Preserving Hong Kong’s status as a private equity hub often appears to be a secondary consideration. Industry participants will be hoping that HKMA can contribute balance and perspective to interpretative decisions that might deny them access to carried interest tax concessions.

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• Topics
• Greater China
• Regulation
• Hong Kong (China)
• tax
• Hong Kong Monetary Authority (HKMA)