This article was written by Justin Cherrington and Guo Sun Lee.
After months of anticipation, the long-awaited consultation paper for the tax concession on returns from a carried interest, first mentioned in February 2020, has been released.
A working group led by the Financial Services and the Treasury Bureau (“FSTB”) alongside members from the Hong Kong Monetary Authority (“HKMA”), the Securities and Futures Commission (“SFC”) and the Hong Kong Inland Revenue Department (“IRD”) was formed to prepare the proposal. Submissions in respect of the consultation paper are due by 4 September 2020.
- The tax concession will only be available to a carried interest in a fund that has Private Equity (“PE”) investment strategies.
- The concessional tax rate is not set out in the paper - the only guidance is that the concessionary tax rate will be globally competitive.
- The concession will apply to both entities (“Profits Tax”) and individuals (“Salaries Tax”) where the return is derived from the provision of investment management services.
- The tax concession will only be available:
- if the carried interest is in a fund (as defined in the Unified Tax Exemption) that has been “validated” by the HKMA; and
- the recipients of the return on the carried interest must have substantial activities in Hong Kong.
- It is anticipated that the legislation to implement the tax concession will be introduced soon, but irrespective of the date it becomes law it will have retrospective application from 1 April 2020.
The consultation paper has used the Unified Fund Exemption implemented from 1 April 2019 to set the framework for the tax concession on the carried interest.
Following this framework - the fund must be a “fund” for the purposes of section 20AM of the Inland Revenue Ordinance and it must be validated by the HKMA.
The recipient of the carried interest must be either: (i) a licensed corporation; (ii) an authorised financial institution; or (iii) the entity providing the investment management services to a qualified investment fund. In the case of a qualified investment fund the carried interest return is limited to no more than 30% of the net proceeds of the fund otherwise it may no longer be a “fund” under the Unified Fund Exemption.
The tax concession for a carried interest also looks through to the employees. That is, where an entity that is recipient of the carried interest return pays part of the return to its employees that payment will be concessionally taxed.
Validating the fund
To qualify for the tax concession the fund must be validated by the HKMA.
A fund will be validated by the HKMA when it makes an application to the HKMA and satisfies the relevant requirements. These requirements are that:
- The HKMA must be satisfied that the fund is focussed on PE investment strategies and likely to fulfil substantiation requirements; and
- In a year of assessment:
- there are an adequate number of qualified employees (a minimum of 2 investment professional or 1 investment professional and 1 related professional in legal, compliance or finance); and
- the funds expenditure in Hong Kong is not less than HKD $3 million.
When an application to validate the fund is made, it will need to include formation documents, structure chart, information on the PE investment strategy and either historical expenditure or the budget of the fund expenditures demonstrating that it will satisfy the local substantiation requirements.
The HKMA will issue a letter of no objection if it is satisfied that the fund will satisfy the requirements.
Finally, when a carried interest distribution of the fund is made it will be necessary to engage an external auditor to ensure that the relevant requirements of the fund have been met in that year. The external auditor’s certification should be kept at the funds office to provide to the HKMA or the IRD on an inspection.
What is a carried interest that attracts a tax concession?
A carried interest refers to the fund manager’s share of the profits of the fund. The profits are usually calculated after the principal amount and a small interest (in percentage terms) on such principal amount (such interest is also commonly known as “preferred return” or “hurdle rate”) is returned to the investor. In private equity spheres such carried interest is usually 20% of the profits. The main point of carried interest is to align the interest of the fund manager with that of the investor(s).
In order for an interest to be a carried interest it must be:
- A sum which is received or accrued to the relevant entity by way of a profit related return; and
- Derived from the provision of investment management services.
A profit related return has three conditions:
- The return can only arise if the fund is making profits;
- The quantum of the return varies by reference to the profits of the fund; and
- The return to the external investors is determined by reference to the profits that determine the return on the carried interest.
The consultation paper also proposes extending the definition of a carried interest, by providing an alternate test to the three conditions, to profits arising out of qualifying transactions provided that the return is paid after all of the external investors have been a paid a preferred return at an annual rate of 6% of compounded interest.
Investment management services will include:
- Seeking funds for the fund;
- Researching potential investments for the fund;
- Acquiring, managing or disposing of fund property; and
- Acting on behalf of the fund in assisting an entity into which the fund has made an investment.
Determining the amount of the return on the carried interest
The tax concession will be applied to the net return. Accordingly, the return on the carried interest will be reduced by any relevant deduction (expenses and depreciation).
Also, any loss will not be able to set off against assessable profits in any current or future year.
The consultation paper also touches on the possibility of the Commissioner of Inland Revenue denying the tax concession on a return of a carried interest he forms that view it was to obtain a tax benefit. The paper provides an example of a potential “tax benefit’ arising where the return on the carried interest reflects other services, that are not investment management services.
King & Wood Mallesons intends to make a submission in respect of the consultation paper. Whilst we are still considering the issues, a few of the more immediate matters that may be of a submission are:
- Will the tax concession be available to funds that would have investment strategies akin to a PE fund, but a mandate that is limited a certain class of assets?
- Why isn’t the tax concession being made more broadly available to the wider funds industry if they can satisfy the requirements?
- Will the tax concession on a return to a licensed entity be limited to 30% so that it is consistent with the qualified Investment fund restriction?
- The substantiation requirements seem to be limited to the year of assessment, however, in order to be consistent with the BEPS substantiation requirement we expect that it will require an examination of the substantiation obligation over the period of the investment in the qualified transaction that have given rise to the carried interest return. An examination of the entire period would appear to be consistent with the proposed extended definition of a carried interest.
- What is the rationale for the alternate definition of "what is a carried interest have they picked a rate of 6% compounded"? Is it based off the explanation on paragraph 3(b) that hurdle rate is usually an IRR of 7% to 8%? Should the final legislation provide that as part of the validation process, the HKMA can have flexibility around the appropriate rate of return, having regard to the type of fund and expected returns?
Where to from here
Potential recipients of this tax concession should consider whether that requirements, both in terms of the carried interest contemplated (or in place given that it will be retrospective in its application) and the practical realties of the relevant funds being able to satisfy the substantiation requirements.
If you have any further queries or would like assistance in such a submission, please contact us.
IRD practice note DIPN61: https://www.ird.gov.hk/eng/pdf/dipn61.pdf
Any reference to “Hong Kong” or “Hong Kong SAR” shall be construed as a reference to “Hong Kong Special Administrative Region of the People’s Republic of China”.