Insight,

Hong Kong tax concession for carried interest

HK | EN
Current site :    HK   |   EN
Australia
China
China Hong Kong SAR
Japan
Singapore
United States
Global

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.

Key highlights

  • 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[1]) 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 framework

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.

Anti-avoidance measures

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.

Observations

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.


[1] 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".

LATEST THINKING
Publication
The Hong Kong Monetary Authority (the “HKMA”) has extended its Green and Sustainable Finance Grant Scheme (the “GSF Grant Scheme”) for an additional three years, through 2027. Initially launched in May 2021, the GSF Grant Scheme supports the issuance of eligible green and sustainable bonds and loans in Hong Kong to foster the development of sustainable finance. The details of the extended GSF Grant Scheme were announced on 3 May 2024, with the updated guidelines for grant applications (the “2024 Updated Guidelines”) taking effect on 10 May 2024, the date of the extension. As with the original GSF Grant Scheme, the grants under the extended GSF Grant Scheme continue to consist of two tracks, covering: • General Bond Issuance Costs: This track covers 50% of eligible expenses with the caps maintained at either HK$2.5 million or HK$1.25 million (depending on whether the bond, issuer, or guarantor has a credit rating). • External Review Costs: This track covers the full cost of external review fees with an overall cap maintained at HK$800,000. The eligibility requirements are similar to those under the original GSF Grant Scheme, requiring, among others, the financial instruments to be issued in Hong Kong, the issuance size to be at least HK$1.5 billion for bond issuance cost grants or HK$100 million for external review cost subsidies, and a pre-issuance review by a recognised external reviewer. The key changes in the 2024 Updated Guidelines include: 1 Expansion of the Grant Scope: Transition bonds and loans have been added as eligible financial instruments. 2 Specific Caps for External Review Costs: Sub-caps for pre-issuance and post-issuance external review cost have been set on top of the original total cap. Applications for grants for bonds or loans issued from 10 May 2024 must follow the 2024 Updated Guidelines. The application procedure remains the same as in the original GSF Grant Scheme, where applications for bond issuance costs grants are to be submitted to the HKMA by the lead arrangers or lead lenders while applications for external review costs grants may be submitted by issuers or borrowers directly. Recognised arranger and recognised external reviewer statuses certified by the HKMA before 10 May 2024, will remain valid. Overview of the Hong Kong GSF Grant Scheme For easy reference, the below is an overview of the updated GSF Grant Scheme. For full details on the GSF Grant Scheme, please refer to the 2024 Updated Guidelines. 1. Eligible Instrument Types General Bond Issuance Costs Grant: Green, social, sustainability, sustainability-linked and transition bonds. External Review Costs Grant: Green, social, sustainability, sustainability-linked and transition bonds and loans. 2. Eligible Bond Issuers and Loan Borrowers General Bond Issuance Costs Grant: Eligible for first-time issuers who have not issued any green, social, sustainability, sustainability-linked, or transition bonds in Hong Kong within the five years preceding the eligible issuance, excluding such issuer acting as an arranger for the eligible bond issuance. External Review Costs Grant: Available to both first-time and repeated issuers and borrowers (each entity can apply for subsidy for two eligible loans at most ). 3. Criteria for Eligible Issuances For all applications: • Issued in Hong Kong: For bonds, at least half of the lead arrangers must have recognized arranger status by HKMA, and for loans, at least half of the loan amount must be provided by Hong Kong-based lenders. • Issuance Size: At least HK$1.5 billion for the bond issuance costs grant and HK$100 million for the external review costs grant. Applicable to bonds only: • Must be (i) lodged with and cleared by the Central Moneymarkets Unit (“CMU”) or (ii) listed on The Stock Exchange of Hong Kong Limited (the “HKEX”). • Issued, at issuance, to at least 10 persons, or fewer than 10 persons none of whom is an associate of the issuer. Applicable to green, social responsibility, and sustainability bonds and loans only: • pre-issuance external review related to the issuance demonstrating alignment with internationally-recognised principles, standards or guidance, as provided by a recognised external reviewer. Applicable to transition bonds and loans: • a developed and appropriately disclosed transition plan (or equivalent disclosures on climate transition strategy) at the entity-level . • pre-issuance external review demonstrating the adoption of internationally-recognised transition finance principles, standards or guidance (including the transition plan related elements under such principles, standards or guidance), as provided by a recognised external reviewer; and • for use-of-proceeds instruments, pre-issuance external review demonstrating alignment with an applicable internationally-recognised taxonomy, as provided by a recognised external reviewer. 4. Grant Amounts General Bond Issuance Costs Grant: 50% of eligible expenses (ie. fees to Hong Kong-based arrangers, Hong Kong-based legal advisors, Hong Kong-based auditors and accountants, Hong Kong-based rating agencies, HKEX listing fees and CMU lodging and clearing fees) up to the following caps: • HK$2.5 million where the bond, its issuer or its guarantor(s) possess a credit rating ; or • HK$1.25 million where no credit rating is available. External Review Costs Grant: Transaction-related fees paid to recognised external reviewers for up to a total cap of HK$800,000, further divided into specific caps as follows: • Pre-issuance external review (such as fees paid for certification, second-party opinion, verification, ESG scoring/rating, assurance): up to HK$250,000; and • Post-issuance external review: HK$200,000 per year for the first three years from the date of the eligible issuance or up until the maturity of the issuance, whichever is shorter.

14 May 2024

Publication
Voluntary carbon markets (VCMs) have an important role to play in supporting the transition to a low-carbon economy. Carbon credits are used to offset a corresponding volume of greenhouse gas emissions.

19 April 2024

Insight
China’s National Association of Financial Market Institutional Investors (“NAFMII”) recently published its much-anticipated Swap Connect Cleared Derivatives Agreement (“SCCDA”) , which is designed to further facilitate Northbound Trading under Swap Connect. Pursuant to the SCCDA, an onshore Swap Connect participant and an offshore Swap Connect participant agree to take reasonable steps to enable a Northbound Swap Connect derivatives transaction (“Swap Connect Transaction”) to be centrally cleared. Significantly, the SCCDA documents the parties’ election of “cancellation” as the mutually agreed method under applicable Swap Connect rules for dealing with a transaction that is rejected for central clearing. The SCCDA expressly provides that under the cancellation method, a transaction that is rejected for clearing is void ab initio and no amount is payable by either party in respect of a rejected transaction. The SCCDA also contains an Annex that provides the parties with the flexibility to select the SCCDA’s governing law, dispute resolution mechanism and how it interacts with any existing master derivatives agreement between the parties. This article provides a high-level overview of key provisions of the SCCDA and their significance in the context of Swap Connect.

16 April 2024