Hong Kong has taken another significant step to consolidate its position as the leading private equity investment hub in Asia, by the enactment of the Inland Revenue (Amendment) (Tax Concessions for Carried Interest) Ordinance 2021 on 7 May 2021.
The move follows the establishment of Hong Kong’s new limited partnership fund regime last August and other significant tax and regulatory changes over the last few years.
The new Ordinance exempts "carried interest", which are payments made often in shares or other equity-linked compensation, to the general partners of eligible private equity (PE) funds based in Hong Kong, from taxation, effectively making such payments tax neutral.
Whilst there are some "substantial activities" requirements, in that certain activities need to be carried out in Hong Kong with a minimum headcount and operating expenditure, the news will be welcomed by family offices, hedge funds, and other wealth managers looking to make Hong Kong their premier investment hub.
Main conditions
The special tax treatment will mean that 100 percent of carried interest will be excluded from employment income for tax purposes and profits tax will be levied at zero percent.
The carried interest must be:
- A profit-related return, which only arises if the underlying investments are profitable and which varies depending on the profits generated.
- Subject to a hurdle rate, defined as a preferred rate of return on investments that is specified in the agreement governing the operation of the fund or entity. Some funds may not have this explicitly set out in existing documentation, and this may need to be reviewed in light of the changes.
Investment management services which qualify for the concession include:
- Seeking funds for the fund or entity from external investors or potential external investors.
- Researching and advising on potential investments to be made for the fund or entity.
- Acquiring, managing, or disposing of property or investments for the fund or entity.
- Acting for the fund or entity with a view to assisting an entity in which the fund or entity has made an investment to raise funds.
Such services must meet the "substantial activities" test for each year of assessment, meaning there must be two more full-time employees in Hong Kong carrying out the services and a minimum HK$2 million in total operating expenditure. The commissioner of Inland Revenue must also be satisfied that the expenditure and proposed staffing is adequate for the fund.
The carried interest must also have arisen from profits on investments or on disposal of investments that are earned from a transaction in shares, stocks, debentures, loan stocks, funds, bonds, or notes issued by a private company; or in shares in a special purpose entity that holds and administers one or more investee private companies. Gains on investments in public companies will not qualify.
The sums must be paid by an investment fund certified by the Hong Kong Monetary Authority (HKMA) within the meaning of section 20AM of the Inland Revenue Ordinance or by The Innovation and Technology Venture Fund Corporation, a HK$2 billion fund established in 2017 with the aim of attracting venture capital (VC) funds to co-invest in local innovation and technology start-ups in Hong Kong.
The carried interest must be paid by or accrued to a qualified recipient, including licensed corporations or authorized financial institutions under the Securities and Futures Ordinance (SFO), or to the employees of such entities.
Employees may qualify for the concession if their employer is a qualifying fund manager and any carried interest entitlement paid to them must be carved out of that paid to the manager. Only that portion of the employee’s income that is considered to be qualifying carried interest will be exempted from salaries tax.
Records must be kept for a minimum of seven years from the date of payment or the accrual of the eligible carried interest, whichever is later. Whilst the requirement accords with the record keeping requirements under the Inland Revenue Ordinance and the Limited Partnership Fund Ordinance, this may not always be the case with funds incorporated outside of Hong Kong.
The Ordinance contains specific anti-avoidance provisions which disapply the where one of the main purposes of entering into the arrangement is seen to be the obtaining of a tax benefit in relation to a profits or salaries tax liability.
The measures apply retrospectively to eligible carried interest received by or accrued to qualifying carried interest recipients on or after 1 April 2020 (from assessment year 2020/21 onwards).
Hong Kong – Asia’s family office hub
According to a survey quoted by a senior executive director of the HKMA in September 2020, there are more than 80,000 ultra-high net worth families in Greater China, a 20 percent increase over the previous three years. 1
At the end of 2019, the amount of assets managed in Hong Kong reached US$3.7 trillion, a 20 percent year-on-year increase and a record high. Hong Kong remains the largest cross-border private wealth management hub in Asia and the second largest in the world, next only to Switzerland.
Hong Kong is also the largest private equity centre outside the mainland, with more than US$160 billion in capital under management. Hong Kong has also done much to foster sustainable banking initiatives, with its own multi-year Government Green Bond Programme.
The concessions on carried interest should be viewed as part of a multi-year strategy to make Hong Kong’s tax and regulatory regime even more competitive and attractive to private investors. This includes the open-ended fund company regime (OFC) introduced in July 2018, together with more recent measures such as:
- The enactment of the Inland Revenue (Profits Tax Exemption for Funds) (Amendment) Ordinance in March 2019, which created a Unified Fund Exemption (UFE) regime which meant it was no longer necessary for the management and control of a hedge to be located outside Hong Kong in order for it to benefit from Hong Kong profits tax exemption.
- The launch of a cross-boundary wealth management connect pilot scheme in June 2020 throughout the Greater Bay Area, linking Guangdong-Hong Kong-Macao Greater Bay Area, helping to meet the asset management needs of residents across boundaries.
- The introduction of the Limited Partnership Fund Ordinance (Cap. 637) in August 2020 which heralded a new era for private funds in Hong Kong, enabling funds to be registered in the form of limited partnerships in Hong Kong (see our alert, Hong Kong’s new limited partnership fund regime comes into operation today).
- Revisions made in September 2020 to the Code on Open-Ended Fund Companies, reducing investment restrictions and allowing hedge funds to invest in all asset classes, subject to constraints in the offering document.
Hong Kong’s InvestHK, a government department for foreign direct investment, has established a dedicated team to offer support to family offices interested in establishing a presence in Hong Kong.
Taken together, these changes should further strengthen Hong Kong’s position as the premier family office hub in the region and beyond.
Authored by Byron Phillips and Nigel Sharman.
