Hong Kong’s latest proposal for 0% carried interest tax on Private Equity Funds.
Carried Interest Taxable at Zero in Hong Kong – Bill Gazetted on 29 January 2021
This month for our Guest Blog spot, we spoke to Lorna Chen, Partner at Shearman & Sterling, to demystify the qualifying circumstances for zero tax on carried interest in Hong Kong.
Here’s what Lorna said:
The Hong Kong government has been working hard to welcome private equity firms to Asia through an attractive set of incentives to set up shop in Hong Kong; for those already in Hong Kong, the government has been working hard to sharpen the existing legal, tax and regulatory frameworks to support seamless local operations.
These efforts from the Hong Kong government are evidenced by the January 2021 legislative proposal for carried interest to be taxed locally in Hong Kong at the rate of zero. Prior to this proposal, local tax authorities had viewed carried interest as a form of employment income, rather than capital gain, and thus deemed it taxable at a standard corporate rate of 16.5%. Historically, in order to avoid this higher tax, fund managers would incorporate the carry recipient in, and thereby receive carry from, a tax haven jurisdiction (e.g., the Cayman Islands or the British Virgin Islands). However, this approach had been subject to an ongoing risk of challenge from the Hong Kong tax authorities based upon a ‘facts and circumstances’ analysis.
Once the recently introduced proposal is adopted, it will retroactively be put into effect from April 2020. Going forward, we expect that this will greatly simplify fund operations by removing the need for a Hong Kong fund manager to split its Asia business across multiple jurisdictions.
To qualify for relief under this proposal, each of the tests summarised below must be met:
The scope of persons qualifying for relief includes SFC licensed corporations and their investment professionals. Relatedly, there must be substantial economic activities in Hong Kong i.e., at least two full-time employees carrying out investment services and at least HK$2 million (US$258,000) per year in operating expenditures.
The relevant carried interest must be paid by a fund and derived from the provision of investment services to such fund, such as fundraising, due diligence, deal execution, and/or investment banking. To qualify, the relevant fund may be domiciled in any legal jurisdiction and take any legal form (e.g. a Hong Kong limited partnership), so long as such fund is a collective investment scheme (meaning that single-family offices and other ‘funds-of-one’ would likely not qualify).
The amount of carried interest payments must be linked to the amount of investment profit earned over an agreed hurdle (and thus, management fees that are charged based on an amount of capital under management, irrespective of profit, would not qualify). Qualifying profit must relate to “private equity” transactions, including venture capital. If the holding and exit structure are not properly tailored, then the sale of direct real estate holdings and the divestment of interests held in other investment funds might not be qualifying profit.
The proposal sets out a procedure for being pre-certified by the Hong Kong Monetary Authority (HKMA), during which the fund manager applicant would submit copies of legal documents and provide descriptions of firm operations. Those seeking to qualify would be well-advised to consult with legal counsel and examine the existing arrangements at the manager, fund, and asset levels to see that, when interfacing with the HKMA, a solid case is presented that these qualification tests are met.
About the author:
Lorna Chen, Asia Regional Managing Partner and Head of Greater China, Shearman & Sterling
Apart from serving as regional leader, Lorna Chen is also a member of the firm’s Executive Group. Lorna founded and leads our asset management and investment funds practice in Asia. She has 20 years’ experience in the investment funds and private equity field, advising clients in the structuring, restructuring, formation and operation of alternative investment products, including private equity funds, venture capital funds, hedge funds, real estate funds, funds of funds, project funds and co-investment structures. Her recent publications include the chapters on Hong Kong investment funds in the Chambers Global Practice Guide and The Private Equity Review.
Anil Motwani, Associate, Shearman & Sterling
Anil Motwani is an associate who represents fund sponsors in all major asset classes and is regularly involved in the design and development of alternative investment products and services, and the structuring and restructuring of private equity funds. He also advises private equity fund sponsors and investors on ongoing operational matters. Anil has extensive experience representing limited partners and general partners in their fund transactions. He is a co-author of chapters on Hong Kong investment funds in the Chambers Global Practice Guide and The Private Equity Review.
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