What is an “eligible carried interest” referred to in paragraph 1 above?

An “eligible carried interest” is a sum received by, or accrued to, a person by way of “profit-related return” from the provision of “investment management services” by the person for a “certified investment fund” or the Innovation Venture Fund Corporation⁴.

“Profit-related return” means:

(a) the payment of “eligible carried interest” is subject to a hurdle rate⁵;

(b) the “eligible carried interest” must arise only if there are profits (whether for a period in investments, on particular investments, or arising from a disposal of investment of a fund);

(c) the amount of “eligible carried interest” paid would vary by reference to profits, i.e. there is a significant risk that at least a certain amount would not be paid (other than by reason of insolvency or otherwise) having considered all the arrangements as a whole; and

(d) the returns to external investors are also determined by reference to the same profits.

Accordingly, management fees or disguised carried interest which by their nature are virtually certain to arise in respect of a fund and which are not payable to external investors would not qualify as an “eligible carried interest”.

“Investment management services”, in relation to a “certified investment fund” (see below) or The Innovation and Technology Venture Fund Corporation, include:

(i) seeking funds from external investors and potential external investors,

(ii) researching and advising on potential investments to be made;

(iii) acquiring, managing or disposing of property and investments; and

(iv) assisting an entity in which the fund has invested to raise funds.

The investment management services must be (A) either carried out in Hong Kong by the person, or arranged by the person to be carried out in Hong Kong, and (B) not carried out outside Hong Kong by a permanent establishment⁶.

What are “qualifying transactions” referred to in paragraph 2 above?

The “eligible carried interest” must arise from “qualifying transactions”, which means transactions:

(a) in shares, stocks, debentures, loan stocks, funds, bonds or notes of, or issued by, a Hong Kong or foreign private company;

(b) in shares or comparable interests of a special purpose entity or interposed special purpose entity which is holding and administering one or more investee private companies and not any other specified asset class that is set out in Schedule 16C of the IRO which mainly relates to non-private equity investments;

(c) in shares, stocks, debentures, loan stocks, funds, bonds or notes of, or issued by, an investee private company held by a special purpose entity or interposed special purpose entity; or

(d) incidental to the carrying out of the foregoing transactions listed in items (a) – (c) above,

provided that profits arising from these transactions must also be exempt from profits tax under the unified fund exemption regime as set out under section 20AN or 20AO of the IRO (Unified Tax Exemption for Profits Tax)⁷, a key requirement⁸ of which is either⁹:

(i) the qualifying transactions of the fund and certain special purpose entities must be (A) carried out in Hong Kong by or through a corporation licenced under the Securities and Futures Ordinance (Chapter 571 of the laws of Hong Kong) (SFO) to carry on a regulated activity, or an authorised financial institution registered under the SFO for carrying on such regulated activity, or (B) arranged in Hong Kong by such licensed or regulated person; or

(ii) the fund must be a “qualified investment fund” being a fund where (A) the number of investors (excluding the person who originates or sponsors the fund and who has the power to make investment decisions on behalf of the fund, and its associates) is at least 5, and the capital commitments of investors unaffiliated to the originator or sponsor of the fund exceeds 90% of aggregate commitments, and (B) not more than 30% of the net proceeds arising out of the fund’s transactions are to be received by the originator or sponsor of the fund and its associates¹⁰.

Basically, the fund itself needs to qualify for the key components under the Unified Tax Exemption for Profits Tax before the Tax Concession could apply.

Who is a “qualifying payer” referred to in paragraph 3 above?

A “qualifying payer” is:

(a) a fund within the meaning of a “fund” under section 20AM of the Unified Tax Exemption for Profits Tax¹¹, which is certified by the Hong Kong Monetary Authority (the HKMA) as a “certified investment fund” in that such fund is “in compliance with the criteria for certification published by the HKMA”;

(b) an “associated corporation”, or an “associated partnership”¹², of a “certified investment fund”; or

(c) The Innovation and Technology Venture Fund Corporation.

In determining whether a fund is a “certified investment fund”, the HKMA will assess (i) whether the fund invests in “qualifying transactions” (see the section ‘What are “qualifying transactions” referred to in paragraph 2 above?’), and (ii) whether the Minimum Activities Requirements (as defined below) of the “carried interest recipients” are likely to be met, based on the information provided by the fund¹³. However, a certification from the HKMA does not automatically mean that the relevant “qualifying persons” or “qualifying employees” would be able to benefit from the Tax Concessions as that would be subject to further assessment by the IRD that all other applicable conditions for the Tax Concessions are also satisfied.

Any non-resident fund is required to appoint an authorised local representative for liaising with the HKMA and the IRD.

Who is a “qualifying person” that may benefit from the Profits Tax Concession referred to in paragraph 4 above?

Only a “qualifying person” may benefit from the Profits Tax Concession i.e. may have its chargeable profits tax reduced in respect of eligible carried interest. A “qualifying person” refers to any of the following persons:

(a) a corporation licensed under the SFO to carry on regulated activities or a Hong Kong authorised financial institution¹⁴ registered under the SFO for carrying on regulated activities - importantly, there is no requirement for such services to be provided to a fund which is a “qualified investment fund”¹⁵; or

(b) any person providing “investment management services” in Hong Kong or arranging such services to be provided in Hong Kong for a “certified investment fund” which is a “qualified investment fund”¹⁶ or for The Innovation and Technology Venture Fund Corporation,

provided that such person must also have for each year of assessment (covering the period from the commencement date of the provision of “investment management services” up to the date the carried interest is received by or accrued to such person):

(i) at least 2 full-time employees on average in Hong Kong who carry out the “investment management services” with the necessary qualifications; and

(ii) at least HK$2 million of operating expenditure incurred in Hong Kong for providing the “investment management services”,

(collectively, the Minimum Activities Requirements) which are, in the case of items (i) and (ii) above, considered adequate by the Commissioner of Inland Revenue¹⁷.

Who is a “qualifying employee” that may additionally benefit from the Salaries Tax Concession also referred to in paragraph 4 above?

In addition, a “qualifying employee” may benefit from the Salaries Tax Concession i.e. may have his or her assessable income reduced in respect of eligible carried interest accruing to such employee. A “qualifying employee” means:

(a) an individual employed by a “qualifying person”, or any qualifying person’s “associated corporation” or “associated partnership”¹⁸ which is carrying on a business in Hong Kong; and

(b) an individual which provides investment management services in Hong Kong for, or on behalf of, the “qualifying person” for a “certified investment fund” or The Innovation and Technology Venture Fund Corporation.

What are the ongoing obligations for retaining the Tax Concession?

These include the following:

(a) A “qualifying person” must provide to the IRD information in relation to the eligible carried interest that it receives and additional information in relation to its employee who is receiving the eligible carried interest, including the amount of “eligible carried interest” received by such employee. It must also maintain sufficient records for not less than 7 years.

(b) A “qualifying payer” must provide to the IRD information which may be required by the IRD in relation to payments made to such person, and maintain sufficient records for not less than 7 years.

(c) The fund is required to inform the HKMA within 90 calendar days of any change to any information or documents provided in connection with a certification application or a pre-application for certification. In the case of a pre-application for certification, the fund and the “qualifying persons” will also be required to make annual declarations that they have complied and intend to continue to comply with all certification requirements.

(d) In each year where there is a distribution of “eligible carried interest”, it is also expected that an external auditor will be required to be appointed to verify that (i) the Minimum Activities Requirements are met in the relevant years of assessment, and (ii) the distribution satisfies the conditions for the Tax Concession, which auditor’s report should be kept at the fund’s local office or with the local authorised representative of a non-resident fund.

Observations

As carried interest constitutes a key financial reward to private equity fund sponsors, the key advantage of the zero-rate Tax Concession is that it allows fund sponsors to operate in Hong Kong with certainty knowing that they will not be taxed on the carried interest received provided the relevant conditions are fulfilled. Despite the relatively tedious conditions, we believe that fund sponsors will be able to benefit from such Tax Concession with proper structuring and planning.

Concerns regarding the Tax Concession include the following:

(a) It is uncertain why the hurdle rate must be an element of “eligible carried interest” since the “eligible carried interest” must already be linked to profits, and there is no guidance as to a minimum or threshold rate which should be applied. While a hurdle rate is commonly seen in a typical distribution waterfall for private equity funds, a hurdle rate requirement will inevitably limit the parties’ freedom and flexibility to agree to a bespoke distribution waterfall.

(b) Given that a “qualifying person” must either be a corporation licensed under the SFO to carry on regulated activities, a Hong Kong authorised financial institution registered under the SFO to carry on regulated activities, or such other person that is providing “investment management services” in Hong Kong or arranging such services to be provided in Hong Kong, it is doubtful whether fund sponsors can utilise a designated holding vehicle for receiving carried interest from a fund (e.g., a special limited partner) to benefit from the Tax Concession, which will likely limit the structuring options for receiving carried interest.

(c) If a “qualifying person” is not a corporation licensed under the SFO to carry on regulated activities or a Hong Kong authorised financial institution registered under the SFO to carry on regulated activities, then the fund must be a “qualified investment fund” (see paragraph (ii) under the section ‘What are “qualifying transactions” referred to in paragraph 2 above?’ above) which requires it to have (i) at least 5 investors which are, and 90% or more commitments from, persons which are not affiliated to the fund originator or sponsor, and (ii) not more than 30% of the net proceeds arising out of the fund’s transactions being received by the fund originator or sponsor and its associates. This will limit fund structuring options for such persons, typically overseas incorporated funds e.g. “fund of one”, fund launches where initial commitments are seeded by the originator, and certain bespoke “club deals”.

(d) Although the intent is to allow all genuine private equity funds with different investment strategies to apply for certification with the HKMA, the regime appears to exclude certain private equity funds from benefiting from the Tax Concession, such as those funds that make real estate investments, private investment in public companies, investments using non-traditional instrument such as “SAFE” instruments¹⁹, investments with IPO as an exit strategy, or investments in public companies to facilitate privatisation (where the privatisation fails to materialise), as these investments will not fall under the asset classes / transactions prescribed as “qualifying transactions”.

(e) Since the Tax Concession is applied in respect of each tax assessable year, in a year where a private equity fund does not conduct any investment or disposal but merely receives dividends and interest income from investments already made, it is uncertain whether and to what extent the Tax Concession can still apply to such dividends and interest income from investments given that the dividends and interest income may exceed the “incidental transactions” threshold (likely to be 5% as per the equivalent limit for the Unified Tax Exemption for Profit Tax) in that assessable year i.e. whether all, or only the excess over the threshold, will be excluded.

(f) An application to the HKMA for obtaining the “certified investment fund” validation will likely involve submitting to the HKMA the fund’s private placement memorandum and/or constitutional document (e.g., limited partnership agreement) which some fund sponsors may be reluctant to provide given the confidential nature of these documents and that the fund is not a regulated fund. As these fund documents may also be updated from time to time, it may also mean that fund sponsors may have to revalidate their funds’ certification status by submitting the updated fund documents to HKMA and be subject to the HKMA’s re-approval, which may result in the fund being in an ongoing disclosure (but not publication) regime not dissimilar to that which applies to regulated funds in Hong Kong.

(g) The definition of “qualifying employee” only covers those employees who provide investment management services in Hong Kong, but excludes those employees providing back office and supporting services in Hong Kong to the fund sponsor (or those working outside Hong Kong), which means that even if they receive any “eligible carried interest” from the fund sponsor, they will not be able to enjoy the Salaries Tax Concession.

Conclusion

The Tax Concession represents another major effort in developing Hong Kong into a leading hub for private equity funds, following the introduction of the unified fund exemption regime for profits tax on 1 April 2019 and the establishment of the limited partnership fund regime on 31 August 2020²⁰, particularly in light of the recent “economic substance” tax reforms in major offshore jurisdictions such as the Cayman Islands and that the Cayman Islands being recently been added to the “grey list” of the Financial Action Task Force which warrants increased monitoring of anti-money laundering practices and which may in future result in yet more regulation and compliance costs for sponsors using Cayman Islands fund vehicles. We believe that the Tax Concession will provide further incentive for private equity funds and their fund sponsors to operate in Hong Kong, and make Hong Kong become one of the most competitive jurisdictions in the world for private equity fund sponsors.

1. Profits tax is applicable to investment managers or advisers who provide investment management or advisory services in Hong Kong. Profits tax is currently charged at a rate of 16.5% for corporations and 15% for unincorporated businesses in respect of assessable profits above HK$2 million (equivalent to approximately US$256,410).
2. Salaries tax is applicable to employees of investment managers or advisers who provide professional services in Hong Kong. Salaries tax is currently charged at a progressive rate of up to 17% or a standard rate of 15%.
3. “Fund sponsors” is used generically in this article to include investment managers and advisers.
4. The Innovation and Technology Venture Fund Corporation is established by the Hong Kong Government to co-invest with selected venture capital funds as co-investment partners in eligible local innovation and technology start-ups.
5. A hurdle rate is a preferred rate of return on fund investments stipulated in the governing agreement of the fund. Under the CI Tax Exemption Ordinance, no particular minimum threshold is prescribed for the hurdle rate so its impact is unclear at this stage.
6. See section 5(2) of Schedule 16D to the IRO.
7. See section 4(2)(d) of Part 2 of Schedule 16D to the IRO.
8. Another key requirement of Unified Tax Exemption for Profits Tax is that the fund’s profits are earned from qualifying transactions (being transactions in assets of a class specified in Schedule 16C to the IRO) and incidental transactions (being transactions incidental to such qualifying transactions), provided that the trading receipts from such incidental transactions shall not exceed 5% of the total trading receipts from the qualifying transactions and incidental transactions. 
9. See section 20AN(3) of the IRO.
10. See section 20AN(6) of the IRO.
11. The following is a simplified summary of the definition of “fund” in section 20AM of the IRO (which is subject to certain exceptions), (a) (i) the fund assets are managed as a whole by, or on behalf of, the person operating the arrangement, and/or (ii) the contributions of participants, and the profits or income from which payment are made, are pooled, (b) the participating persons do not have day-to-day control over the fund assets, and (c) the purpose or effect is to enable participants to receive (i) profits or returns represented to arise from the purchase, holding, management or disposal of the fund assets, or (ii) a payment or returns arising from purchase, holding, or disposal of, the exercise of any right in, the redemption of, or expiry of, any right title or interest in the fund assets.
12. An “associated corporation” or an “associated partnership”, in relation to a corporation or a partnership, means another corporation / partnership which is under the control, has control over, or under the common control, of the corporation / partnership.
13. According to the HKMA’s guidelines for certification of funds which was published on 16 July 2021, an application for certification may be submitted after the eligible carried interest has been received by, or accrued to, a “qualifying person” for a particular year of assessment but not later than an applicable deadline which is determined based on the financial year end of the relevant “qualifying person”. The application should comprise a “certification application form” and the required supporting documents including an auditor’s report. As at the date of this article, the HKMA has indicated that funds may request for the “certification application form” from the HKMA but details that are required to be set out in such auditor’s report are yet to be released. According to an earlier industry consultation published in August 2020, the applicant is required to submit the fund’s formation documents (e.g. private placement memorandum, structure chart, etc.), historical local expenditure and/or budget of the entire fund structure, historical local hire and/or estimated hire of investment manager and a list of local employees containing details about position and functions. While it is possible to make a pre-application for certification before any eligible carried interest has been received by, or accrued to, a “qualifying person”, such pre-application is only indicative of the HKMA’s certification approval and is not final. HKMA will endeavor to issue a certification (in the case of a certification application) or letter of acknowledgement (in the case of a pre-application of certification) within 2 months of receiving all required information and documents. 
14. There is no restriction on the types of regulated activity (as defined in the Securities and Futures Ordinance (Chapter 571 of the Laws of Hong Kong)) that can be carried on by the SFC licensed entity or authorised financial institution in order to be a “qualifying carried interest recipient”.
15. See section 4(3) of Appendix 16D to the IRO.
16. See the definition of “qualified investment fund” above.
17. See section 5(3) of Schedule 16D to the IRO.
18. See footnote 12 above.
19. “SAFE” means “simple agreement for future equity”, which is usually used in early-stage venture capital financing and involves issuing equity only upon the occurrence of a triggering event.
20. For details about the limited partnership fund regime, please refer to our client alert which is accessible at reedsmith.com.

In-depth 2021-214