Following the entry into force of the Limited Partnership Fund Regulation last year, which was heavily used in the first eight months of its existence, the new tax break for interest carried over from the activities of private equity funds, provided by the Hong Kong government Proposed in 2000, 2020 has now been introduced. The Inland Revenue (Amendment) (Tax Relief for Transferred Interest) Ordinance 2021 ("regulation") Was amended on May 7, 2021 by amendment of the Inland Revenue Ordinance ("IRO”). Under this new concession, creditable interest income received or accrued on or after April 1, 2020 is subject to a profit tax of zero percent. Persons who have received interest income or who have accrued such an amount are also entitled to a 100% deduction of these amounts from their taxable income.
In formulating policies for the development and growth of the local fund management industry, the Hong Kong government has worked closely with local service companies and industry associations to make Hong Kong a more attractive environment for fund managers. In addition to passing laws to provide new fund vehicles (1) known to international sponsors and investors, a focus was on developing a tax-friendly system, especially for private equity funds, for which taxes are a key factor if you look at, where the registered office and business of each fund and manager are located. In 2019, the Hong Kong government took the final step in creating the so-called “Unified Funds Exemption” regime (“UFE”) When the scope of the existing tax exemption for offshore funds was extended to onshore funds. From April 1, 2019, tax legislation created a level playing field for the treatment of onshore and offshore funds. Given that interest carried over is an integral part of the remuneration for private equity professionals, the next step in introducing a carried interest tax break is intended to improve Hong Kong's game of competition with other countries, particularly Singapore, for its asset business Manager. The Hong Kong government's goal is to create the conditions to attract more managers ashore who are expected to bring their own tangible economic benefits to Hong Kong.
Hong Kong-centered approach
Before determining the main conditions for eligibility for the new tax break, it should be noted that the main requirement for the concession is that it only apply to transferred interest incurred in Hong Kong in return for investment management or derived from Hong Kong services which are carried out in Hong Kong. This reflects the policy objective of the regulation to motivate private equity managers to set up operations in the area and the eligibility conditions underscore this point. As a key example, a Essential Activity Test (2) described below requires that a minimum operating threshold be set and met in Hong Kong to ensure eligibility.
Another important component is that the fund itself must first be qualified for a tax exemption under the UFE so that the tax break is available at fund level. In view of the fact that the entitlement to tax relief only exists if the transferred interest is paid by a certified fund ("certified investment fund") By the Hong Kong Monetary Authority ("HKMA") In order to meet the certification criteria to be published, funds aiming for this status, as well as their management structures, should presumably be subjected to a more detailed examination by the Inland Revenue Department ("IRD”).
Current tax treatment of interest income
Hong Kong has a territorial tax system that sets the corporate income tax on a person who conducts a business in Hong Kong in relation to profits made or derived from that business in Hong Kong. Interest payable on profits originating or originating from Hong Kong would be subject to normal profit tax assessment principles, which are to be assessed at the marginal rate. If there is both an onshore advisor and an offshore manager / general partner, the IRD would attempt to determine if the advisor was adequately remunerated for his services compared to those of the offshore company. If the offshore compensation is found to be disproportionate, it will likely attribute part of the offshore income to the onshore manager who applies the local general anti-avoidance rules.
In addition, interest income paid to a Hong Kong employee who is or is a Hong Kong resident would be subject to wage tax. This is due to a factual question of where the employment, the source of income, was, which often arises from the surrounding circumstances. The new tax break will also extend to any wage taxes that might otherwise be levied on an employee receiving an interest payment eligible for the concession.
Eligible Interest Income
The term “qualifying interest carried forward” refers to any amount received or accrued to an individual as for-profit income from the provision of investment management services by the individual in Hong Kong. These services must have been provided to a “certified investment fund”.
Generally, an amount will be received or accrued as a "Income-Related Return" if (a) it is made after a return on investment has been paid into the Fund once the preferred return for investors in the Fund (ie “Hurdle” interest rate ”) has been met, (b) there are profits for a certain period of time from the investments or from the sale of an investment, (c) it is variable in relation to these profits and (d) the returns on the external fund assets investors are also determined by reference to these profits . However, if such amounts are received by an individual in this manner and there is no material risk that at least a portion of those amounts will not be received by the person or will accrue to that person, that portion of the amounts will not be treated as an eligible interest. (3)
Interest tax relief – conditions
Must be paid by a qualified payer
The interest transferred must be funded by a certified mutual fund, i. H. A qualified payer, to be paid (see below). “Fund” has the meaning set out in the IRO (4), which largely reflects the definition of a “collective investment plan” set out in the Securities and Futures Ordinance (“Wertpapier- und Terminverordnung”).SFO”) (5). The certification of the fund to be implemented by the HKMA is carried out according to a separate management system (6), according to which the fund must submit an application to the HKMA, which is supported by the documents and information that the HKMA may require its assessment of the applicant. The fund would then go through a validation process to determine if it qualified as a certified mutual fund. A non-resident fund would apply for this certification through its locally appointed agent.
Must be derived from qualified PE transactions
Only interest income that represents profits from “Qualifying Transactions” in PE-Type investments will be eligible for the tax break. These must be profits from transactions that mainly (i) stocks, shares, bonds, loan stocks, funds, bonds or debentures of a private company (7) or a private investee company (8) or (ii) shares or comparable shares in a special purpose entity ("SPE") (9) or an intermediate SPE (10) which (directly or indirectly) only owns and manages one or more private investees ("qualifying PE transactions”). It should be noted that the scope of these transactions does not include all asset classes and, in particular, investments of the fund of fund type are not included in the list. (11)
As already mentioned, profits from such transactions of a certified investment fund or an SPE must also be exempt from profit tax under the UFE. This final requirement would mean first determining that profits are exempt at the Fund level as a basis for granting the tax break on any carryforward interest paid or received on those profits.
Must be received by a qualified recipient
The recipient of the interest transferred must be one of the following persons for a valuation year during the base period for the valuation year (the persons in paragraphs (a) and (b) who "qualifying person”):
(a) a company licensed to carry on business or an authorized financial institution registered to carry on business in a regulated activity under the securities intermediary regime under the OFS;
(b) a person who does not fall under paragraph (a) who provides investment management services in Hong Kong for a certified mutual fund or causes such services to be provided for a certified mutual fund which is a “qualifying mutual fund”; (12) or
(c) a person who has earned a measurable income from employment with a person under paragraph (a) or (b) by providing investment management services for a certified mutual fund in Hong Kong for or on behalf of that person.
Provision of investment management services
The interest carried forward must be derived from the provision of investment management services in Hong Kong for a certified mutual fund. In connection with a certified investment fund, “investment management services” are understood to mean: (a) finding funds from external investors or potential external investors, (b) research and advice on potential investments, (c) buying, managing or selling real estate or investments and (d) act on behalf of the Fund to assist a company in which the Fund is invested to raise funds.
Essential job requirements
Threshold and ongoing requirements will apply to ensure that beneficiaries of the tax break conduct core income generating activities in the relevant Hong Kong tax year. The condition requires that during the entire period commencing on the day on which a person commences, directly or indirectly, the provision of investment management services for a certified mutual fund, and ends on the day on which eligible transferred interest is received on or on or accrued, the person:
- The average number of full-time employees in Hong Kong providing the investment management services and having the qualifications required to do so during the Base Period for each Valuation Year that falls within the Applicable Period is, in the opinion of the IRD, reasonable in each case 2 or more; and
- The total amount of operating expenses incurred in Hong Kong for the provision of the Investment Management Services during the Base Period for each Valuation Year falling within the Period, in the opinion of the IRD, is reasonable and in any event will be HK $ 2,000,000 (13). or more.
Interest earned by individuals
As mentioned above, the scope of the tax break also extends to interest income received by a person who is subject to wage tax. A person who is a “Qualified Worker” is entitled to a 100% deduction of the amount of eligible interest income from the worker's evaluable income resulting from the employment for the evaluation year. To be a "Qualified Employee", the employee must (a) be employed by or be employed by (i) a Qualified Person (see above) or (ii) the Affiliate or Associate Partnership of a Qualified Person that is a Company Partnership if the associate or associate has a business in Hong Kong and (b) carries out the employment functions by providing investment management services in Hong Kong for or on behalf of the Qualified Person.
The use of “associates” and “associate partnerships”, which include a typical “control” concept (ie group concept) to define the relationship with the qualified person, is helpful as the private equity experts are usually employed within the group of become a separate group employing a company that provides the services of the skilled workers to the other parts of the group. However, these terms have not been specifically included in the separate provisions for essential activities requiring a minimum number of employees, and in light of this, it remains to be seen how the IRD will apply these provisions when employees are employed by a group employment company.
As mentioned above, a key component of the tax break is that the fund from which the transferred interest will ultimately be earned must be certified by the HKMA. This requirement that the fund is a certified mutual fund, meets the conditions of the concession and, after certification, is a fund for which claims have been made, is subject to an ongoing monitoring and validation process. It is seen as a positive move that the task of certification has been entrusted to the Central Bank of Hong Kong, which has indicated its desire to make the certification criteria as user-friendly as possible. The regulation also provides that upon receipt of a claim by the HKMA, the IRD can seek advice on any matter it deems appropriate in connection with the claim.
Although the regulation does not include this subject, in a specific valuation year in which there is a distribution of the permitted transferred interest, the Fund will require an external auditor to check whether the above-mentioned essential operational requirements are met have been met in the respective valuation years and that the distribution meets the conditions of the tax concession regime. (14) This report should then be kept at the local office of the Fund or with the local agent of a non-resident fund. if necessary for inspection. (15)
Expansion of the investment scope for SPEs within the UFE
A separate and welcome change in the regulation is the expansion of the scope of the investment transactions permitted at SPE (16) level in order to align them with those at fund level in order to qualify the profits generated from these transactions for exemption from the profit tax according to the UFE (referred to as "Qualified Transactions") (17). The in-scope transactions that are permitted for a private equity fund that qualifies for exemption from UFE are broad and include, for example, listed securities, fund shares, foreign exchange contracts, etc. In comparison, an SPE is currently only Allowed holding and managing investees, but not other financial assets. The regulation allows an SPE to (a) hold and manage assets in the same classes as a private equity fund and (b) transact such assets on behalf of the fund. However, this expansion of the categories of transactions has not been extended to the interest tax credit, which is only limited to profits from "qualified PE transactions".
The main objective of the new tax break combined with UFE is to create the right conditions to foster increased critical mass in the onshore private equity fund industry and to develop Hong Kong as a “leading PE fund hub” (Aug. ). Given the popularity of the new regime for limited partnership funds, it is very likely that creating additional tax incentives for private equity funds and their onshore managers will only help improve this position. The bigger question looming that can only be answered in the longer term will be whether, or to what extent, the larger offshore PE companies, especially the global ones that currently have no onshore fund and asset management businesses in Hong Kong might be attracted enough to bring some of these operations ashore to benefit from these incentives?
(1) As well as the Limited Partnership Fund Regulation that came into force in August 2020 (see our customer notification “The Arrival of the Limited Partnership Fund Regime in Hong Kong”), legislation creating the regime for open-ended fund companies (OFC) came into effect on July 30, 2018 in force.
(2) The purpose of the test is to ensure that the latest international tax standards of the OECD are complied with, including their countermeasures against erosion and profit shifting. In determining whether a preferential tax system complies with international standards to combat BEPS, the OECD will consider whether the regime can meet the essential activity requirements to ensure that these preferential tax beneficiaries carry out core income-generating activities in their jurisdiction (LC Paper No. CB (1) 780 / 20-21).
(3) This is based on the language of the UK Income Tax Act 2007 (Section 809EZC (3) (b) (meaning “carried over interest” in Section 809EZB)) which refers to amounts disguised as carried over interest and in substance are practically certain to arise.
(4) See Section 20AM of the IRO.
(5) See Part 1 of Appendix 1 of the SFO.
(6) The HKMA has prepared a draft of the guidelines including the forms that are circulating for consultation. However, at the time of writing, the final version has yet to be released.
(7) “Private Company” means a company (whether incorporated in Hong Kong or outside of Hong Kong) that is not permitted to make any public solicitation of shares or debt securities in the company (see Section 20AO of the IRO).
(8) In relation to a Fund, this refers to a private company held by an SPE or an intermediary SPE as a shareholder on behalf of the Fund (see Section 20AO of the IRO).
(9) A company, partnership or trustee or other entity wholly or partially owned by a Fund (see Section 20AO of the IRO).
(10) Refers to any company, partnership, trustee or other entity intermediary between the SPE and the Portfolio Company (see Section 20AO of the IRO).
(11) The scope should, however, include PE exits in the event of an IPO, taking into account any blocking of the securities held by the fund (see LC Paper No. CB (1) 821 / 20-21 and IRD Departmental Interpretation and Practice Note No. 61 (Income tax – income tax exemption for funds)).
(12) See Section 20AN of the IRO. This refers to a fund with certain required characteristics as one of the conditions for qualifying for tax exemption under the UFE.
(13) Equivalent to approximately $ 250,000.
(14) See the Legislative Council's letter on the draft law (reference number: ASST / 3/1/8 / 1C).
(15) See paragraph 16 of the Legislative Council's brief on the draft law (reference number: ASST / 3/1/8 / 1C).
(16) See footnote 9.
(17) See Appendix 16C of the IRO.
(18) See footnote 14.
© 2021 Proskauer Rose LLP. National Law Review, Volume XI, Number 137