Proposals To Enhance Tax Concession Regimes For Funds And Carried Interest

In the 2024/25 Budget, the Hong Kong Financial Secretary announced plans to enhance the tax concession regimes for both funds and carried interest by reviewing the current concessions, increasing the types of qualifying transactions, and providing more flexibility in respect of incidental transactions.

On November 25, 2024, the Financial Services and Treasury Bureau (FSTB) released a consultation paper detailing proposed improvements to the unified fund exemption (UFE) regime, the carried interest tax concession regime, and the family-owned investment holding vehicle tax concession regime. The consultation paper also proposed introducing a tax reporting mechanism and a substantial activities requirement under the UFE tax concession regime. This article focuses on the proposed changes to the UFE and carried interest tax concession regimes.

UFE Proposals

Definition Of Fund

Under the current UFE tax concession, the definition of ‘fund’ includes sovereign wealth funds, but does not include pension funds which, depending on their specific structure and arrangements, may not fall within the definition.

As a result, the consultation paper proposes to specifically include pension funds within the meaning of ‘fund’. The proposed scope will be defined as “an arrangement that is established and operated in a jurisdiction exclusively or almost exclusively to administer or provide retirement benefits and ancillary or incidental benefits to individuals, and regulated as such by that jurisdiction or one of its political subdivisions or local authorities”, which has been closely modelled on the definition in the Global Anti-Base Erosion Model Rules under Pillar Two.

The consultation paper also proposes to include endowment funds within the ‘fund’ definition but does not propose to include single investor funds, which are commonly used for a number of commercial and practical reasons by investors.

Expanding The Scope Of Schedule 16C Assets

The UFE regime currently applies only to those classes of assets (Specified Assets’) set out in Schedule 16C to the Inland Revenue. Schedule 16C was introduced in 2019 and has not been updated since, with the result that it is limited to traditional assets like shares, debentures, and derivatives.

To update the UFE regime, which is not currently applicable to a number of assets, including loans and private credit investments, the consultation paper proposes expanding the list of Specified Assets to include:

1. Immovable property located outside Hong Kong.
2. Emission derivatives, carbon credits, and allowances.
3. Insurance-linked securities.
4. Interests in non-corporate private entities (eg partnerships).
5. Loan and private credit investments.
6. Virtual assets.

This expanded scope would be a very welcome change, as credit funds have grown in popularity in recent years in order to capitalise on global market opportunities, but have been unable to take advantage of the UFE regime because loans are not Specified Assets, and interest income received from loans is not considered incidental income.

Virtual Assets

The consultation paper proposes that the definition of ‘virtual assets’ should align with the definition under the Anti-Money Laundering and Counter-Terrorist Financing Ordinance, but with a modification to include digital representations of value issued by a central bank, government, or their authorised entities.

This definition will cover widely traded crypto assets like exchange tokens, utility tokens, security tokens, and stablecoins, but will exclude digital representations that give holders any interest in underlying assets that are not Specified Assets. This distinction is designed to protect Hong Kong’s tax base and prevent the potential misuse of virtual assets to circumvent existing limitations.

Interests In Non-corporate Private Entities

The UFE regime currently applies to transactions in the securities of private companies but excludes interests in non-corporate private entities such as partnerships. The Consultation Paper proposes to expand the Specified Assets to include such interests.

Definition Of Private Company

A ‘private company’ is currently defined as a company (whether incorporated in or outside of Hong Kong) that is not allowed to issue any invitation to the public to subscribe for any shares or debentures of the company. Whilst that is fairly simple to determine in the case of a company incorporated in Hong Kong, for companies incorporated in other jurisdictions, overseas legislation needs to be looked at, and it must also be considered whether such a company is allowed to issue invitations to the public by taking additional steps or seeking approval, without requiring a significant change to its nature.

As the existing definition may cause ambiguity when foreign laws need to be looked at and interpreted, the consultation paper proposes simplifying the definition to mean a company whose shares or debentures are not traded on any stock exchange.

Carried Interest Concession Proposals

Private Equity Transactions

Under the current carried interest tax concession regime, the zero per cent concessionary tax rate is only applicable to eligible carried interest, which arises from profits on private equity transactions that are exempt from profits tax under the UFE regime.

Under the proposals set out in the consultation paper, the types of transactions capable of generating eligible carried interest will be broadened. Provided certain conditions are met, it is proposed that eligible carried interest will accrue from a fund’s (i) profits from all Specified Assets which are exempted from tax under the UFE regime; (ii) other non-taxable income (such as dividend income and offshore income); and (iii) other taxable income.

The result of the proposals will be that fund managers who employ a wide variety of different strategies (including hedge funds, private equity funds, venture capital funds, and private credit funds) and who adopt different approaches to managing the Hong Kong tax position of their funds, such as using the UFE tax concession or keeping the fund offshore, will all be able to benefit from the expanded carried interest concession which is being proposed.

Payment Flow

It is common for employees of the fund manager or investment advisor to receive carried interest via an offshore special purpose vehicle, such as a designated carried interest limited partner of the fund, to provide flexibility in the distribution of the carried interest for commercial reasons. However, there has been a concern that, as the carried interest tax concession requires that carried interest be distributed to a qualifying person who then onward distributes it as income accrued from employment to the qualifying employees, this type of carried interest structure and payment flow may not qualify.

The consultation paper therefore proposes to remove the “paid through the qualifying person” requirement and to broaden the scope of “associated corporation/associate partnership of certified investment fund” in respect of the meaning of “qualifying payer”. This change aims to include “closely related entities” of a certified investment fund, regardless of the legal form such entities take, thus providing greater flexibility when structuring the payment flow of eligible carried interest to qualifying employees. The consultation paper proposes that an entity will be considered a closely related entity of another if (i) one has control over the other; and (ii) both are under the control of the same entity or person.

The consultation paper also proposes expanding the scope of “associate” to include a “closely related entity”, thereby aligning it with the revised definition of “qualifying payer”. The result would be that individuals employed by an entity with the same group, regardless of the legal form of the entity, would qualify as “qualifying employees”.

Hurdle Rate

The current carried interest tax concession regime requires there to be a hurdle rate in a carried interest arrangement. This has led some people to question whether that hurdle rate can be set as zero. From a practical perspective, the terms of each fund, including the hurdle rate, should be a matter for commercial agreement between the investors and the general partner, and it is not practical to benchmark the hurdle rate of one fund against other funds.

The consultation paper therefore proposes removing the hurdle rate requirement from the definition of “eligible carried interest” which would provide welcome flexibility.

Certification Requirement

The current carried interest tax concession regime is only applicable to carried interest paid out from a “certified investment fund”, that is a fund certified by the Hong Kong Monetary Authority (HKMA) as complying with certain specified criteria. Part of the certification process requires a fund manager to submit an auditor’s report to the HKMA to assist it in determining whether the fund has made any investment in a private company. However, even after a fund has been certified, the carried interest distributed by that fund does not automatically qualify for the tax concession, because the Inland Revenue Department is still required to first assess whether other conditions have been met.

The consultation paper proposes removing the HKMA certification requirement, including the requirement to prepare an auditor’s report, which will greatly simplify the use of the carried interest concession.

Positive Impact

The proposed enhancements to the two tax concession regimes should further bolster Hong Kong’s status as a pre-eminent international asset management centre. In particular, the proposal to expand the carried interest tax concession regime to include carried interest accruing from all types of qualifying assets, rather than the current narrow subset of private equity transactions, will greatly expand and improve that tax concession. Specifically, it should enable almost all types of fund managers whose funds invest in the expanded range of Specified Assets and derive income from one or more sources, to benefit from the tax concession. It is hard to see how this will not have a hugely positive impact in terms of attracting fund managers to set up in, and operate from, Hong Kong.

The changes are also likely to be welcomed by the industry as they better reflect the arrangements that would already be adopted by funds in the absence of contradictory tax concession requirements.