Publish Date
Feb 06, 2025
A&M Tax Advisor Update
Significant impact for private equity, real estate and other private capital funds; sovereign wealth and pension funds; as well as family offices – The Financial Services and the Treasury Bureau (FSTB) issued a consultation paper on 25 November 2024 setting out the long-awaited proposed enhancements to the preferential tax regimes for privately offered funds, i.e., the Unified Funds Exemption regime (UFR) and the Family-Owned Investment Holding Vehicle regime (FIHVs) (managed by single family offices), as well as certain proposed changes to the carried interest tax concession regime.
The proposed changes, are a welcome move by the Hong Kong SAR Government (the Government) to reinforce and strengthen Hong Kong’s status as a leading regional hub for wealth and asset management activities, and accordingly will be welcomed by the industry. The enhancements should provide a much higher degree of upfront tax certainty to private investment funds, allowing them to invest confidently with certainty around the tax outcomes. Further, the proposal would significantly expand the scope of qualifying investments to include loans, private credit investments and interests in non-corporate private entities etc.
In addition, the carried interest concession is proposed to be extended to cover carried interest arising from all types of qualifying assets (i.e., not just private equity investments but also more traditional and commonly adopted investment strategies). This makes the carried interest concession for private capital funds far clearer and more certain, and it is hoped that it will attract more private capital activity to Hong Kong. The current rules are seen as somewhat impractical by the industry.
The proposed changes represent more practical and certain approach to implement the long-standing policy direction of the Government to incentivize and attract the asset management industry. However, it is critical that the legislation is drafted and implemented in a manner that aligns with the policy intent as set out in the consultation paper. This has been a challenge in the past with respect to Hong Kong’s implementation of well-meaning tax policy initiatives, where the policy intent may not have been fully achieved due to the actual drafting of the legislation.
Tax legislation, including the Inland Revenue Ordinance (IRO), is complex. Global best practice is for draft legislation to be released for public and industry comment prior to the draft legislation being tabled at the Legislative Council. This provides industry and tax experts the opportunity to review the proposed changes in detail and provide constructive input providing the Government an opportunity to refine the draft legislation prior to the legislation being enacted. This is particularly important, if Hong Kong is to achieve its ambitious and deeply commendable goals that this consultation paper proposes.
We have set out below our high-level comments and practical insights grouped by various fund strategies in order to highlight the most important aspects to our clients. We note that some of the comments below will apply across fund strategies as well.
Under the current UFR, there are certain transactions / profits which do not qualify for the profits tax exemption. The consultation paper proposes to expand the scope of permissible assets under Schedule 16C and refines the definition of “private company” such that a wider range/form of private companies are covered. We welcome the proposed expansion of the exemption scope, and we recommend that the definition of “private company” is further refined to make it certain for take-private scenarios (which are common forms of acquisitions undertaken by private equity funds).
The current UFR provides tax exemption on profits arising from transactions in securities of a private company if the “immovable property test”; and one of “two-year holding period test” or “control test” or “short-term asset test” are satisfied. The consultation paper proposes to remove the control test and short-term asset test in assessing whether tax exemption is available for profits arising from transactions in a private company, with the intention to further simplify the rules. Nevertheless, the removal of “control test” may be considered unnecessary and result in narrowing the scope of the UFR. In addition, the alignment with the tests under the Tax Certainty Enhancement Scheme for non-taxation of onshore equity disposal gains may be irrelevant given the UFR is intended to cover all profits arising from qualifying transactions (and not only capital gains). From a practical perspective, since the timing of exit may be less certain in non-control deals, we view it is important to retain the “control test” as a back-up test to the “two-year holding period test” such that non-control deals are exempt.
The above point serves as a good example of what private equity (PE) funds need from these tax rules, which is certainty of taxation outcome at the time of investment (and at the time of fund-raising, as far as possible). The “control test” and “two-year holding period test” are bright-line tests that are straight forward to anticipate, whereas other tests such as the short-term asset test can only be applied with any level of certainty at the time of exit.
The consultation paper proposes a new tax reporting framework for funds and special purpose entities (SPEs) benefiting from the UFR and also proposes to include a substantial activities requirement which will need to be satisfied. The Inland Revenue Department (IRD) will be engaging with the industry on the form and content of the proposed tax reporting mechanism.
While the UFR has historically been a self-assessment regime (meaning that no tax reporting/filings were previously required if the income or gains were offshore-sourced or tax exempt), the introduction of the proposed (albeit simplified) tax reporting requirements is seen as an administrative burden for privately offered funds managed in Hong Kong. Accordingly, it is essential to understand how the annual tax reporting will be implemented in practice, and which data points the IRD will consider and review.
It is hoped that the IRD will engage with the industry on these matters, and take onboard the potential concerns, and that any form of tax or information reporting will be simplified as compared to the filing of annual profits tax return. By way of example of the concern here, it is common for managers to use many non-Hong Kong entities (that may still have a link back to Hong Kong through investment committee members or the manager generally) and to achieve certainty of tax outcomes and it is important for all of these entities to continue to fit within the UFR where appropriate. If the UFR can only be accessed by reporting on every single SPV, whether Hong Kong-incorporated or not, this will potentially lead to greater uncertainty, as the compliance burden is likely to be too great in this scenario.
The proposed substantial activities requirement requires at least two qualified employees, and an annual operating expenditure of at least HK$2 million, subject to an adequacy test. In the context of meeting the substantial activities requirements, we view that the relevant investment service, which produces the qualifying profits, should be broadly defined to also include operational activities supporting the acquisition, management and disposal of investments as well as ongoing legal, regulatory and tax compliance (instead of just “investment management services” as defined under Schedule 16D of the IRO).
Under the current UFR, an SPE is exempt from profits tax on its assessable profits to the extent that corresponds to the portion of interest in an SPE held by a UFR-exempt fund. The consultation paper proposes to introduce a “de minimis rule” whereby the SPE’s profits from qualifying transactions will be fully exempt, if the UFR-exempt fund has at least 95 percent of the interest in the SPE. This rule is intended to simplify the analysis where the PE fund may be investing with co-investors. While this change is expected to further enhance the application of the UFR, we view that a higher threshold would be warranted. Based on market experience, we note it is common that co-investors hold more than 5 percent interest in a co-investment structure and in this regard, we view that 60–70 percent is a more appropriate threshold for the de minimis rule.
The anti-round tripping provisions under the current UFR provides that a resident person will be deemed to have derived assessable profits in respect of the trading profits earned by the fund from the qualifying transactions if the resident person who, either alone or jointly with his associates, has a beneficial interest of 30% or more in a tax-exempt fund (or any percentage if the fund is an associate of the resident person). The consultation paper proposes to relax these provisions by adopting a list of excluded persons/entities. While this is a very positive change facilitating Hong Kong resident investor investing into UFR-exempt funds, it is essential to further understand how the additional safeguards (i.e., the 10 percent threshold) around financial institutions, insurance business and money lending business will be implemented and monitored in practice. For example, if one affiliate carried on money-lending business in Hong Kong within the entire group, it is important to understand if this takes away the ability for any other group entity to be exempted on profits from credit investments under the UFR (once the investor holds more than 10 percent in the UFR-exempt fund).
The current UFR provides tax exemption for transactions in securities of private companies, excluding interests in partnerships etc. The consultation paper proposes to expand the scope of permissible assets under Schedule 16C by including interests in noncorporate private entities. Accordingly, it is expected that a broad range of investment vehicles, including common forms of real estate investing and holding vehicles (e.g., Australian MITs, Japan TMKs, Korea REF Trusts) will be covered under the UFR.
In order to further enhance the application of the UFR, it is worth considering the inclusion of disposal gains arising from the holding of Hong Kong operating assets such as data centers, logistics warehouses and hotels. Although Hong Kong does not tax capital gains, it often requires prolonged discussions with the IRD to substantiate that the disposal gain is of a capital nature. By including disposal gains arising from operating assets under the UFR, it will further promote Hong Kong as an asset management hub, attract foreign investments, and boost the local (industrial) property market, which is currently one of the priority tasks for the Government.
The current UFR specifically includes sovereign wealth funds in the definition of “fund”. The consultation paper proposes to also include “pension funds” and “endowment funds” within the specific definition of “fund” to make it clear that these funds are covered by the UFR, which we are fully supportive.
We would propose to take this change even a step further by deeming sovereign wealth funds, pension funds and endowment funds as not only “funds” but as “qualified investment funds” for UFR purposes (generally defined as a fund with more than four investors), as they are often established with a broad investor base. This should have practical benefits of making it more certain and clearer that these funds qualify for UFR exemption when investing and coinvesting using Hong Kong structures.
In addition, “fund of one” arrangements should be deemed as a “fund” for UFR purposes, as it is common for commercial or other reasons that a fund-of-one or single investor fund is set up for investors or by bona fide widely held funds such as sovereign wealth funds and/or pension funds. The current anti-round tripping provisions and the proposed changes on the provisions (as described above) should be sufficient to mitigate the risks of Hong Kong resident investors using fund of one structures to avoid tax. Continuing to carve out this kind of arrangement from the scope of UFR would undermine Hong Kong’s competitiveness as a regional hub for wealth and asset management activities.
Under the current UFR, bond interest income is considered as “incidental income” and subject to a 5 percent threshold for the tax exemption. The consultation paper proposes to remove the “incidental transactions” and the 5 percent threshold. This is a very positive change for credit funds, which often derive interest income as their primary source of revenue.
Private credit funds
The current UFR does not provide tax exemption on profits from loan transactions nor interest income derived from loans. The consultation paper proposes to expand the scope of permissible assets under Schedule 16C by including loans and private credit investments. This is a long-awaited change by private credit funds in the market, as the proposed changes provide a much higher degree of upfront tax certainty for these types of funds relying on the UFR, as compared to determining the source of interest income under the provision of credit test and/or operations test under the general charging provisions. It is helpful to also consider the impact on the symmetrical deductibility of interest for a Hong Kong borrower (especially in cases of a syndicated loan arrangement where certain lenders are tax-exempt credit funds and others are taxable financial institutions in Hong Kong).
To further enhance tax certainty for funds engaged in loans and private credit investments, we recommend that the proposed legislation explicitly states that the nature of any underlying collateral should be irrelevant in determining eligibility for the UFR.
The current UFR does not provide tax exemption on profits from loan transactions nor interest income derived from loans. The consultation paper proposes to expand the scope of permissible assets under Schedule 16C by including loans and private credit investments. This is a long-awaited change by private credit funds in the market, as the proposed changes provide a much higher degree of upfront tax certainty for these types of funds relying on the UFR, as compared to determining the source of interest income under the provision of credit test and/or operations test under the general charging provisions. It is helpful to also consider the impact on the symmetrical deductibility of interest for a Hong Kong borrower (especially in cases of a syndicated loan arrangement where certain lenders are tax-exempt credit funds and others are taxable financial institutions in Hong Kong).
To further enhance tax certainty for funds engaged in loans and private credit investments, we recommend that the proposed legislation explicitly states that the nature of any underlying collateral should be irrelevant in determining eligibility for the UFR.
The consultation paper proposes to expand the scope of permissible assets under Schedule 16C by including virtual assets. This long-awaited change aligns with industry needs and supports the Government’s vision to promote Hong Kong as Asia’s booming Web3 and virtual asset hub.
In order to further enhance the applicability of the UFR, we recommend that decentralized autonomous organizations (DAOs), which are commonly used for collective investments in virtual assets, should be included as the definition of a “fund,” as they play a significant role in collective investments in the virtual asset market. This inclusion will further position Hong Kong as a leader in digital finance, fostering innovation and attracting investment while ensuring regulatory clarity.
The consultation paper proposes refinements to the carried interest tax concession regime. These proposed enhancements are welcomed by the industry for resolving various longstanding issues of the regime, particularly with regard to the certification requirements (and the related audit procedures) under the current rules.
Subject to how the proposed changes are being legislated and implemented, the proposed refined tax concession regime for carry is expected to be more widely applicable and better utilized, by catering to carry arrangements in a non-PE context, and to cover carry arising from transactions of all classes of qualifying assets.
Importantly, the amendments should facilitate the coverage of typical carry arrangements commonly used by the industry, in particular through the removal of the requirement for carry to be “paid through the qualifying person,” which historically has required a Hong Kong entity. The consultation paper also proposes to broaden the qualifying payer requirement to include a closely related entity. In order to provide greater flexibility of the payment flow of eligible carried interest, it is worth considering refining the definition of “closely related entity” such that an entity “managed and/or controlled by” another entity may be seen as a “closely related entity” as well.