Proposed changes to preferential tax regimes enhance Hong Kong’s appeal to fund managers

At present, the unified fund tax exemption regime (the “UFR”) exempts privately offered funds and special purpose entities (SPEs) that are wholly- or partially-owned by a tax-exempted fund from tax on profits earned from “qualifying transactions” and “incidental transactions”, with the latter subject to a 5% threshold. Schedule 16C to the Inland Revenue Ordinance (Cap. 112) (the “IRO”) outlines the classes of assets that are considered to be “qualifying investments” (the “Qualifying Investments”). “Qualifying transactions” refer to those transactions in Qualifying Investments, and “incidental transactions” refer to those transactions that are incidental to the “qualifying transactions”. 

The Consultation Paper proposes the following key enhancements to the UFR: 

Expansion of the scope of “fund” 

Under the current IRO, the definition of “fund” requires an arrangement to embody the characteristics of a pooled investment to be eligible for tax exemption under the UFR. Whilst sovereign wealth funds are explicitly included in the definition despite not meeting the pooling requirement, pension funds and endowment funds are not. As such, the Consultation Paper proposes to expand the scope of eligible funds under the UFR to cover pension funds and endowment funds as well.

Clarification on “business undertaking for general commercial purposes”

A business undertaking for general commercial or industrial purposes is not regarded as a fund and therefore does not qualify for tax exemption under the UFR. At present, such business undertaking includes one that directly engages in various activities such as purchase and sale of assets, or money lending. The Consultation Paper sought to clarify that an entity that solely engages in transactions in or derives income from Qualifying Investments would not be regarded as such. 

Expansion of the scope of Qualifying Investments

At present, funds do not benefit from the UFR with respect to direct lending and certain private credit investments, which would mean that most private credit funds would not be eligible for the exemption under the UFR. In addition, interests in non-corporate private entities (such as partnerships) and virtual assets are not also excluded from the exemption.

The Consultation Paper proposes to broaden the scope of Qualifying Investments to include these assets as well as immovable property situated outside Hong Kong, emission derivatives/emission allowance and carbon credits, insurance-linked securities, etc. 

Specifically, in relation to “virtual assets”, it is proposed that those virtual assets that are covered under the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (Cap. 615) will be eligible for exemption, except for those virtual assets that reference to an interest in any underlying asset other than a Qualifying Investment. 

The Consultation Paper also proposes to expand the definition of “private company” to include those companies whose shares or debentures are not traded on any stock exchange. 

Expansion of the scope of eligible tax-exempt income 

At present, incidental transactions of a fund or its SPE are eligible for profits tax exemption under the UFR, provided that the trading receipts from the incidental transactions do not exceed 5% of the total trading receipts from both qualifying and incidental transactions. Interest received from the holding of a debt security is an incidental transaction, and thus subject to the aforementioned 5% threshold. As a result, this creates an unlevel playing field for many private credit funds and fixed income funds as they are unable to benefit from the profits tax exemption that are generally applicable to private funds that invest in private equity and listed equities.

It is proposed that all income derived from Qualifying Investments by funds and SPEs will be eligible for profits tax exemption, regardless of whether the income arises from qualifying or incidental transactions, and the 5% threshold requirement will be removed. The Consultation Paper also proposes to introduce an exclusion list to specify the types of income that will not qualify for tax exemption under the UFR. The Consultation Paper further proposes that income from private companies engaged in property trading or development of immovable properties in Hong Kong may be included in this exclusion list.

Expansion of the scope of activities of SPEs

Under the current regime, an SPE is defined as an entity that is wholly- or partially-owned by a fund that is established “solely” for the purpose of holding and administering Qualifying Investments or investee private companies. However, this definition is restrictive and does not capture all activities typically performed by SPEs, for example, investment-related financing activities. The Consultation Paper therefore proposes to expand the scope of activities of SPEs to include the acquisition, holding, administration and disposal of investee private companies and/or other SPEs, as well as activities incidental to these primary functions. 

Introduction of new ‘de minimis rule’ for SPEs

At present, the profits tax exemption for an SPE is proportional to the fund's ownership percentage in the SPE for the relevant assessment year. To enhance flexibility, the Consultation Paper proposes to introduce a de minimis rule that allows an SPE’s assessable profits from qualifying transactions to be fully exempt from profits tax if the fund holds at least 95% of the beneficial interest (either directly or indirectly) in the SPE. 

Amendment to the tests applicable to eligible transactions in private companies

Under the UFR, profits of a fund or a SPE derived from transactions in specified securities of, or issued by, a private company (the “private company”) are eligible for tax profits exemption if:

1. the private company holds less than 10% of its assets in immovable property in Hong Kong (excluding “infrastructure”) (the “immovable property test” ); and 
2. the relevant securities in the private company have been held by the fund or the SPE for more than two years (the “holding period test”); provided that if the holding period test is not satisfied, the private company is not controlled by the fund or the SPE (the “control test”); and provided further that if both the holding period test and the control test are not satisfied, the private company holds less than 50% of its total assets in short-term assets (the “short-term asset test”). 

In response to industry concerns that the control test and the short-term asset test create uncertainty and impose unnecessary compliance burden, the Consultation Paper proposes to eliminate these two tests, which therefore restricts the applicability of this exemption to only those securities that have been held for more than two years. The Consultation Paper also proposes to apply the same tests (i.e. the immovable property test and the holding period test only) to non-corporate private entities and to amend the definition of “infrastructure” to such that certain infrastructure assets such as data infrastructure and logistics centres would not be subject to the immovable property test. 

Amendment to the deeming provisions for anti-round tripping

The current anti-round tripping provisions stipulate that a 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 the resident person’s associate) will be deemed to have derived assessable profits from the fund’s trading profits from qualifying transactions.

With a view to encouraging resident investors to invest in UFR funds, the Consultation Paper proposes to relax the anti-round tripping provisions such that the deeming provisions would not apply to the following persons:

1. resident natural persons; 
2. resident holding entities that meet specific conditions; 
3. resident funds exempted under the UFR but are beneficial owners of a fund benefitting from the UFR; and 
4. resident persons who would have qualified for tax exemption if they had held the Qualifying Investments or undertaken the transactions therein directly. 

Further, to prevent abuse of tax exemption regarding income from direct lending and certain private credit investments (which are proposed to be included as Qualifying Investments), it is proposed that stricter deeming provisions for financial institutions or persons engaged in insurance or money-lending businesses holding a beneficial interest of 10% or more in a tax-exempt fund (or any percentage if the fund is the relevant person’s associate) will be introduced.

Introduction of tax reporting mechanism and substantial activities requirement

At present, the UFR operates as a self-assessment regime, allowing funds and SPEs to enjoy tax concession and exemption without the need to obtain the IRD’s prior approval. In view of the need to facilitate information exchange between tax authorities in line with international standards and to ensure effective implementation of the enhanced UFR, the Consultation Paper proposes to introduce a tax reporting mechanism, requiring funds and SPEs benefiting from the UFR to submit specific accounting data and information demonstrating compliance with the tax exemption conditions and substantial activities requirement (as further discussed below). It is indicated that the proposed tax reporting mechanism is intended to be simple and straightforward and only necessary information will be requested. 

In addition, in order to align with international standards against harmful tax practices, the Consultation Paper also proposes to introduce substantial activities requirements for funds, mandating at least two qualified employees and annual operating expenditure of at least HK$2 million incurred in Hong Kong. In determining whether a fund satisfies the substantial activities requirement, all facts and circumstances relating to the fund, including the activities of the fund manager in Hong Kong, will be thoroughly examined by the IRD.

The FIHV tax concession regime, which is modelled after the UFR, offers profits tax concessions for eligible FIHVs managed by eligible single family offices (“SFOs”) in Hong Kong and family-owned SPEs. Similar to the UFR, this regime applies to assessable profits arising from qualifying transactions and incidental transactions, with the latter being subject to a 5% threshold. Notably, the qualifying transactions must be carried out in Hong Kong by or through the SFOs, or arranged in Hong Kong by the SFOs. 

The proposed enhancements for the FIHV regime mirror those for the UFR, including: 

• expanding the scope of Qualifying Investments as qualifying investments; 
• expanding the scope of eligible tax-exempt income; 
• expanding the scope of activities of SPEs; 
• the introduction of new 'de minimis rule' for SPEs; and 
• amending the tests applicable to eligible transactions in private companies. 

The carried interest tax concession regime offers profits tax and salaries tax concession for eligible carried interest distributed by eligible private equity funds. The tax concessions apply to qualifying persons and qualifying employees who receive or accrue eligible carried interest from providing investment management services in Hong Kong for funds certified by the Hong Kong Monetary Authority (the “HKMA”), provided that they meet specific conditions. 

The following enhancement are proposed to the carried interest tax concession regime:

Removal of the HKMA certification requirement 

A fund must undergo a certification process implemented by the HKMA in order to become a “qualifying payer” of eligible carried interest under the current tax concession regime. As part of the certification requirement, the HKMA will evaluate whether the fund is engaged in private equity investments and if it meets the relevant substantial activities requirements. After obtaining the HKMA’s certification, the fund will undergo an assessment by the IRD to ensure compliance with other specific conditions. In view of industry concern on the overlapping roles of the HKMA and the IRD and to streamline the application process, the Consultation Paper now proposes to remove the HKMA’s certification requirement.

Expansion of the scope of “qualifying payer” and “qualifying employee”

At present, a “qualifying payer” of eligible carried interest includes a certified fund and its associated corporation or partnership. Further, “qualifying employees” refer to individuals employed by a qualifying person or its associated corporation or partnership. To better align with commercial reality, the Consultation Paper proposes to expand the scope of “associate” to include entities within the same group, irrespective of their legal forms. 

Removal of the hurdle rate requirement

Under the current tax concession regime, eligible carried interest refers to the sum received or accrued by a person for providing investment management services after the payment of a return on investments in the fund, subject to the fulfilment of the hurdle rate. In other words, the relevant carry arrangement must have a specified hurdle rate. Industry feedback notes that this has led to uncertainty as to whether distributions to qualifying persons qualify as eligible carried interest under the tax concession regime, as it is unclear whether the hurdle rate can be nil and because some start-up or angel funds may not have a specified hurdle rate. In order to accommodate commercial practicality and provide further tax certainty, the Consultation Paper proposes to remove the hurdle rate requirement. 

Broadening of the scope of eligible transactions

The current tax concession regime applies to eligible carried interest arising from profits earned from private equity transactions which are exempted from profits tax under the UFR. It is proposed under the Consultation Paper that the sources of profits or income that may give rise to eligible carried interest be expanded to include:

1. profits earned from all transactions which are exempt from profits tax under the UFR (i.e. not limited to private equity transactions only); 
2. other non-taxable income, such as offshore income and dividend income; and
3. other taxable income, such as income specified in the proposed exclusion list (as discussed above). 

Removal of the “paid through the qualifying person” requirement

Carried interest must be paid through a qualifying person under the existing tax concession regime. As such, carried interest which is allocated via other distribution arrangements (for example, through an offshore carry vehicle) is not eligible for tax concession. To address this issue and to provide for commercial flexibility, the Consultation Paper proposes to remove the requirement that carried interest must be paid through the qualifying person.