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Why Hong Kong needs to change its view of carry

If it wants to compete with other regional private equity hubs, the territory needs to solve the issue of the tax treatment of carried interest, writes KPMG China's Darren Bowdern.

In a further breakthrough for Hong Kong’s private equity industry, the government announced in its recent budget that it intends to look at further tax arrangements to promote the city as a PE hub in the region. This follows the recent tax reforms that fundamentally change the previous funds tax regime to ensure PE funds managed from Hong Kong are not subject to tax.

Darren Bowden

The reforms and recent announcement are positive steps towards ensuring that Hong Kong remains competitive as an international PE centre and the leading hub in Asia. However, some additional measures are still needed to maintain Hong Kong’s leading position. One of these key reforms relates to the tax treatment of carried interest.

On 7 March, Hong Kong’s financial secretary announced that as part of the government’s review of the tax arrangements to further promote PE, it will look at the tax treatment of carried interest. This is an exciting development for the industry and is in line with the tax treatment of carried interest in other international financial centres. It is hoped that this will ultimately lead to legislation that will respect the legal form of carried interest as an exempt gain or distribution.

The tax treatment of carried interest has been a key topic of debate in Hong Kong for the last few years. The Inland Revenue Department (IRD) has previously held the position that carried interest is essentially a fee for services, or a type of disguised management fee. However, our view is that genuine carried interest is an investment return and is legally – and in essence – the same nature as the returns received by other investors in the fund.

While case law establishes that blatant salary or service fee substitution schemes are capable of being struck down and taxed as income, the IRD’s approach of seeking to challenge these arrangements needs to take into account the legal and commercial basis on which fund structures have long been established.

Hong Kong’s salaries tax provisions provide for employees to be taxed on the value of the shares acquired in connection with employment where insufficient consideration has been paid to acquire such shares. However, the lack of similar provisions under the profits tax rules for non-employees has resulted in questionable interpretations and applications of the law with respect to carried interest.

Carried interest aligns the interest of the manager with those of the investors in the fund. It is similar to other joint venture investment arrangements where one party contributes the capital and the other provides the technical experience, but they both share in the profits of the venture. In such arrangements, the profits distributed and shared between the investors are treated the same.

It has never been in dispute that carried interest entitlements arise only from the successful performance of the fund’s investments. Nonetheless, attempts to pre-empt the general anti-avoidance provisions (section 61A of the Inland Revenue Ordinance) by contending that all carried interest arrangements would have been structured as salary or service fee income if not for the tax benefits overlooks the standard features common to PE fund structures, which have evolved as a response to commercial considerations over time.

Fundamentally, a PE structure is a risk/reward proposition for the management team and limited partners alike. A partnership structure aligns both general partner and LP interests, where both parties’ returns are contingent on making profits from the realisation of investments. Both LPs and GPs contribute capital into the fund structure; whether a fund performs or fails, both LPs and GPs share in the upside and downside. A partnership is a perfectly legitimate structure for two groups to participate in risk and reward.

The government’s announcement to look at further tax arrangements to promote Hong Kong as a PE hub in the region is welcomed by the industry. The recent tax reforms ensure that the territory remains internationally competitive as a PE hub, but the tax treatment of carried interest is an issue that needs to be resolved in order to cement Hong Kong’s leading position and attract major PE houses to establish in the city.

Darren Bowden is partner and head of alternative investments at KPMG China.