Hong Kong may tax carry as capital gain

The jurisdiction is bucking the global trend toward treating carried interest as a fee rather than a capital gain.

Hong Kong has been touting tax changes to make itself a more attractive destination for private equity fund managers, and this year it is looking at carried interest.

In most jurisdictions – where carried interest has typically been taxed as a capital gain rather than income – this would represent bad news for PE professionals. Not so in Hong Kong, where authorities have always held it to be a fee for services or a type of disguised management fee. Details are scant as to when a change could be enacted or how far it would go, but the announcement has put a spring in the step of the local asset management industry, which expects some movement this year.

As and when Hong Kong starts taxing carried interest as a capital gain rather than income, it will represent a move against the grain of most established private equity hubs. The US – after a rancorous run-up to the election of president Trump in which carried interest was often cited as a loophole to be closed – has tweaked the rules to make carry behave more like income if the investment is not held for the long term. As has the UK. Swedish firms will see a proportion of carry taxed as salary at 60 percent, while Italy clarified in 2017 its rules on carried interest – Italian fund managers must personally invest a minimum 1 percent of a private fund’s total equity to ensure its share of carried interest continues to be taxed as capital gain.

There is an age-old philosophical debate around the nature of carried interest. In a recent paper, Oxford University financial economics professor Ludovic Phallipou argues that in its current state it is hard to justify its tax treatment as anything other than income. He therefore suggests modifications to the way carried interest works.

The context around Hong Kong’s prospective changes is that it is jostling with Singapore to be the pre-eminent asset management hub in Asia. The former recently effected fundamental tax reforms to ensure that private equity funds management from Hong Kong are not subject to tax. A change to carry tax would be the icing on the cake.