Hong Kong's stated desire to become a strong hub for private equity funds in Asia faces a fundamental problem: the city lacks experience, a track record and even an appealing tax structure.

Building the first two will take time. Meanwhile, the Hong Kong authorities are trying to tackle the third by introducing a new profit tax exemption for both onshore and offshore funds, provided that certain conditions are met. 

Previously, private funds were only exempt from Hong Kong’s profit tax if they were offshore vehicles and had no central management and control in the city, or if they operated in Hong Kong as private open-ended fund companies. 

Even if those boxes are ticked, qualifying for exemption is difficult. Funds failing to do so had to pay the tax rate of 16.5%. 

Under the new tax rules, private equity funds domiciled in Hong Kong are exempt from the city’s corporate tax. “If there were any taxation, it would be on the individual investors in those funds, at whatever their home country personal income tax rates are,” said Scott Peterman, a Hong Kong-based partner at law firm Orrick.

In other words, Hong Kong won’t impose a withholding tax on investment funds distributing money to their investors, said Florence Yip, Asia Pacific tax leader for asset and wealth management at consultancy PwC.

That’s not to say that private equity companies are totally exempt from paying tax. Yip said the managers of a Hong Kong fund would still have to pay the 16.5% tax on any profits they accrued from operating the vehicle. 

However, that could also change. A spokesman for the Hong Kong Monetary Authority (HKMA) told AsianInvestor that the de facto central bank is working with the government to introduce a more competitive tax arrangement to attract onshore private equity funds. 

LACK OF CLARITY 

While the new tax regime seems appealing, tax experts say a critical element of uncertainty remains: the Inland Revenue Department’s Departmental Interpretation And Practice Notes (DIPN). These are guidelines issued by the tax department on how it interprets and enforces relevant laws. It hasn’t yet issued one in relation to how it interprets profit tax exemptions for onshore and offshore funds. 

John Levack, HKVCA

“There’s likely to be a new DIPN covering the unified tax rules because ultimately the IRD has the say about how they are going to treat some of the very important little details,” said John Levack, vice chairman of Hong Kong Venture Capital and Private Equity Association. “Whether that DIPN maintains the spirit of the legislation or introduces things that cause grit to go into the clause, is yet to be seen.”

Back in May 2016 the IRD did publish a DIPN on profits tax exemption for offshore private equity funds. It was bad news for the vehicles with stakes in Hong Kong companies; one of the note’s requirements essentially disqualifies funds that own shares in companies operating in Hong Kong from tax exemption.

It’s too early to anticipate how a theoretical DIPN could impact the new tax exemption plans. But it’s a risk. 

“What’s the rush to put onshore funds in place until we have seen that IRD is actually supportive and won’t introduce some really tough rules?” said an executive familiar with private equity funds.

Another uncertainty surrounds how the department will treat carried interest under the new plans. While fund fees are captured under profits tax, the IRD hasn’t yet said how it will treat carried interest, which arises from profits from an investment.

Robert Woll, Hong Kong-based partner at law firm Mayer Brown, said it could end up being treated as capital gains, which are not taxed in Hong Kong. 

This story was adapted from the cover story of AsianInvestor Summer 2019 magazine.