An estimated fourfold rise in the number of tax audits of alternative asset managers in Hong Kong last year has raised worries among industry participants.

This comes at a time when some private equity firms are moving parts of their operations to Singapore from the territory, driven at least partly by the lack of clarity on tax rules, say sources.

“Some Hong Kong-based firms have quietly shifted some of their administration and structural things down to Singapore,” says one industry executive, and others confirm this. They declined to provide specific names.

There are around 40 tax audits being conducted in the current tax year, up from around 10 last year, estimate market participants. Hedge fund managers are said to account for 60% of last year’s new audits, and private equity firms 40%. The audits can span multiple years of assessment.

“Although there are a lot of small operations in Hong Kong – some one- and two-man bands – 40 is a large number in any sector,” says Travis Benjamin, a partner and head of tax at law firm Deacons in Hong Kong.

“There is a perception that there is a lot of money out there and that the [Inland Revenue Department (IRD)] wants to see whether Hong Kong is getting its share of that cash,” he adds. “No one doubts that Hong Kong should collect tax which is due. The issue is whether it is really due.”

John Levack, chairman of the technical committee of the Hong Kong Venture Capital and Private Equity Association (HKVCA), says: “We are watching this closely as a private equity industry. [We] have pulled together a group of tax specialists from a range of advisory firms to try to understand the IRD’s concerns.”

The HKVCA wants to see clarity on the IRD’s treatment of carried interest, he adds, given that this is an important part of the PE model and a key element of the alignment of interest between limited partners and general partners.

A broad market consensus says the rise in audits runs counter to the city’s efforts to become an asset management hub, especially given recent proposals by the government to exempt non-Hong Kong resident PE firms from profit tax (see regulatory analysis article in the upcoming March issue of AsianInvestor).

“Two pieces of the government are operating at exact opposite ends and creating an atmosphere of anxiety,” says a lawyer, who declined to be named. “The Inland Revenue is trying to act like everyone is a crook while the government is saying ‘be here and do business’.”

A common question the IRD is asking Hong Kong-based executives is whether fund managers are receiving arm’s length remuneration for the advisory service they provide to their parent company. (PE managers often structure their organisations so that the Hong Kong entity acts as an adviser to the parent, since managing the fund in the city may subject it to local tax.)

The IRD has been reviewing arrangements for transfer pricing between Hong Kong advisers and offshore managers, to verify that the advisory fee correctly recognises the value being contributed by the Hong Kong-based team.

Another area of concern is that IRD may investigate PE managers’ various income streams, including service fees, management fees and carried interest. Carried interest is generated by profits that PE managers make from investments.

Lawyers argue that one of the fundamental pillars of the city’s tax system is that investment income is not taxed and that carried interest should be viewed as investment income.

“The tax on carried interest is a complex issue. Carried interest is taxed as a capital gain in the US and the UK – two of the most prominent private equity markets,” says Levack. “There is however an ongoing debate about whether it should be treated as income. There are undoubtedly real elements of investment revenue in the concept of carried interest.”