Hong Kong LPF Carried Interest Tax Concession: What Fund Managers Need to Know

The Hong Kong Inland Revenue Department (IRD) issued Departmental Interpretation and Practice Notes (DIPN) No. 62 in June 2024, providing the first comprehensive administrative guidance on the carried interest tax concession under the Inland Revenue Ordinance (Cap. 112). This followed the legislative amendments enacted in 2023 that extended the 0% profits tax rate for qualifying carried interest to cover both onshore and offshore funds. For fund managers operating in Hong Kong, the window to secure this concession is narrowing as the IRD intensifies its scrutiny of substance requirements. The 2025-2026 assessment cycle will be the first full year where the IRD actively audits compliance with the new economic substance tests. Any fund manager that fails to meet these tests risks losing the 0% rate and being assessed at the standard 16.5% profits tax rate, plus potential penalties.

The Legislative Framework and Scope

The carried interest tax concession is codified under section 14ZZO of the Inland Revenue Ordinance (Cap. 112). The legislation provides a 0% profits tax rate for qualifying carried interest received by eligible fund managers from qualifying funds. This concession applies to carried interest derived on or after 1 April 2023.

Qualifying Fund Manager

The legislation defines a qualifying fund manager as a corporation, partnership, or individual licensed or registered with the Securities and Futures Commission (SFC) under Part V of the Securities and Futures Ordinance (Cap. 571). The fund manager must be a Hong Kong resident person, meaning it is incorporated in Hong Kong or, if incorporated elsewhere, has its central management and control exercised in Hong Kong.

The fund manager must provide investment management services or investment advisory services to the qualifying fund. These services must be performed in Hong Kong. The IRD’s DIPN 62 clarifies that the fund manager must have the economic substance to carry out these activities, including having adequate physical offices, qualified staff, and actual decision-making authority in Hong Kong.

Qualifying Fund

A qualifying fund is a fund that meets the definition under section 14ZZO(1) of Cap. 112. The fund must be a private fund, meaning it is not an authorized fund under section 104 of the Securities and Futures Ordinance. The fund must be a qualifying fund structure, which includes: (a) a Hong Kong Limited Partnership Fund (LPF) registered under the Limited Partnership Fund Ordinance (Cap. 637); (b) a fund structured as an offshore limited partnership; or (c) a fund structured as a corporate entity.

The fund must have its central management and control exercised in Hong Kong. This is a critical substance requirement. The IRD examines where the fund’s investment decisions are made, where the fund’s books and records are maintained, and where the fund’s partners or shareholders meet.

Qualifying Carried Interest

Carried interest is defined as a share of the profits of a qualifying fund that is allocated to the fund manager, provided the allocation is contingent on the fund achieving a specified minimum return (the hurdle rate) for investors. The legislation requires that the carried interest be derived from the fund’s investment activities and that the fund manager’s entitlement to the carried interest is set out in a written agreement.

The IRD’s DIPN 62 states that the carried interest must be “economically linked” to the fund’s investment activities in Hong Kong. This means the fund manager must demonstrate that the investment management decisions giving rise to the profits were made in Hong Kong. The IRD will consider factors such as where the investment committee meetings are held, where the investment professionals are based, and where the due diligence and monitoring activities are conducted.

The Economic Substance Test

The economic substance test is the cornerstone of the carried interest tax concession. The IRD has made it clear that the concession is not automatic. Fund managers must demonstrate that they have the requisite substance in Hong Kong to justify the 0% tax rate.

The Four-Pronged Test

The IRD’s DIPN 62 outlines a four-pronged test for economic substance. First, the fund manager must have a physical office in Hong Kong. This office must be a genuine place of business, not a virtual office or a shared space without dedicated staff. The IRD will inspect the premises and may request photographs, lease agreements, and utility bills.

Second, the fund manager must employ an adequate number of qualified staff in Hong Kong. The IRD does not prescribe a minimum number, but the ratio of Hong Kong-based staff to total staff must be reasonable. The staff must have the relevant qualifications and experience to perform the investment management functions. The IRD will examine employment contracts, payroll records, and resumes.

Third, the fund manager must incur a minimum amount of operating expenditure in Hong Kong. The IRD’s DIPN 62 states that the expenditure must be “commensurate with the scale and complexity of the fund’s operations.” The IRD will compare the fund manager’s Hong Kong expenditure to its total global expenditure. A fund manager that spends 90% of its costs outside Hong Kong will face significant scrutiny.

Fourth, the fund manager must demonstrate that the core income-generating activities (CIGA) are performed in Hong Kong. CIGA includes making investment decisions, conducting due diligence, negotiating terms, monitoring portfolio companies, and managing exits. The IRD will examine board minutes, investment committee papers, and email communications to determine where these activities occur.

The Anti-Avoidance Provisions

The Inland Revenue Ordinance includes specific anti-avoidance provisions for the carried interest concession. Section 61A of Cap. 112 allows the IRD to disregard any arrangement that has the purpose or effect of obtaining a tax benefit. The IRD’s DIPN 62 warns that artificial arrangements, such as hiring “shell” staff or renting a “sham” office, will be challenged.

The IRD also has the power to impose a penalty of up to 100% of the tax undercharged if it finds that the fund manager has made a false or misleading statement in its tax return. Fund managers should ensure that their carried interest tax returns are accurate and supported by contemporaneous documentation.

Application and Compliance Procedures

The application process for the carried interest tax concession is integrated into the annual profits tax return. Fund managers do not need to file a separate application. Instead, they must complete the relevant sections of the Profits Tax Return (BIR51 or BIR52) and provide supporting documents.

Step 1: Determine Eligibility

The fund manager must first determine whether the carried interest qualifies for the concession. This requires a detailed review of the fund’s structure, the fund manager’s operations, and the carried interest agreement. The fund manager should document its analysis in a memorandum, including references to the relevant provisions of Cap. 112 and the IRD’s DIPN 62.

Step 2: Prepare Supporting Documentation

The IRD requires the fund manager to submit a set of supporting documents with its tax return. These documents include: (a) a copy of the fund’s partnership agreement or constitutional documents; (b) a copy of the investment management agreement; (c) a breakdown of the carried interest calculation, including the hurdle rate and the allocation methodology; (d) a description of the fund manager’s Hong Kong substance, including office details, staff numbers, and expenditure; and (e) a statement confirming that the CIGA are performed in Hong Kong.

The IRD’s DIPN 62 recommends that fund managers maintain a “substance file” containing all relevant documents. This file should be updated annually and be available for inspection upon request.

Step 3: File the Tax Return

The fund manager must file its Profits Tax Return within one month of the IRD’s issuance date. If the fund manager needs more time, it must apply for an extension in writing. The IRD typically grants a two-month extension for fund managers that are tax representatives.

In the tax return, the fund manager must report the qualifying carried interest as a separate item and claim the 0% tax rate. The fund manager must also disclose any non-qualifying carried interest and pay tax at the standard 16.5% rate on that amount.

Step 4: Respond to IRD Inquiries

The IRD may issue a questionnaire or request additional information after receiving the tax return. The fund manager must respond within the specified timeframe, usually 21 days. The IRD’s DIPN 62 states that the IRD will focus on the substance test and may request to inspect the fund manager’s premises.

Fund managers should prepare a response strategy in advance. This includes identifying a point of contact, gathering all relevant documents, and preparing a narrative that explains the fund manager’s Hong Kong operations.

Practical Considerations for Fund Managers

The carried interest tax concession offers significant tax savings, but it also imposes substantial compliance burdens. Fund managers must carefully assess their readiness before claiming the concession.

Substance Planning

Fund managers that are currently operating on a “substance-lite” model should start planning now. The IRD’s DIPN 62 makes it clear that the concession is not available to fund managers that lack genuine Hong Kong substance. Fund managers should consider: (a) relocating key investment professionals to Hong Kong; (b) expanding their Hong Kong office space; (c) increasing their Hong Kong operating expenditure; and (d) moving the fund’s central management and control to Hong Kong.

The Hong Kong government’s 2024-2025 Budget announced additional funding for the IRD to hire more tax inspectors. This means the IRD will have more resources to audit fund managers’ substance claims. Fund managers should expect the IRD to conduct more on-site visits and request more detailed documentation.

Structuring the Carried Interest Agreement

The carried interest agreement must be carefully drafted to meet the legislative requirements. The agreement should specify: (a) the hurdle rate, which must be a fixed percentage or a benchmark rate; (b) the allocation formula, which must be clear and unambiguous; (c) the conditions for vesting and distribution; and (d) the clawback provisions, if any.

The agreement should also include a “Hong Kong substance” clause, which requires the fund manager to maintain its substance in Hong Kong. This clause protects the fund manager in the event that the IRD challenges the concession.

Record-Keeping

The IRD’s DIPN 62 emphasizes the importance of contemporaneous documentation. Fund managers should keep records of: (a) investment committee meeting minutes, showing where the meetings were held and who attended; (b) email communications, showing that investment decisions were made in Hong Kong; (c) travel records, showing that investment professionals were physically present in Hong Kong when making decisions; and (d) expense records, showing that the fund manager incurred costs in Hong Kong.

The IRD may request records dating back six years from the end of the relevant year of assessment. Fund managers should retain all records for at least seven years.

Key Takeaways

1. The carried interest tax concession under Cap. 112 requires fund managers to prove genuine economic substance in Hong Kong, including physical office, qualified staff, adequate expenditure, and core income-generating activities performed locally.

2. The IRD’s DIPN 62, issued in June 2024, provides the first comprehensive administrative guidance and signals that the IRD will actively audit substance claims starting from the 2025-2026 assessment cycle.

3. Fund managers must file a complete Profits Tax Return with supporting documents, including the fund agreement, carried interest calculation, and a substance statement, within one month of the IRD’s issuance date.

4. The anti-avoidance provisions under section 61A of Cap. 112 empower the IRD to challenge artificial arrangements and impose penalties of up to 100% of the tax undercharged.

5. Fund managers should prepare a substance file with contemporaneous documentation, including investment committee minutes, email communications, travel records, and expense receipts, and retain these records for at least seven years.

This does not constitute legal advice. Consult a solicitor for your specific case.