As Hong Kong proposes new rules to combat base erosion and profit shifting (“BEPS”), asset management groups operating in Hong Kong will face an increasingly challenging environment in which to minimize tax liabilities. In this article, we examine the state of the law and offer insights on the how changes to tax laws are affecting traditional schemes to shelter management fees, performance fees and carried interest.
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Though funds are generally exempt from profits tax in Hong Kong notwithstanding the role that a Hong Kong asset manager may play in the establishment and operation of a fund or in the fund investment process, the group managing or advising such funds are generally at risk of being liable for profits tax. Since we first wrote in 2010 about the increasing tax risk facing asset management groups operating in Hong Kong, we have seen an accelerating pace of change in Hong Kong tax laws. These changes enhance the ability of the Inland Revenue Department (”IRD”) to combat traditional schemes to shelter management fees, performance fees and carried interest offshore, creating an ever more challenging tax environment for asset management groups operating in Hong Kong seeking to minimize taxes. The latest development in this increasingly taxpayer unfriendly environment is the introduction of Inland Revenue (Amendment) (No. 6) Bill 2017 (“Transfer Pricing Law”). The Transfer Pricing Law aligns Hong Kong with global practices to combat base erosion and profit shifting strategies to reduce tax burdens.
Historically, it has been common to structure management arrangements using both an offshore manager or adviser (“offshore manager”) and a Hong Kong sub-manager or adviser (“Hong Kong manager”). If the fund is a hedge fund, it will delegate investment management authority to the offshore manager and in exchange, will pay management fees and performance fees to the offshore manager. In turn, the offshore manager will delegate investment management authority to the Hong Kong manager and pay a service fee to the Hong Kong manager.
If the fund is a private equity fund in the form of a limited partnership, any carried interest will rest with the general partner (“general partner”) of the fund. The fund will retain the offshore manager to provide investment advisory services and pay an advisory fee to the offshore manager. In turn, the offshore manager will retain the Hong Kong manger to provide investment advisory services and will pay a service fee to the Hong Kong manager.
In practice, there is little contention as to whether the Hong Kong manager is liable to profits tax as it is operating an investment business in Hong Kong and thus, is normally carrying on a business in Hong Kong with profits arising in or derived from Hong Kong. However, given the nature and extent of an asset management group’s activities in Hong Kong, to what extent can the group lawfully shelter income in group members outside of Hong Kong? This question boils down to 2 questions:
First, are the offshore manager and the general partner liable to profits tax on their management fees, performance fees or carried interest?
Secondly, are the arrangements between the different members of the management group designed in some impermissible fashion to reduce taxable profits in Hong Kong?
Offshore Manager and General Partner
Whether the offshore manager or the general partner is liable to Hong Kong profits tax will depend in part on whether they carry on a business in Hong Kong. Whether they carry on a business in Hong Kong is a question of fact.
A common misconception is that if the offshore manager and the general partner are incorporated outside of Hong Kong (e.g. in the Cayman Islands), they will fall outside the Hong Kong profits tax net. This is not necessarily the case. In determining whether they carry on a business in Hong Kong, the courts will have regard to a number of factors, including where the central management and control is located. Thus, for example, where the directors of the offshore manager or the general partner are located in Hong Kong and make decisions on behalf of the offshore manager and the general partner whilst in Hong Kong, the offshore manager and the general partner would likely be regarded as carrying on a business in Hong Kong even if they are incorporated outside of Hong Kong.
Taxation of Offshore Profits
Even if an offshore manager and general partner are not carrying on a business in Hong Kong and thus, management fees earned by the offshore manager and carried interest distributions made to the general partner are not normally taxable in their hands, the IRD may seek to tax such fees or distributions (or a portion thereof) if it considers that such fees or distributions have been “improperly” allocated offshore. Whether the IRD may appropriately do so raises the fundamental difficulty of tax planning, namely how to distinguish between a “proper” use of a tax benefit available under the IRO and the “improper” use of such a benefit. So, for example, the IRO excludes from profits tax profits which arise in or derive outside of Hong Kong. If an asset management group includes an offshore manager in its structure and this offshore manager earns management fees, is this exclusion properly engaged or not? As the Court of Final Appeal noted in Ngai Lik Electronics Co. Ltd. v. Commission of Inland Revenue, it would be non-sensical to “attack arrangements made to secure tax benefits which are legislatively intended to be available to the taxpayer”.
As set out in Departmental Interpretation and Practice Notes No. 46 (Transfer Pricing Guidelines – Methodologies and Related Issues) (December, 2009) (“DIPN 46”), in the context of tax benefits arising from arrangements between members of a group, the IRD’s approach to deciding what is a proper use of a tax benefit and what is not follows that of the Organisation for Economic Co-Operation and Development (“OECD”). In other words, the IRD will assess whether those arrangements are consistent with that which may be expected in an arm’s length arrangement. Thus, for example, where an offshore manager appoints an affiliated Hong Kong manager to provide investment advisory services, the Hong Kong manager should be remunerated on the same basis as it would be if the offshore manager and the Hong Kong manager were not affiliated but were dealing with each other on an arm’s length basis. If an arrangement is not conducted on an arm’s length basis and a tax benefit arises, the IRD may invoke anti-avoidance provisions in the Inland Revenue Ordinance (“IRO”) to counteract the tax benefit.
Remuneration of Asset Managers
Though DIPN 46 is general in nature, there is no doubt that the approach outlined in DIPN 46 applies equally to the asset management industry. Departmental Interpretation and Practice Notes No. 51 (Profits Tax Exemption for Offshore Private Equity Funds) (May, 2016) (“DIPN 51”) sets out specific examples of the application of this approach to the private equity industry. As a result of DIPN 51, it would appear that:
Hong Kong Manager - If the IRD considers that the Hong Kong manager is not adequately remunerated for its services after considering the functions, assets and risks attributed to its Hong Kong operations, it may invoke anti-avoidance provisions under the IRO to attribute to the Hong Kong manager the management fees or distributions of carried interest paid to the offshore entities as profits derived from management or advisory services rendered in Hong Kong.
Executives of Hong Kong Manager – Similarly, if the IRD considers that the distributions of carried interest are not comparable to the returns arising on investments made by external investors in the fund, it may invoke anti-avoidance provisions under the IRO to attribute such distributions as salaries or profits of executives of the Hong Kong manager who may be entitled to onward receipt of such distributions.
Carried Interest and Other Investment Returns
DIPN 51 applies the arm’s length principle to fees disguised as investment returns, providing that where a Hong Kong manager receives returns which are not commensurate with those on an arm’s length basis, it may scrutinize such returns to determine whether they are fees disguised as investment returns. In this regard, it indicates that a return would be regarded as being an arm’s length return if:
the return is on an investment which is of the same kind as investments made by external investors;
the return on the investment is reasonable comparable to the return to external investors on those investments; and
the terms governing the return on the investment are reasonable comparable to the terms governing the return to external investors.
Though DIPN 51 specifically references carried interest distributions as a possible form of a fee disguised as an investment return, it is not clear how these criteria would apply in the context of carried interest. Carried interest is in the nature of an equity share in a fund resulting from the work to be performed. It is difficult to compare this equity share to an equity share arising from a capital investment from a financial investor.
Statutory Transfer Pricing
Though DIPN 46 and 51 articulate the IRD’s reliance on the arm’s length principle, the IRO itself does not contain a specific provision which gives effect to this principle. The closest is s. 20, which provides that where a nonresident person, such as an offshore manager, carries on a business with a resident person with whom he is closely connected, such as a Hong Kong manager, and the course of such business is so arranged that it produces to the resident person either no profits which arise in or derive from Hong Kong or less than the ordinary profits which might be expected to arise in or derive from Hong Kong, then the non-resident person may be deemed to carry on a business in Hong Kong. As a result, the nonresident person may be assessable and chargeable with tax in respect of his profits from such business in the name of the resident person.
However, s. 20 only deems the non-resident person to be carrying on a business in Hong Kong but does not deem its profits to arise in or derive from Hong Kong. Both must be established for profits tax liability to arise. Furthermore, the section does not allow for an apportionment of the profits between the resident person and the non-resident person based on the arm’s length principle favoured by the IRD. Instead, it subjects all of the profits of the non-resident person to tax. In this regard, the section is not only inconsistent with the modern approach to transfer pricing accepted by the international tax community but may also possibly be regarded as penal in nature.
Given these limitations, whilst not impossible, it is unlikely that the IRD will invoke s. 20 as a weapon against asset management groups.
Artificial or Fictitious Transactions
The IRO, s. 61 enables the IRD to attack arrangements between related parties. It authorizes the IRD to disregard a transaction or disposition where it believes that the transaction which reduces or would reduce the amount of tax payable is artificial or fictitious or the disposition is not in fact given effect. Though DIPN 46 and 51 reference s. 61 as a tool to implement the arm’s length principle, s. 61 makes no express reference to this principle.
Fundamentally, s. 61 draws the line between a proper and improper obtaining of a tax benefit on the basis that the transaction used to obtain it is “fictitious” or “artificial”. The term “fictitious” has been held to mean that the parties to it never intended it should be carried out. In other words, the transaction is a counterfeit, not genuine or imaginary. Though there is little dispute that a tax benefit so derived would be improper, this is a high threshold which is unlikely to be met in most cases.
The term “artificial” has been held to have a wider meaning. Though the courts have indicated that the lack of commercial realism is a factor to be taken into account, they have also indicated that it is necessary to have regard to the totality of the facts. It is by no means certain that on an ordinary language interpretation, a transaction on terms other than those expected in an arm’s length relationship would be “artificial”. Generally, when s. 61 has been invoked successfully, it has been used to attack arrangements which serve no commercial purpose at all. This may arise, for example, where an offshore manager which has no commercial purpose is interposed between the fund and the Hong Kong manager.
Perhaps equally significantly, even where a transaction is artificial, s. 61 only permits the IRD to disregard the transaction. It does not entitle the IRD to substitute a different transaction (which it may regard as being more consistent with an arm’s length arrangement) for the purpose of assessing profits tax. Thus, it may be that where a fund launches with both an offshore manager and a Hong Kong manager and s. 61 is successfully invoked to attack the use of the offshore manager as artificial, the Hong Kong manager may have no tax liability as, disregarding the arrangement with the offshore manager, there is no pre-existing arrangement by which it would earn any fees.
General Anti-Avoidance Rule (GAAR)
The IRO, s. 61A enables the IRD to attack a transaction (including an operation or scheme, whether or not enforceable by legal proceedings) entered into or carried out for the “sole or dominant purpose” of enabling a person to obtain a “tax benefit”. As compared to s. 61, the IRO, s. 61A provides a better basis for the IRD to attack transactions which are not concluded at arm’s length. First, s. 61A not only enables the IRD to disregard a transaction but also enables the IRD to assess liability to tax in such manner as the IRD considers appropriate to counteract the tax benefit which would otherwise be obtained. Secondly, though s. 61A focuses on whether the sole or dominant purpose of a transaction is to obtain a tax benefit, (i) whether the rights and obligations created by the transaction are consistent with those in an arm’s length transaction is one of the factors that must be taken into account in assessing the purpose, and (ii) the existence or non-existence of a tax benefit depends on what a taxpayer might reasonably have been expected to do without the tax benefit. This latter test hints that what the taxpayer would do would be to act as if he were operating on an arm’s length basis.
A major difficulty with s. 61A is that on an ordinary language reading, it is so broad that it could deny a taxpayer the right to take advantage of any exemptive relief available under the IRO, even if the taxpayer were undertaking the very activity which the legislature sought to encourage by offering such relief. This is because in this case, it may well be that the taxpayer’s “dominant purpose” in undertaking that activity was to obtain such relief. As alluded to above, the courts have (sensibly) declined such an interpretation.
The courts have set out an objective test of purpose (i.e. one that does not depend upon the actual purpose of the taxpayer) based on the statutorily enumerated factors. These factors are:
The manner in which the transaction was entered into or carried out and the form and substance of the transaction.
The result that, but for the operation of s. 61A, would have been achieved by the transaction as well as any change in the financial position of the taxpayer that has resulted, will result or may reasonably be expected to result from the transaction;
Any change in the financial position of any person who has, or has had, any connection with the taxpayer, being a change that has resulted or may reasonably be expected to result from the transaction;
Whether the transaction has created rights or obligations which would not normally be created between persons dealing with each other at arm’s length under a transaction of the kind in question; and
The participation in the transaction of a corporation resident or carrying on business outside Hong Kong.
Though none of these factors is conclusive by itself, taken together, the courts have commented that where a transaction does not produce any change in the financial position of a taxpayer or its corporate group but results in a tax benefit to the taxpayer or the group, that is evidence of the sole or dominant purpose of the transaction being to obtain a tax benefit. Equally, whilst not adopting an arm’s length test, the courts have commented that where a transaction is not on an arm’s length basis, the features of the transaction which are not commercial may be evidence that the sole or dominate purpose is to obtain a tax advantage. The net effect is that although s. 61A is not a statutory codification of the arm’s length principle, it can be effective to achieve the IRD’s objectives as set out in DIPN 46 and 51.
Proposed New Base Erosion Profit Shifting (BEPS) Rule
The new Transfer Pricing Law aims to codify the arm’s length approach to transfer pricing. This legislation, once passed, will introduce 3 key requirements, namely (i) a requirement (“arm’s length requirement”) for the price for a transaction between 2 associated persons to be made on an arm’s length basis, failing which profits or losses will be adjusted to reflect an arm’s length price, (ii) record keeping requirements, and (iii) reporting requirements. The latter two provide greater transparency to the IRD and tax authorities globally so as to enable them to assess whether transactions between members of a group are concluded on an arm’s length basis.
Whilst all asset management groups operating in Hong Kong must comply with the arm’s length requirement, the majority of asset management groups operating in Hong Kong are likely to be exempt from the latter requirements for record keeping and reporting.
Requirement for Arm’s Length Pricing
If and when passed, new s. 50AAF of the IRO will require a taxpayer’s income or loss is to be computed on the basis of an arm’s length provision rather than the actual provision where:
Non-Arm’s Length Terms Conferring Tax Benefit - The actual provision (i) has been made or imposed between the taxpayer and another person by means of a transaction or series of transactions, (ii) differs from the arm’s length provision, meaning the provision that would have been made or imposed as between independent persons, and (iii) confers a potential advantage in relation to the taxpayer’s Hong Kong tax; and
Non-Independent Persons - The same person participates in the management, control or capital of both the taxpayer and the other person or the taxpayer or the other person participate in the management, control or capital of the other;
The new arm’s length requirement will mean that asset management groups may need to undertake an assessment to determine the terms which would prevail if dealings were taking place between independent persons in the case of dealings between a Hong Kong manager and an offshore manager and in the case of dealings between a Hong Kong manager and a fund directly managed by the Hong Kong manager on the basis that:
in the case of a typical hedge fund structure, the management shares of the hedge fund are held by the asset management group; or
in the case of a typical private equity fund structure, the shares of the general partner are held by the asset management group.
At the same time, the new arm’s length requirement may result in higher tax liabilities for groups who seek to operate across multiple legal entities in Hong Kong.
Advanced Pricing Arrangements
To provide greater certainty to taxpayers as to whether intra-group arrangements satisfy the arm’s length principle, the new Transfer Pricing Law proposes to establish a statutory mechanism for taxpayers to obtain an advance ruling on how profit or loss in such arrangements should be properly calculated. In this respect, the IRD’s practice is expected to be governed by a revised Departmental Interpretation and Practice Note 48 (Advance Pricing Arrangement) (March, 2012) (“DIPN 48”) which will build upon the IRD’s experience in such advance rulings in the context of tax treaties.
Record Keeping Requirements
To facilitate the work of tax authorities in enforcing the arm’s length requirement, the new Transfer Pricing Law proposes to establish 2 different record keeping requirements. The first takes the form of master and local files which, unless an exemption applies, must be kept each tax year by Hong Kong entities within a group or which have branch offices in different jurisdictions. The second takes the form of a general requirement for Hong Kong taxpayers to be in a position to prove that intra-group arrangements are consistent with the arm’s length principle. This second requirement applies even if a Hong Kong taxpayer is exempt from master and local file requirements.
Master and Local Files
Master and local file requirements apply only to a Hong Kong entity that is a member of a corporate group (including a single enterprise operating through permanent establishments in multiple jurisdictions). The term “Hong Kong entity” at least covers an entity that (i) is resident for tax purposes in Hong Kong, or (ii) has a branch office in Hong Kong.
In an asset management group with a Hong Kong manager and an offshore manager where the financials of both managers are consolidated, the Hong Kong manager is likely to be subject to master and local file requirements. However, as will be seen below, given the limited scale of their operations, many Hong Kong managers will be exempted.
Funds managed by the asset management group however, are unlikely to be subject to master and local file requirements as they will neither be resident in Hong Kong nor operate a branch in Hong Kong and their financials will not normally be consolidated with those of the asset management group.
Master and local files are comprehensive dossiers of information to give tax authorities a comprehensive overview of the taxpayer, its dealings with its associated parties and the methods used to determine pricing between them. These files must be kept for at least 7 years.
As proposed, a local file must contain:
Description of Hong Kong entity – The description must describe the taxpayer’s management structure, its business and strategy and its key competitors; and
Details of Each Controlled Transaction – The details of each controlled transaction (i.e. a transaction with an associated party) must, amongst other things, include a description of the context of the transaction, a breakdown of money movements for the transaction by tax jurisdiction, an identification of the associated party and the Hong Kong entity’s relationship with that party, a copy of material agreements concluded with that associated party, an analysis of the functions carried out by the Hong Kong entity and that associated party, an explanation of the method for determining the price as between the Hong Kong entity and the associated party and a justification, with reference to any comparisons made to pricing used by independent parties, as to why the price is an arm’s length price.
As an “associated entity” includes a person under common control, a Hong Kong manager subject to a local file requirement will likely need to keep details of dealings with its related offshore manager, a related general partner of a fund and even the funds managed by the Hong Kong manager.
As proposed, a master file applies to a Hong Kong entity which is a member of a group and must contain:
Group Organizational Chart - The chart must show the group’s legal and ownership structure, the geographical location of each group member.
Group Business – The file must describe (i) the group’s business including the important drivers of the business, (ii) the supply chain for its largest products and services, (iii) the important intra-group service agreements together with a description of the capabilities of the locations providing the services and the transfer pricing policies for allocating costs, (iv) the main geographic markets of its products and services, and (v) important mergers, acquisitions and restructurings during the tax year.
Group Intangibles – The file must describe (i) the group’s strategy for development, ownership and exploitation of intangibles, including the location of principal research and development facilities and management, (ii) the intangibles that are important for transfer pricing purposes, identifying ownership of such intangibles, (iii) the material agreements related to these intangibles, (iv) the group’s transfer pricing policies for research and development and intangibles, and (v) any important transfers of intangibles during the tax year.
Group Finances – The file must (i) describe how the group is financed, including financing arrangements with unrelated lenders, (ii) identify any group member that provides central financing for the group, including the place where that member is organized and managed, and (iii) describe the group’s transfer pricing policies in relation to intra-group financing arrangements.
Exemptions from Master and Local File Requirements
The master and local file record keeping requirements will not apply to a Hong Kong entity in a financial year if during that financial year any 2 of the following conditions are satisfied:
The total amount of the Hong Kong entity’s revenue for the financial year does not exceed HK$200 million;
The total value of the Hong Kong entity’s assets at the end of the financial year does not exceed HK$200 million; and
The average number of persons employed by the Hong Kong entity during the financial year does not exceed 100.
As the Hong Kong office of many asset management groups will not itself hold assets exceeding HK$200 million and will not employ more than 100 employees, many asset management groups will be exempt from master and local file requirements.
Local files need not cover de minimis related party transactions. In this regard, where in any financial year, transactions of each of the following types between a Hong Kong entity and an associated entity do not exceed the threshold for that type, the local file need not cover that type of transaction:
Transfers of Non-Financial and Non-Intangible Assets (whether movable or immovable but excluding financial assets and intangibles) - HK$220 million;
Transfers of Financial Asset – HK$110 million;
Transfers of Intangibles – HK$110 million; and
Other Transactions (not being transfers of the types described above) - HK$44 million. Such transactions may include, for example, service fee income.
If a Hong Kong taxpayer is not required to prepare a local file to cover any of these types of transactions in any financial year, then it need not prepare any master file for that financial year.
Reporting Requirements
The new Transfer Pricing Law proposes to establish a new reporting requirement, which will mandate the preparation of filing and a country-by-country return (“CbC Report”). Like the master and local file requirements, the new reporting requirement is intended to facilitate enforcement of the arm’s length requirement. It is unlikely to be applicable to asset management groups except those of very significant scale. As proposed, the requirement will only apply to multinational enterprise groups with annual consolidated group revenue equal to or more than HK$6.8 billion.
The authors gratefully acknowledge the assistance of Clayton Tse, a trainee solicitor at Timothy Loh LLP.