By Eric Gong, Tax Partner, PwC Hong Kong
2022 was a tough year: the Russia-Ukraine war broke out and governments around the world continued to take measures to manage the COVID-19 pandemic. An unfortunate by-product has been the significant adverse impact to the global economy.
While the 2008 global financial crisis saw private credit being transformed into a major global asset class, its rise was largely concentrated in Europe and the United States. However, the demand for private credit has now gone global and Asia is no longer segregated from the looming liquidity crisis that may arise in the challenging world.
Over the past few years, we have seen plenty of private credit funds being set up in the region to offer non-bank lending to the private non-financial sector, especially to small and mid-sized enterprises who are vulnerable to any pullback in the availability of bank credit. In the current macroeconomic environment, we expect this activity to increase exponentially.
Key tax issues to consider for Hong Kong managed private credit funds
One of the key considerations for setting up fund management operations in a jurisdiction is the availability of safe harbor rules for investment funds in that jurisdiction. Whilst an investment fund is generally established in a tax neutral jurisdiction, the activities of the manager in the jurisdiction in which it operates could expose the fund to income tax in that jurisdiction. Hence, safe harbor rules are very important as they allow an investment manager to manage a fund in a jurisdiction without exposing the fund to any income tax in that jurisdiction.
Hong Kong offers several safe harbor rules for investment funds; among which, the unified fund tax exemption regime is widely used to protect private investment funds from being exposed to profits tax. Nonetheless, under the Hong Kong tax authority’s interpretation, direct lending of loans is currently not a qualified asset under the unified fund tax exemption regime.
Further, although debt-featured securities such as bonds and notes are generally qualifying assets, Hong Kong sourced interest income is interpreted as “incidental income”, which has to be less than 5% of the fund’s total trading receipts in order to be exempted. As a result, depending on the nature and structures of the investments, the unified fund tax exemption regime may not be a suitable option for a Hong Kong managed private credit fund that primarily enters into direct lending of loans or primarily derives interest income.
That being said, given that Hong Kong adopts a territorial basis of taxation, it is still possible to set up the governance structure of a private credit fund such that it doesn’t carry out business in Hong Kong or its interest income is non-taxable offshore sourced income. Such an alternative option may however limit the manager’s activities in Hong Kong.
Hong Kong needs to expand the scope of “qualifying assets” under the unified fund tax exemption regime to cover private debt
Despite the above tax considerations, Hong Kong is still one of the preferred jurisdictions in Asia for managers to establish private credit fund management or advisory operations. This is owing in part to Hong Kong’s excellent infrastructure, simple tax system, availability of talent and sophisticated capital market.
In order to develop Hong Kong as a world-class fund management hub covering all major asset classes, industry players in the jurisdiction have been continuously in discussion with the government to explore the expansion of the unified fund tax exemption regime to cover private debt.
This would be particularly relevant with Hong Kong’s ambitious plan to become a leading investment fund hub for green and sustainable infrastructure financing. Green and sustainable assets require significant amounts of capital and often become profitable only after a long investment period. We believe non-bank lenders such as private credit funds could play an important role in offering alternative sources of financing.