On December 12 2003, the Belgian minister of finance and the Hong Kong secretary in charge of financial services and the treasury signed a double tax treaty. As regards Hong Kong, the treaty became operative on April 1 2004, while the effective date for Belgium was October 7 2004. For Belgian withholding tax purposes, the treaty had effect on income attributed or declared payable on or after January 1 2004.

This is Hong Kong's first comprehensive double tax treaty ever, but, the territory is reported to have engaged in discussions with the Netherlands, Ireland and other countries to enter into similar treaties.

On March 31 2005, the Belgian Administration of Fiscal Affairs issued Circular AFZ/97.0060 No 4/2005. The circular explains various provisions of the Belgium-Hong Kong double tax treaty, mainly focussing on aspects that deviate from the OECD Model Convention.

Exchange of information and administrative assistance

The circular starts with explaining article 25 of the treaty providing for exchange of information as regards the treaty provisions and domestic regulations on taxes covered by the treaty. The importance of this clause has already been shown in recent case law on the application of a participation exemption to dividends of Hong Kong origin.

However, the circular emphasizes that the treaty does not include administrative assistance with tax collection.

Scope of the treaty

The circular reminds us that, since July 1 1997, Hong Kong is a part of the People's Republic of China, of which it has become a special administrative region (SAR). However, the Belgium-China double tax treaty (existing since 1985, and supplemented with a protocol in 1996) does not apply to Hong Kong residents, because, within the People's Republic of China, the Hong Kong SAR is a separate political and tax jurisdiction until 2047.

The Belgium-Hong Kong treaty expressly refers to the territory of the Hong Kong SAR, including Hong Kong Island, Kowloon, the New Territories and the waters of Hong Kong.

For Belgium, the treaty applies to the traditional income taxes, including late payment interest and tax increases, in accordance with the principle that an accessory obligation follows the same treatment as the relevant primary obligation. Administrative and criminal law penalties, on the other hand, do not fall within its scope.

Offshore income and residents of Hong Kong

In Hong Kong, the concept of "resident" is not defined by domestic law because it is not relevant there - Hong Kong taxes both residents and non-residents equally if they carry on business in Hong Kong and have Hong Kong-sourced profits. For this reason, the treaty authors built in a special definition of "Hong Kong resident" in the protocol to the treaty. Income that is not of Hong Kong origin (commonly referred to as offshore income) is not taxable in Hong Kong.

Some found this rather confusing in terms of treaty protection for Hong Kong taxpayers who earn offshore income, particularly because article 4 of the treaty states that "this term (read: resident), however, does not include any person who is liable to tax in that Party in respect only of income from sources in that Party or capital situated therein". In other words, article 4 seems to say that the treaty doesn't apply to a Hong Kong business because it is always taxed on a source-only basis.

The protocol to the treaty, on the other hand, clarifies this strange outcome by stating that "the last sentence of that paragraph does not preclude a person from being treated as a resident in a Contracting Party by reason of a territorial source principle in the taxation system of that Party".

The circular confirms that the protocol ensures that Belgium interprets the last sentence of article 4, section 1 in the sense of the OECD Commentary on article 4. Under those guidelines, a person subject to taxation in Hong Kong is not excluded from the scope of an agreement due to the fact that he is taxed there on a territorial basis. Hong Kong companies that are not taxed on their foreign-source income are therefore residents of Hong Kong for treaty purposes if they are companies incorporated in the Hong Kong SAR or - if incorporated outside the region - have their central management and control there. In short, as the circular concludes, these companies, too, can claim treaty protection.

No withholding tax on dividends

Needless to say, the crown jewel of the treaty is the fact that no withholding tax on dividends is levied if the beneficial owner of the dividends is a company which is a resident in the other party and which at the moment of the payment of the dividends holds, for an uninterrupted period of at least 12 months, shares representing directly at least 25% of the capital of the company paying the dividends. A 10% holding results in a maximum source tax of 5%. In all other cases, the upper limit of source tax will be 15% of the gross dividend.

For dividends of Hong Kong origin, this has no advantage because there is no dividend withholding tax in Hong Kong anyway. In the opposite situation, of course, the treaty offers the solution that Belgian withholding tax on dividends (usually 25% or 15% under domestic law) can be reduced to 0% provided the relevant formalities are fulfilled (that is, filing of a form 276 Dividend Authorization). Table 1 compares the tax treaty withholding tax rates with the domestic ones.

Table 1: Withholding and domestic tax rates
	Belgium Non-treaty rate	HK Non-treaty rate	Treaty rate
Dividend	15%/25%	Nil	0%/5%/15%
Interest	15%	Nil	10%
Royalty	15%	5,25%	5%

Note that the determination of the minimum holding for the purposes of the treaty is the payment of the dividend, whereas, under Belgian law, the taxable event triggering application of withholding tax is the time when the dividend is attributed or declared payable. These dates may, but do not have to, coincide.

As agreed by the treaty, withholding tax of interest is limited to 10% of gross interest. Under Belgian tax law, the rate is usually 15%, but 0% is also possible in respect of payments to non-residents provided certain conditions are met.

The circular confirms that, in application of the treaty, the withholding tax rate is 0% in respect of, among other things, interest from accounts receivable due to goods, merchandise or services being purchased in instalments, and mentions that, in accordance with Belgian law, that interest (due on account of late payment) does not constitute investment income but rather professional income that is not liable to withholding tax.

Withholding tax on royalties is limited to 5% of the gross amount. Under Belgian domestic law, the rate applicable to payments to non-residents is usually 15%. A Belgian domestic law exemption is only provided for according to the transposition of the EU Interest & Royalty Directive, meaning never for Hong Kong residents.

Table 2:
HK income		HK tax	Belgian tax	Total tax
Onshore	100	17.5%	0%	17.5%
Offshore	900	0%	0%	0%
Total	1000	17.5	0%	0%
Effective tax rate		1.75%	0%	1.75%

Rules for withholding tax relief

The circular emphasizes that the application rules for income to qualify for withholding tax relief in Hong Kong are not known to date. This is particularly relevant in respect of royalties originating in Hong Kong, where 5.25% tax should be withheld to meet the Hong Kong income tax liability of the non-resident. Belgian residents who, for instance, receive royalties from Hong Kong are requested to file an application for treaty protection with the Hong Kong Inland Revenue Department to limit this tax to 5%. To that end, they have to produce all documents that evidence their qualifying for treaty protection. They can prove their status of Belgian (tax) residents by submitting a form 276 CONV issued by the Belgian tax office within whose jurisdiction they are located. To obtain that certificate, the recipient of the income has to produce an accurate description of the nature and amount of the relevant income.

Capital gains and Hong Kong property companies

In principle, the treaty awards taxing power in respect of realized capital gains to the country where the seller is residing for tax purposes. If the country of tax residence is Belgium, this would mean that a capital gain on shares is normally exempted because (see below for an explanation) the circular confirms that dividends distributed by Hong Kong companies qualify for participation exemption.

However, where it concerns shares of a company more than 50% of the value of which is derived directly or indirectly from immovable property situated in the other contracting party, the gains may be taxed in that other party. On the other hand, that other party does not have taxing power if:

• the shares are quoted on a recognized stock exchange of one of the parties ; or

• the shares are alienated or exchanged in the framework of a merger, a demerger or a similar reorganization; or

• more than 50% of the value of the shares is derived from immovable property in which the company carries out its activity.

Hong Kong does not tax gains from the sale of capital assets, so the sale of shares or real property is typically not taxed there. However, as a result of the above a Belgium resident may be liable to Hong Kong tax on sale of property shares in the rare circumstance where:

• the Belgium resident is a share trader (then the profit is not a capital gain but an income gain);

• the profit arises from trading in unlisted shares (listed property shares would be treaty protected);and

• the profit has a Hong Kong source (contracts executed in Hong Kong).

Profits from a Hong Kong PE

Under article 22, section 2(a) of the treaty, where a resident in Belgium derives elements of income, not being dividends, interest or royalties, which may be taxed in the Hong Kong SAR in accordance with the provisions of the treaty, and which are taxed there, Belgium exempts those elements of income from tax but may, in calculating the amount of tax on the remaining income of that resident, apply the rate of tax which would have been applicable if such income had not been exempted (that is, subject to the reservation of progressive taxation, if appropriate). Point 7(a) of the protocol adds that elements of income received by a Belgian resident will not be deemed to be taxed in the Hong Kong SAR when these elements of income are regarded as non-taxable under the laws of the Hong Kong SAR or are exempt from taxation under same laws.

The circular confirms that the aforementioned elements of income that are either untaxed or exempt in Hong Kong are not exempted in Belgium.

However, the circular immediately specifies that the mere fact that Hong Kong applies the territorial principle may not result in Belgium not providing exemption in respect of the profit derived by a Belgian company through a permanent establishment (PE). The rationale developed by the circular is that, for article 22, section 2(a) to apply, all of of the PE's profit must be considered when determining whether or not that profit has undergone taxation in Hong Kong. If taxation has been performed in Hong Kong, Belgium will be required to exempt the profit of the PE even if the effective tax burden in Hong Kong is lower than in Belgium.

The circular also points out that the exemption regime as provided for in the treaty is stricter than the one defined in the OECD Model Convention, as the latter generally requires that the profit of the PE "may" be taxed (which is a theoretical and not an effective taxation) there as a condition to qualify for tax exemption or tax credit in the country where the head office is situated. Hence, tax exemption in respect of the profits of the PE to promote the economic development of the area where the PE is situated should - in application of the OECD Model Convention - not preclude tax exemption or tax credit in the country where the head office is situated.

The circular continues by stating that point 7(b) of the protocol confirms the global approach. It is true, in so far as Belgium exempts the entire profit of the Hong Kong PE, that profit also includes dividends, interest and royalties that are attributable to the PE. The profit thus attributable to the PE has to be determined in accordance with Belgian tax law.

Diagram 1 and table 3 below illustrates this.

Diagram 1: What is exempt

Table 3
	Amount	HK CTX	HK WHT	Bel CTX	ETR
Offshore royalty	500	0	n/a	0	0%
Offshore interest	400	0	n/a	0	0%
Onshore income	100	1.75%	n/a	0	1.75 %
Total	1000	1.75%		0

In short, as the circular interprets the treaty, the condition to be met for full Belgian exemption to apply to profit that is attributable to a Hong Kong PE is that a taxation is performed in Hong Kong. Taking into account the wording of the circular and the treaty, this probably means that the PE must have some level of onshore income (which, in Hong Kong, is taxable at 17.5%) - even if its profit (also and mainly) consists of offshore income (that is not taxable in Hong Kong).

Table 4: Impact of the Belgian participation exemption on a Belgian shareholder's cash flow
	Situation A		Situation B		Situation C
	Tax	CF	Tax	CF	Tax	CF
Gross dividend HK WHT Net frontier	100 (   0) 100	100 (   0) 100	100 (   0) 100	100 (   0) 100	100 (   0) 100	100 (   0) 100
Interest (*)	(   5)	(   0)	(   0)	(   0)	(   0)	(   0)
Par. Ex. Tax basis	(   95) 0		(   95) 5		(   0) 100
33.99% CTX	(   0)	(   0)	(   1.7)	(   1.7)	(   34)	(   34)
Net dividend	100	100	98.3	98.3	66	66
Effective tax rate:	0%		1.7%		33.99%
Situation A: leveraged parent eligible for participation exemption Situation B: non-leveraged parent eligible for participation exemption Situation C: non-leveraged parent not eligible for participation exemption   (*) per assumption, paid to a related company

Hong Kong dividends qualify for participation exemption

The question is whether a dividend of Hong Kong origin qualifies for the 95% participation exemption in Belgium since Hong Kong tax law is characterized by a nominal corporation tax rate of 17.5%, which, however (and this applies to all Hong Kong-based companies), is only applied to income originating in Hong Kong itself. Other (what is referred to as offshore) income is not taxed in Hong Kong. Hence the question whether or not a dividend of Hong Kong origin stands the subject-to-tax test to qualify for the participation exemption. According to this condition, the following are excluded from the participation exemption: dividends from a company that is not subject to Belgian corporation tax or any similar foreign tax or which is established in a country where the common law tax provisions are significantly more favourable than in Belgium.

Effective from assessment year 2004 (that is, financial years ending on December 31 2003), an additional participation exemption provision applies to the effect that a foreign taxation regime is deemed as significantly more favourable than in Belgium when either the common law nominal rate on the profits of the company or the common law rate corresponding to the real tax burden is lower than 15%.

The circular notes that the participation exemption analysis has to be performed on the conditions and within the limits laid down by Belgian law. However, it immediately adds that, as regards Hong Kong law as currently in effect, the common law tax provisions in Hong Kong are not "significantly more favourable than in Belgium" (in spite of the territorial system applied there). In this respect, the circular refers to the commentary on article 4 of the OECD Model Convention providing that residents of countries that apply a territorial principle for tax purposes may not be excluded from treaty protection. Furthermore, the circular states that the consequences of the territorial principle do not fundamentally differ as compared with the exemption regime applied by Belgium on the basis of numerous double tax treaties signed by Belgium. It is also pointed out that Hong Kong is not included in the "black" participation exemption list of tax havens (see the Belgian Royal Decree dated February 13 2003). In short, according to the circular, Hong Kong dividends stand the subject-to-tax condition couched in article 203, section 1, 1° of the Belgian Income Tax Code 1992 (BITC 1992) as regards participation exemption.

Table 4 illustrates the impact of the Belgian participation exemption on a Belgian corporate shareholder's cash flow, and a situation where the Belgian parent is sufficiently leveraged (per assumption, by a related company).

Court's 2004 decision

It should be noted that this conclusion is in line with the judgement of April 23 2004 as handed down by the Court of First Instance in Brussels, though with respect to the assessment years 1992 and 1993. Nonetheless, in its grounds, the court then linked the case a few times to the current participation exemption legislation, which makes the line of argument chosen all the more interesting. On October 31 2003, for instance, the Brussels court requested the tax authorities explain why Hong Kong is included in a "participation exemption blacklist" issued in 1991 and not in the Royal Decree of February 13 2003. In this manner, the court wanted to ascertain whether the Hong Kong taxation regime had been substantially "tightened" between 1991 and 2003 or whether, in 1991, the Belgian tax authorities had adopted a position that was "too strict". The report to the King with respect to the Belgian Royal Decree of 2003 clearly provides that, without sufficient data with respect to a country, the country will be deemed to be "black-listed". The fact that Hong Kong is not included in the list leads to the assumption that Belgium has been able to arrive at this conclusion after in-depth analysis. Furthermore, in the course of this lawsuit, the tax authorities themselves confirmed that Hong Kong had a rather constant taxation regime, only the nominal rate of which slightly fluctuated from time to time (for example, from 16.5% to 17.5% in 1992).

It should also be noted that the court also found the observations (as regards assessment year 1997) made by the minister of finance with respect to the notion of "significantly more favourable" relevant in the case at hand (assessment years 1992 and 1993). In short, keeping the dictionary Le Petit Robert within hands' reach as the official language of the lawsuit was French, the court ruled that refusing the participation exemption on the sole basis of a Hong Kong corporation tax rate of 16.5% (assessment year 1992) or 17.5% (assessment year 1993) failed to appreciate the adverb "significantly" (notablement) as expressly used in tax law. A restrictive interpretation of tax law is imperative, all the more because this participation exemption test does not constitute a transparency rule, unlike other participation exemption exclusions.

Finally, the court referred to the recent treaty between Belgium and Hong Kong and pointed out that the Belgian tax authorities attached great importance to the exchange of information clause included there (that is, in article 25 of the treaty). What is more, when drafting the 2003 blacklist, the tax authorities would allegedly have said that countries that did not exercise any control over income from transactions of foreign origin and which, furthermore, did not cooperate with foreign tax authorities must certainly be listed. The fact is that article 27 of the protocol to the Belgium-Hong Kong treaty includes a number of anti-abuse provisions that, in the view of the court, rather confirms the absence of any significantly more favourable nature of the Hong Kong taxation regime.

Compliance with the offshore income test

The circular also confirms that dividends of Hong Kong origin stand the offshore income test defined in article 203, sections 1, 3° (and 2°, that is, special taxation system for financing, treasury or investment companies) BITC 1992 because all Hong Kong companies benefit from the taxation system as described above. According to that test, the following are excluded from participation exemption: companies - in so far as the income they receive, other than dividends, originates outside the country where their main residence for tax purposes is located - that, in the country where their main place of residence is located, benefit from a separate taxation regime that deviates from ordinary law.

A tax credit for dividends after all?

The circular also mentions that, pursuant to article 22, section 2(b) of the treaty, dividends that are not collectively taxed in Belgium and which do not benefit from participation exemption qualify for a tax credit for Hong Kong withholding tax. However, since Hong Kong does not levy any withholding tax on dividends, the circular states that said paragraph is not currently applied.

Kurt De Haen (kurt.de.haen@pwc.be) Brussels and Guy Ellis (guy.ellis@hk.pwc.com) Hong Kong