Adapting to a complex world: The evolution of Hong Kong SAR tax
The Hong Kong SAR government has continued its international focus, introducing incentives to boost competitiveness while taking steps to address global tax avoidance, write Curtis Ng and Ivor Morris.
Maintaining Hong Kong SAR's position as an international business hub remains a key objective of the Hong Kong SAR government. The government has identified a number of sectors where it sees Hong Kong SAR having a significant role. In many of these areas, Hong Kong SAR has already had tax rules designed to encourage international groups to undertake activities in the jurisdiction, but the rules have not always been as business-friendly as in other parts of the world. As a result, substantial changes have been made over the past year to both the funds exemption and the research and development (R&D) incentive.
Hong Kong SAR has long been an important centre for the asset management industry but has historically suffered in the context of private equity and real estate funds from not having an advantageous funds regime. This has led to fund managers in Hong Kong SAR sometimes adopting complex management structures and protocols in order not to create a taxable presence for the fund.
An attempt was made to improve the position a few years ago by introducing a revised offshore funds exemption, extending the scope of the tax exemption to non-resident private equity funds, and also providing an exemption for special purpose vehicles (SPV) holding companies on their gains on disposal. Unfortunately, the anti-avoidance provisions around the legislation were drawn too tightly to make it commercially practicable and the incentive remained largely unused.
The drive to amend the legislation came partly because of pressure from the OECD over harmful tax practices. The previous legislation had restricted the incentive to funds based outside Hong Kong SAR making investments outside Hong Kong SAR. Following discussions with the OECD, this was amended to allow for Hong Kong SAR resident funds and investments in Hong Kong SAR businesses (although Hong Kong SAR real estate was still excluded).
The government also took the opportunity to take on board some of the feedback from the industry. A particular concern with the earlier legislation was that a single bad investment could taint the treatment of the entire fund. This has now been amended so that only income from the bad investment in question is excluded from the exemption. It is a welcome development.
However, it is still hard to avoid the conclusion that the government has interpreted the phrase 'private equity' too literally for the industry to be able fully to embrace it. The restriction of the exemption from tax for SPVs to transactions on shares in private companies will restrict those looking to undertake a private or listing transaction. Similarly, the focus on equity means that many common debt or trust arrangements may fall outside the scope of the exemption. In addition, the restriction on activities that may be undertaken by a SPV remains so tight that it is questionable whether the directors could comply both with their duties under company law and the restrictions imposed by the Inland Revenue Department (IRD).
A pattern repeated
The tale with the R&D incentive is not dissimilar. Hong Kong SAR has for several years had a specific provision in its tax legislation specifying that a deduction may be taken for R&D expenditure. Since a deduction may in any case, under general principles, be taken for most revenue expenditure incurred, its application had been limited to qualifying capital expenditure. In line with many other jurisdictions around the world, and as part of wider measures to encourage R&D activity in Hong Kong SAR, the incentive has now been expanded to allow qualifying R&D expenditure to benefit from enhanced deductions of 200% to 300% of the amount incurred.
R&D has been widely defined, meaning that a wide range of businesses and activities potentially qualify. It includes activities in the fields of natural or applied sciences to expand knowledge, original and planned investigations undertaken with the prospect of getting new scientific or technical knowledge or understanding, and the application of research or knowledge to a plan or design for producing new or substantially improved materials, devices, products, processes, systems or services.
The IRD has made it clear that any sector of the economy, including financial services, may qualify for enhanced R&D expenditure if it meets the criteria. Expenditure will not qualify if it merely seeks to implement knowledge which is public or readily deducible by a competent professional. This means that simple adaptation of open-source data or adapting existing tools to localised systems are unlikely to qualify. Expenditure on feasibility or market studies or on non-scientific aspects of bringing a product to market will also not quality.
Unfortunately, there are a few restrictions that make the incentive less flexible than in a number of overseas jurisdictions. In order to qualify, expenditure must be incurred in Hong Kong SAR and incurred in generating taxable profits. More problematically, the right to the intellectual property created must vest with the person incurring the expenditure and claims are limited to expenditure on employment costs, consumables used in the R&D process and payments to designated research institutions. This is considerably more restrictive than in many other jurisdictions and fails to address the commercial nature of how groups arrange their businesses. For example, a group may have a bankruptcy remote company taking on development risk while using employees of another company to undertake the work. It may decide to outsource some work to specialist consultants. It may want to set up a joint-venture with another enterprise, each bringing separate expertise to the project. Each of these arrangements poses potential challenges in terms of being able to claim expenditure that ought otherwise to be eligible.
Appropriate documentation will clearly be an important aspect of substantiating any claim. Companies will need to consider how to record staff time spent on projects, how to document the process and risks involved and how to demonstrate the innovative nature of the research.
Sadly, Hong Kong SAR's international endeavours over the past year have not been entirely focused on developing incentives, and on the opposite side of the scales, Hong Kong SAR has had to move into line with international standards by introducing a transfer pricing (TP) law. The new law places Hong Kong SAR within the framework of country-by-country reporting, master files and local files, and for the first time, mandates companies to deal with related parties at arm's length. There are exemptions for some domestic transactions (where these do not result in a tax advantage) and some pre-existing arrangements have also been grandfathered.
The new rules also bring in important changes to the taxation of permanent establishments in Hong Kong SAR. While the concept of a permanent establishment has for many years been hidden away in the apocrypha of the IRD's rulebook, the central principle of Hong Kong SAR tax has historically been that entities are taxable when they carry on business in Hong Kong SAR and derive Hong Kong SAR sourced income from that business. Under the new rules, entities with a permanent establishment in Hong Kong SAR are required to compute the income of that permanent establishment as though it were a separate entity from the main company. This potentially results in a significant change to the tax base of branches and permanent establishments operating in Hong Kong SAR.
The IRD has recently issued three particularly lengthy practice notes giving guidance on the new TP rules and setting out their expectations in terms of documentation. It is clear that even those companies that do not meet the thresholds for mandatory reporting will still need to maintain documentation that their transactions are computed at arm's length if they are to avoid penalties. The guidance notes are also reflective of the increasing complexity of Hong Kong SAR's tax system as it evolves to meet an international environment in which the old system of simple and low taxation is becoming harder to sustain. They are also perhaps indicative of the fact that too much is being left to the whims of the tax authority rather than being unambiguously set out in legislation.
The IRD's guidance reinforces the position that the source principle still needs to be considered on top of the TP position. Groups of companies should therefore consider not only the arm's-length pricing but also whether the resulting income can rightfully be said to have arisen in Hong Kong SAR. It will be interesting to see how this evolves in practice as returns are submitted.
As part of the legislation affecting transfer pricing, a number of less prominent changes that impact international taxation were also enacted.
One of these was a provision for taxing income from the development, enhancement, maintenance, protection and exploitation (DEMPE) of intangibles. Where DEMPE functions take place in Hong Kong SAR and the intangible is subsequently transferred to a related offshore company, any income arising in respect of that DEMPE function will remain taxable in Hong Kong SAR. The widely drawn nature of the legislation means that commercial arrangements with high tax jurisdictions are potentially in the scope of the tax, and that certain transactions may effectively be subject to double taxation. The legislation also applies to transfers undertaken before the legislation came into force, meaning that historical arrangements may need to be addressed.
While the offshore transfer of intangible assets has clearly been one of the concerns focused on by the BEPS project, the legislation drafted seems a little indiscriminate and risks undermining the efforts to develop the innovation sector in Hong Kong SAR, which are spearheaded by the R&D incentive.
Another change affected the legislation that governs the credit or deduction of foreign taxes by setting out in greater detail the approach to double tax agreements (DTAs). The new legislation imposes separate tests for transactions with DTA partners, where the treaty should apply, and non-DTA partners, where domestic law tests will apply.
Using these changes, the IRD has published guidance seeking to amend long-standing practice in respect of foreign withholding taxes. Case law in Hong Kong SAR has stated that where an overseas tax is imposed on gross income that is also taxed in Hong Kong SAR, then the withholding tax is deductible as an expense incurred in generating that income. Nothing in the legislation has overturned the case law or updated the general principle on which the Board of Review reached its decision.
Clearly, where a treaty is in place, a credit should be available for the overseas tax and is in many cases likely to give a preferable outcome. In other cases, taxpayers will need to decide whether to adopt the IRD guidance or apply the law as it stands. It is unfortunate that they are being put in this position; if the IRD wishes to amend the law it should either legislate or take a case to a higher court for judgment. In any case, taxpayers will need to look at the potential impact of the changes on their tax positions.
The years to come are likely to be dominated by similar patterns to those recently seen, on the one hand making Hong Kong SAR an attractive hub both internationally and within the Greater Bay Area and, on the other, ensuring that its tax profile remains compatible with increasingly restrictive global standards.
Particular areas of focus may include developing a Hong Kong SAR funds vehicle and addressing how Hong Kong SAR's low-tax, source-based approach is affected by the roll-out of BEPS 2.0. The coming 12 months will also be a chance to see how the IRD approaches the new legislation in practice. Indeed, the ability to use the new legislation in a commercial context will be key to enabling Hong Kong SAR to cement its place as an international business centre.
Hong Kong SAR
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Curtis Ng is the regional tax partner-in-charge in the Hong Kong SAR office of KPMG China. He joined the Hong Kong SAR office in 1995 and became a tax partner in 2006. He is also the head of real estate of the Hong Kong SAR office.
Curtis is well versed in the complexities of delivering compliance and advisory services to multinational clients in various sectors. His experience includes a depth of experience in cross-border business activities, and coordination and liaison with specialists to provide the most efficient and effective services.
Curtis received his BSSc degree in economics. He is an associate member of the Hong Kong Institute of Certified Public Accountants (HKICPA), CPA Australia and Taxation Institute of Hong Kong. He is the vice chairman of the executive committee of the Taxation Faculty of the HKICPA. Curtis is also a certified tax adviser (Hong Kong) and a member of the committee on real estate investment trusts of the Securities and Futures Commission.
Hong Kong SAR
Tel: +852 2847 5092
Ivor Morris joined KPMG's Hong Kong SAR office in 2009 and became a tax partner in 2017.
Ivor has extensive experience of advising international investors in Europe and Asia. His experience includes assisting fund managers with investment into various sectors in Asia and advising on tax efficient financing and structuring for investment funds, as well as advising multinational organisations on restructurings and cross-border transactions.
Ivor graduated from the University of Cambridge. He is a fellow member of the Institute of Chartered Accountants in England and Wales. He is also a member of the British Chamber of Commerce real estate committee, and vice chair of the regulatory committee for the Asian Association for Investors in non-listed real estate vehicles (ANREV).