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Hong Kong SAR: IRD issues guidance on ship leasing tax concessions

The PTA's approach is based on a trial and error method

Lewis Lu and John Timpany of KPMG analyse the impact of the ship leasing concessions on taxpayers.

The Inland Revenue Department (IRD) issued an updated guidance, Departmental Interpretation & Practice Notes No. 62 (DIPN), setting out its views on the concessionary tax treatment for: (i) qualifying ship lessors; and (ii) qualifying ship leasing managers in Hong Kong SAR.

Lease vs ship operator

One of the biggest concerns of the new rules was that the envisaged segregation of the activities of ship owners into ‘pure leasing’ and ‘ship operating’ is not as clear. Many ship owners engage in a range of activities, seeking to maximise the return on their vessels in whatever ways they can, according to the nature of the market at different points in time. The nature of the market in recent years has tended to require greater flexibility on the part of ship owners to consider short-term charters or taking on greater operational risk.

The legislation sought to impose an all-or-nothing test, posing problems for more complex businesses. The DIPN reiterates that ship operators are not eligible for the exemption and that to be eligible, a lessor must be acting as a standalone corporation engaging solely in ship leasing activities. It makes clear that the provisions can apply to both wet and dry leases.

Although not addressed in the DIPN, the IRD has indicated in correspondence with concerned parties that some leasing arrangements may continue to fall within section 23B. In particular, the IRD has stated that where a ship operator generates income from leasing a ship on a voyage charter or a time charter fully equipped, crewed and supplied, this will be treated as income of the ship operator’s ship operations. Income from bare boat charters, which are an incidental or ancillary activity of the ship operator, may continue to be assessed in accordance with section 23B.

The test set out in the IRD’s correspondence is not straightforward and leaves room for interpretation. Nevertheless, it does appear that the IRD has accepted that there is a need for flexibility in the application of the two sets of rules in order to avoid the situation where a taxpayer ends up paying tax despite conducting business which is supposed to fall entirely outside the tax net. The exact application of the rules and how best to apply them is likely to vary from business to business, and ship owners should pay careful attention to this. The best way to obtain certainty is to apply for a ruling.

Substance requirements

It is a condition of the concession that central management and control be exercised in Hong Kong SAR. The DIPN stresses the role of day-to-day work by the directors in Hong Kong SAR. Given the wider substance requirements, it is not clear why this should be an area of focus, and the IRD’s comments seem to go beyond what is often considered necessary for demonstrating a place of effective management.

Anyone claiming the concession is required to have substance in Hong Kong SAR. This consists of at least two full-time employees in Hong Kong SAR with appropriate qualifications (one employee for ship leasing management) and at least $7.8 million of operating expenditure in Hong Kong SAR ($1 million for ship leasing management). In addition, the number of employees and the amount of the expenditure must be adequate in the opinion of the assessor and they must undertake the business’s core income generating activities (CIGAs) in Hong Kong SAR.

The CIGAs for ship leasing activities include agreeing funding terms, identifying or acquiring ships to be leased, setting the lease terms and duration, monitoring or revising any funding agreements and managing any risks associated with leases.

The IRD helpfully notes that a wide range of expenditure will be regarded as operating expenditure including staff costs, rental and admin costs. It also includes any finance costs directly related to the acquisition of a ship for use in the leasing business. Importantly, provided the loan is taken out for the purpose of acquiring a ship for use in a Hong Kong SAR ship leasing business, the IRD will accept that it is incurred in Hong Kong SAR even if it is borrowed from an overseas financial institution.

The IRD has said that it will not allow depreciation on the vessel to be included as operating expenditure on the basis that the ship is used for earning lease payments but not for carrying out CIGAs. It is a little hard to follow the logic here, given that they have accepted that interest payments on loans taken out to acquire the vessel can be included. Nevertheless, it is unlikely many lessors will need to rely on depreciation to meet the threshold, provided they have incurred sufficient interest expense.

The comments on the adequacy test are concerning. The Commissioner will view each case on its facts and circumstances, taking into account a range of factors and would deny any tax benefit that seems disproportionately large relative to the number of employees employed and the amount of operating expenditure incurred in Hong Kong SAR.

KPMG observations

The IRD has provided some clarifications on its interpretation of the legislation, although a number of uncertainties remain. Given the complexity of the arrangements and the IRD’s form on applying concessionary rates, taxpayers should review their business models to ensure compliance and consider seeking a ruling to ensure their proposals are in line with the IRD’s view.

Lewis Lu



John Timpany




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