A proposed tax certainty scheme for capital claim on onshore equity disposal gains in Hong Kong
Lewis Lu and John Timpany of KPMG China discuss the bright-line test to be introduced for treating certain onshore equity disposal gains as capital in nature and non-taxable.
On March 23 2023, the Hong Kong SAR government issued a consultation paper entitled “Enhancing Tax Certainty of Onshore Gains on Disposal of Equity Interests”, which proposed to introduce a tax certainty enhancement scheme for onshore equity disposal gains.
The paper is partly in response to the stakeholders’ recommendation that an objective test be introduced to determine whether onshore equity disposal gains are capital in nature and non-taxable in light of the revised foreign-sourced income exemption (FSIE) regime that became effective in Hong Kong on 1 January 2023. The recommendation results from offshore equity disposal gains being deemed as taxable when received in Hong Kong unless the relevant requirements/conditions are met under the FSIE regime, and a capital claim no longer being applicable to such offshore gains.
The proposed tax certainty scheme
Basic conditions for non-taxation
Under the proposed scheme, onshore equity disposal gains derived by an investor entity would be regarded as non-taxable without the need to conduct the ‘badges of trade’ analysis if the following condition is met: “An investor entity must have held at least 15% of the total equity interest in the investee entity for a continuous period of at least 24 months ending on the date immediately prior to the date of disposal of such interest”.
The scheme offers an alternative option for taxpayers to make a non-taxable claim for their onshore equity disposal gains. Failing to meet the above-mentioned conditions under the scheme, taxpayers could still make a capital claim on the disposal gains based on the principles established by case law to ascertain whether income is capital or revenue in nature. For investment funds, an additional alternative option for enjoying non-taxation of their onshore equity disposal gains is the tax exemption under the unified fund exemption regime, provided that the specified conditions under the regime are met.
Eligible investor entities
Eligible investor entities (1) include a legal person (other than a natural person) and an arrangement that prepares separate financial accounts, such as a partnership and a trust, and (2) can be a Hong Kong or non-Hong Kong resident.
Eligible equity interests
The scheme is applicable to onshore gains from the disposal of different forms of equity interests – for example, ordinary shares, preference shares (but not including those accounted for as a financial liability under the applicable accounting principles) and partnership interests – subject to the exclusions discussed below. The investee entity can be incorporated or established in or outside Hong Kong.
Exclusions from the scheme
The following exclusions apply:
Excluded investor entities – insurers are not an eligible investor entity and gains on the disposal of equity interests by an insurance business will not be covered by the scheme.
Excluded equity interests – special rules apply to exclude gains from the disposal of equity interests in certain investee entities engaged in property trading, property development and property holding from the scheme. Please refer to the diagram below for details.
Equity interests that have previously been regarded as trading stock for tax purposes in accordance with the badges of trade analysis will be excluded from the scheme.
Tax treatment of equity disposal losses
The scheme will not affect the existing tax rule whereby the nature (i.e., capital versus revenue) of onshore losses from the disposal of equity interests will continue to be determined based on the badges of trade analysis.
The timeline is as follows:
Consultation period – March 23 2023 to May 22 2023;
Introduction of the amendment bill into the Legislative Council – second half of 2023; and
Effective date of the scheme – 1 January 2024.
KPMG is glad to see that the Hong Kong SAR government has responded to stakeholders’ (including KPMG’s) recommendation of introducing objective criteria for treating onshore equity disposal gains as capital in nature and non-taxable to enhance tax certainty in Hong Kong.
Subject to the details of the legislative amendments being released, the following are some of the potential issues arising from the proposed scheme that would need to be considered:
Whether there will be a ‘beneficial ownership’ requirement and if yes, how to assess the beneficial owner status of the equity interests.
A business group may set up a special purpose vehicle (SPV) to hold an immovable property (and no other assets) that is rented out for rental income. The SPV may only be engaged in property holding and not property development. Subject to further clarification, it appears that the SPV would be excluded from the scheme because the exception to the proposed exclusion of investee entities engaging in property development does not apply to it and it is regarded as an investee entity engaged in property holding.
The exclusion of equity interests previously treated as trading stock from the scheme suggests that if there is a change of intention in holding the (remaining) equity interests from trading to long-term investment purposes, the investor entity cannot rely on the scheme and has to make a non-taxable claim for future disposal of the remaining equity interests based on the badges of trade principles.
For further analysis of the proposed scheme, such as (1) its interaction with the global minimum top-up tax under BEPS 2.0 and (2) a comparison with the relevant tax exemption offered by Singapore, please see KPMG’s publication here.