Hong Kong’s latest proposals on the tax certainty scheme for onshore equity disposal gains and expanded FSIE regime
Lewis Lu and John Timpany of KPMG China discuss the latest developments on the proposed tax certainty scheme for onshore gains from disposal of equity interests and the expanded foreign-sourced income exemption (FSIE) regime in Hong Kong.
The initial proposals
The Hong Kong SAR Government issued the following two consultation papers earlier this year to seek inputs from stakeholders:
To introduce a tax certainty scheme which includes a bright-line test for treating certain onshore equity disposal gains as capital in nature and non-taxable. For more details of the initial proposal on this scheme, please refer to KPMG’s publication in March 2023;
To expand the scope of the existing FSIE regime to cover foreign-sourced gains from disposal of assets (other than equity interests) – see KPMG’s publication in April 2023 for more details.
The key changes/clarifications
The Inland Revenue Department (IRD) recently conducted two engagement sessions with stakeholders to provide an update on these two proposed tax regimes:
The proposed tax certainty scheme
Definition of equity interest – in addition to being interest that carries rights to profits, capital or reserves, the interest must be accounted for as equity in the books of the investee entity;
The 15% ownership threshold can be counted on a group basis - i.e. equity interest held by the investor entity and its closely related entities (determined based on the “control test”) can be aggregated for meeting the 15% threshold;
Disposal in tranches is allowed but subject to a 24-month restriction – e.g. if the investor entity had held 15% of Co A shares for 24 months and then disposed the shares in three tranches (i.e. 5% for each tranche), provided that the second and third disposals were made within 24 months from the first disposal, the tax certainty scheme can still apply to the second and third disposals even though the holding percentage is less than 15% prior to these disposals; and
Trading stock is not to be counted for determining whether the 15% ownership threshold is met.
We are glad that the government has considered several recommendations made by stakeholders during the earlier consultation exercise to make the tax certainty scheme more business-friendly and practicable.
We understand that the IRD will continue to work on a number of issues related to the revised proposal. Based on our observations, some issues for further consideration are:
If trading stock needs to be excluded for counting the 15% ownership threshold, taxpayers may face an uncertainty on which portion (if any) of the equity interest held by them are regarded as “trading stock”; and
For disposal in batches, if the 24-month restriction is counted from the first disposal, it would mean holding the equity interest that remains after the first disposal for a longer (i.e. more than 24 months) period would result in the subsequently disposed interest not being eligible for the tax certainty scheme.
For more details, such as an illustrative example on equity interests previously regarded as trading stock for tax purposes, the application on cases involving a change of intention from trading stock to a capital asset, and observations on the proposed exclusions of property development and holding activity, please see KPMG’s full article via this link.
The proposed expanded FSIE regime
The carve-out for disposal gains of traders will apply to both disposal gains on equity interests and other types of assets but not intellectual property assets (where the nexus requirement applies), once the expanded FSIE regime becomes effective (from January 1 2024);
A trader refers to a person who sells, or offers to sell, property in its ordinary course of trade; and
The IRD will consider accepting other means of fulfilling the 75% threshold for association, in addition to via issued share capital; and
The relief will be revoked if these two conditions are not met: (1) both the transferor and the transferee are within the charging scope of Hong Kong profits tax for six years after the transfer and (2) the transferor and the transferee remain associated for two years after the transfer.
We welcome the apparent adjustment to the exclusion for disposal gains of traders whereby a reference to “substantial business activities in Hong Kong” is no longer made. While it is understandable for the trader to be within the charging scope of Hong Kong profits tax and for the FSIE regime to apply, the trader must be carrying on a trade or business in Hong Kong. A distinction between carrying on a trade or business in Hong Kong and performing the profit generating activities in Hong Kong suggests it is possible for a MNE entity to qualify for the trader exclusion in one hand, and make an offshore claim on its trading profits from disposal of assets in the other.
We also applaud the government’s positive response to the stakeholders’ request of considering other means of association for the purpose of the intra-group relief. That would cater for different forms of legal entity used by businesses in the commercial sector.
The government plans to introduce the tax bills on the above two regimes to the Legislative Council in October this year, with an aim to enact the bills by the end of this year and for the two regimes to take effect from January 1 2024.
KPMG will continue to provide our comments and suggestions to the government on how to deal with the outstanding issues of the proposed regimes and other possible enhancements to make the regimes more useful and practicable. Business groups that may be affected by the regimes should also take this opportunity to provide their inputs to the government.