Further to an article by KPMG China in April 2023, the draft legislation on the tax certainty scheme (the Scheme) for non-taxation of onshore disposal gains in Hong Kong SAR (Hong Kong) was enacted into law on December 15 2023.
Under the Scheme, a bright-line test with the equity holding conditions (i.e., an ownership threshold of at least 15% and a holding period of at least 24 months before disposal) will be applied to treat onshore equity disposal gains as capital in nature and non-taxable, subject to certain exclusions. For more details about the Scheme and KPMG’s comments on its key features (including a comparison with a similar scheme in Singapore), please refer to this KPMG publication.
The Scheme will apply to qualified onshore equity disposal gains from disposals occurring on or after January 1 2024.
KPMG observations
The introduction of the Scheme is a welcome move as it will provide enhanced certainty on non-taxation of capital gains from the disposal of equity interests.
A few observations on the practical interpretation and application of the Scheme are set out below.
1. Exclusion of equity interests regarded as trading stock
The exclusion of equity interests that “are regarded as trading stock for any period” from the Scheme may create some uncertainty among taxpayers, as illustrated in the below example:
Investor A (with a December accounting year end) acquired 20% of the equity interests in Investee B on 1 October 2022.
Investor A recognised an unrealised fair value (FV) gain on the equity interests for the accounting year ended December 31 2023.
Investor A has elected for the FV basis of taxation but did not include the unrealised FV gain or deduct any expenses in relation to the equity interests in computing its assessable profits for years of assessment (YOAs) 2022–23 and 2023–24 on the basis that any such amounts are capital in nature.
2022–23 and 2023–24 tax assessments were issued to Investor A based on the tax returns filed and no objection was lodged on those assessments so the assessments have become final and conclusive.
Investor A sold all equity interests in Investee B on October 1 2024 with an onshore disposal gain and made an election under the Scheme to treat the gain as non-taxable in YOA 2024–25.
Upon review of the 2024–25 tax return filed, the Inland Revenue Department (IRD) issued an additional assessment for 2023–24 treating the unrealised FV gain as taxable on the basis that it is revenue in nature.
In the above situation, if Investor A does not object to the 2023–24 additional assessment, the assessment would become final and conclusive and there is a risk that the equity interests would be regarded as trading stock from January 1 2023. On the other hand, if Investor A objects to the 2023–24 additional assessment, there is uncertainty as to whether its capital claim on the unrealised FV gain based on the badges of trade analysis would be successful and that would, in turn, affect its non-taxable claim on the disposal gain in YOA 2024–25 under the Scheme, pending the final outcome of the objection to the 2023–24 additional assessment.
Further clarification from the IRD on its approach to deal with the above situation would be helpful to taxpayers.
2. Disposal of equity interests in tranches – the long-held left-over exception
The Scheme contains an exception to the equity holding conditions to cater for the disposal of equity interests in tranches and where the investor entity’s equity holding in the investee entity falls below 15% after one or more earlier disposal(s). The IRD has included two examples on its website to illustrate the application of this exception, but those examples do not cover the scenario related to the third disposal in the following example.
Gains from the first disposal
The Scheme adopts the ‘first in, first out’ basis to deem the 24% equity interests disposed on February 1 2026 as part of the 30% equity interests acquired by the investor entity on January 1 2024. As such, the equity holding conditions are met.
Gains from the second disposal
Although at the time of the second disposal, the investor entity only held 14% of the equity interests in the investee entity and the equity holding conditions are not met, the long-held left-over exception applies such that the gains are treated as capital in nature and not taxable. This is on the basis that (i) the second disposal occurred within 24 months after the first disposal and (ii) the first disposal is a ‘Section 5(2) disposal’ (i.e., a disposal of equity interests to which the non-taxable capital treatment under the Scheme applies on the basis that the equity holding conditions are met for that disposal of those interests).
Gains from the third disposal
At the time of the third disposal, the investor entity only held 12% of the equity interests in the investee entity and the equity holding conditions are not met. A clarification from the IRD on whether the long-held left-over exception would apply to the third disposal is welcomed.
The key issue is whether the second disposal, of which the non-taxation treatment of the gains is based on the long-held left-over exception rather than meeting the equity holding conditions, is regarded as a Section 5(2) disposal. In the above example, the long-held left-over exception does not apply to the third disposal by referring to the first disposal as a Section 5(2) disposal because the third disposal occurred more than 24 months after the first disposal.
