Hong Kong's network of comprehensive DTAs
Hong Kong has expanded its network of DTAs to 29 with the signing of agreements with Italy, Guernsey and Qatar in January, April and May 2013 respectively. The agreements with Kuwait and Jersey became effective in July 2013, bringing the total number in force to 25. Negotiations are underway with a number of other jurisdictions, including South Korea, India and South Africa.
The development of Hong Kong's DTA network continues to enhance its position as a regional investment and trading hub. Hong Kong continues to look for new treaty partners to expand its network of double tax treaties further. However, it should, where possible, prioritise DTAs with its major trading partners such as Germany, the US, Australia and Taiwan, as well as countries in South America and Africa, which all remain the focus of Chinese outbound investment.
The Inland Revenue and Stamp Duty Legislation (Alternative Bond Schemes) (Amendment) Ordinance 2013 was enacted in July 2013. The ordinance, which amends the Inland Revenue Ordinance (IRO) and Stamp Duty Ordinance (SDO), places common types of Islamic bonds on a level playing field with the taxation of conventional bonds, thereby removing a perceived impediment to the development of a Sukuk market in Hong Kong.
The legislation was preceded by a consultation in March 2012 on the proposed amendments and was a policy initiative first articulated by the SAR [Special Administrative Region]'s chief executive in his 2007 policy address and most recently by the financial secretary in the Hong Kong Budget for 2012-2013. The legislation reflects the importance attached by the government to support alternative financing arrangements such as Islamic finance.
As the leading financial services centre in the Asia-Pacific region, Hong Kong is committed to ensuring that it has a legal and tax framework to support the development of Islamic financing in the region. The introduction of Islamic finance in Hong Kong will help diversify its financial platform and add to the breadth and depth of its financial market by widening the spectrum of financial products and range of market participants. This will, in turn, reinforce Hong Kong's position as an international finance centre.
The ordinance does not confer special tax concessions on the Islamic finance sector, but ensures that financial instruments of similar economic substance are afforded similar tax treatment. In addition, it does not make specific references to Shariah terminology, but adopts a religion-neutral approach using the term "alternative bond scheme" (ABS), rather than Sukuk, to denote the arrangement to which the proposed tax treatment will apply.
Four types of investment arrangements are specified that correspond to the different underlying structures by which investment returns are generated in the five most common types of Sukuk in the global market. The types of investment arrangements specified are:
- a lease arrangement (Ijarah) where a bond issuer enters into a lease for an acquired asset with an originator to generate an investment return;
- a profit sharing arrangement (Musharakah and Mudarabah) where a bond issuer enters into a business undertaking with an originator to carry on business activities to generate an investment return;
- a purchase and sale arrangement (Murabahah) where a bond issuer sells an acquired asset to an originator with a markup to generate an investment return; and
- an agency arrangement (Wakalah) where a bond issuer appoints an originator as its agent to manage an acquired asset to generate an investment return.
The ordinance also contains a provision to empower the financial secretary to expand the coverage of eligible ABS, by way of subsidiary legislation in the future.
The ABS must satisfy certain conditions to be a "qualified bond arrangement". These conditions are that the ABS must: (i) generate a reasonable commercial return; (ii) the bond arrangement represents a financial liability; (iii) there is a Hong Kong connection; (iv) the ABS has a maximum term of 15 years; and (v) overall, the arrangements must be performed according to the terms.
The new rules also contain safeguards to minimise tax avoidance and to ensure the ABS has a nexus with Hong Kong, thereby promoting the territory's financial market development.
The rules also provide for extended record-keeping requirements. They are obliged to inform the commissioner of Inland Revenue and the Collector of Stamp Revenue of any disqualifying event, which may lead to a withdrawal of the relief granted in its entirety under the IRO and SDO. The time limits for raising additional profits tax assessments/recovery of stamp duty are also extended where a disqualifying event occurs.
Tax information exchange agreements
The Inland Revenue (Amendment) (No 2) Ordinance 2013, enacted in July 2013, allows Hong Kong to enter into stand-alone TIEAs with other jurisdictions. Before the enactment of this legislation, Hong Kong's position was that it was only prepared to exchange tax information in the context of a broader DTA.
The legislation was introduced after a recommendation of the OECD's Global Forum on Transparency and Exchange of Information for Tax Purposes (the global forum) which conducted a Phase 1 review of Hong Kong in 2011. The review strongly recommended that Hong Kong introduce legislation allowing it to enter into stand-alone TIEAs. In particular, the OECD noted Hong Kong's policy to agree to the exchange of tax information only in the context of a DTA and not to enter into TIEAs. Given Hong Kong's importance as an international financial centre, the global forum considered it essential that Hong Kong enters into agreements (regardless of their form) that meet the international standard on the exchange of tax information (the international standard) with all relevant partners.
Hong Kong went through a Phase 2 review by the global forum which examined how well its legal framework for exchange of tax information does in practice. The review assigned a rating both for its compliance with each element of the global forum's terms of reference as well as an overall rating. The ratings were applied on the basis of a four-tier system: compliant, largely compliant, partially compliant or non-compliant and were finalised by the global forum at its plenary meeting in Jakarta in November 2013.
Had Hong Kong not introduced the legal framework for TIEAs, there was a risk that it would be labelled an uncooperative jurisdiction. Such an outcome would have been detrimental to its international reputation and could have undermined Hong Kong's position and competitiveness as an international business and financial centre.
A TIEA will allow Hong Kong to exchange information in relation to any tax imposed by the laws of Hong Kong and the other jurisdiction. The coverage of the types of taxes that are covered by the existing exchange of information (EoI) agreement is expanded from direct taxes or similar types of taxes, to taxes of any type. In the case of Hong Kong, direct taxes are limited to profits tax, salaries tax and property tax whereas other jurisdictions generally have a broader range of taxes. The government has indicated that it will seek to list in the relevant DTA/TIEA details of the types of taxes that are subject to EoI.
The ordinance also enhances the existing EoI arrangements which Hong Kong can incorporate into a DTA. Under the new provisions, information can be exchanged and used for other non-tax related purposes if such use is permitted under the laws of both jurisdictions and the competent authority of the supplying party authorises such use.
The commissioner of Inland Revenue's powers have also been extended to include not only tax information in a person's possession, but also to tax information in a person's control. In the future, however, the commissioner will be able to obtain information, which is in the control of a person, even if the information may be in another jurisdiction. It remains to be seen how 'control' in this context will be interpreted.
The limitation on disclosure of information relating to a period before the relevant agreement has taken effect has also been relaxed. In future, the commissioner will be allowed to disclose tax information generated before the effective date of the relevant DTA or TIEA where he is satisfied that the information relates to the carrying-out of the provisions of the relevant arrangements. The government has also indicated that it will continue to adopt a policy of imposing a limitation on information to be exchanged. Information to be exchanged must relate to the carrying-out of the provisions of the relevant agreement or the administration or enforcement of the tax laws of the DTA/TIEA partner concerning taxes imposed in the periods after the agreement came into effect. Examples of the type of information that may be exchanged under this provision, relate to the identity of individual taxpayers or information concerning transactions, which occur after the DTA/TIEA comes into operation, for instance, details of the original purchase price of an asset purchased before, but subsequently sold after the effective date of the arrangement.
Even with these amendments, Hong Kong will still only meet the minimum requirements of the 2012 version of the EoI article of the OECD's model tax convention. For example, it will neither entertain requests for tax examinations abroad nor will it provide assistance in the collection of taxes.
However, the enactment of the Bill demonstrates Hong Kong's commitment to implementing the internationally agreed standards of transparency and exchange of tax information and is further evidence that it is a cooperative jurisdiction. In the future, the tax information to be exchanged under a DTA/TIEA will have a broader coverage and the commissioner will have wider powers to collect and disclose tax information.
One concern that the enactment of the legislation raises is whether there will be sufficient incentive for jurisdictions to enter into a DTA with Hong Kong when they can obtain tax information under a TIEA. There are good reasons why Hong Kong should conclude TIEAs with jurisdictions such as the Cayman Islands and the British Virgin Islands. However, it is important that Hong Kong continues with its efforts to conclude DTAs with its major trading partners.
At this point, it should also be noted that the international tax landscape continues to evolve. In June 2013, an OECD report, prepared at the request of the G8, outlined a number of steps required to put in place a model agreement on automatic EoI. This followed the endorsement in April 2013 by the G20 finance ministers and central bank governors of automatic EoI of taxes as the expected new standard, rather than exchange of tax information on request. In June 2013, the OECD presented a report to the G8 summit on delivering a standardised and global model of automatic exchange and it is likely that at some time in the future, Hong Kong will come under pressure to comply with this new standard.
Base erosion and profit shifting
In July 2013, the OECD produced, at the request of the G20, an action plan on base erosion and profit shifting (BEPS). This action plan follows a call by the G20 finance ministers for the OECD to develop one to provide governments with the domestic and international instruments to prevent corporations from paying little or no tax and address BEPS in a coordinated and comprehensive manner. The action plan arose from concerns that the development and interaction of domestic tax laws by sovereign states does not deal adequately with the way in which globally integrated groups operate and structure their tax affairs.
Rapid globalisation has resulted in the increased integration of businesses, domestic economies and markets. This integration has been accompanied by operating models that have progressed from country-specific models to globally integrated ones with functions centralised at a regional or global level. Against this background, there is a consensus that tax reform is required to achieve tax symmetry between jurisdictions.
BEPS strategies in themselves are not illegal, but take advantage of rules which do not reflect an environment where intangibles and risk management are of increasing importance. As a result, many governments have concerns that tax planning arrangements allow global organisations to take advantage of the interaction of domestic tax laws and perceived weaknesses in international tax rules, leading to double non-taxation or less than single taxation. These outcomes principally arise because domestic or international tax rules are not seen as taxing profits adequately in accordance with where the economic interests or value creating activity occurs.
Globally the OECD report on BEPS has had a noticeable impact on raising the debate on the topic of harmful tax practices. Neither Hong Kong nor China will be immune from the outcome of the OECD's initiatives on BEPS and businesses in the region cannot ignore the discussion. It is also notable that China has recently signed the Multilateral Convention on Mutual Administrative Assistance in Tax Matters, which means that all G20 countries have now signed the convention. China has also come out in support of the OECD's initiatives on BEPS.
The OECD's report contains 15 broad actions designed to address a number of areas of perceived harmful tax practices. The report highlights key areas such as:
- arrangements which may involve shifting profits to locations with more favourable tax rules;
- the differences in tax treatment applied to similar types of transactions in different countries;
- the effectiveness of current transfer pricing methodologies; and
- the application of tax treaty concepts to modern business operating models.
Businesses will therefore need to monitor these developments carefully to evaluate the potential impact on their business models as the debate evolves.
While the action plan is in its consultative phase, the general direction and the broad types of recommendations that are likely to come out of the OECD's review seem clear. However, there is still time for taxpayers to review their arrangements and structures and where necessary, modify existing arrangements and structures to better align with the general principles outlined in the action plan.
If broad consensus can be achieved, the BEPS developments could lead to a fundamental overhaul of how global profits are taxed in the future. Companies should review their existing business structures, operating models and transfer pricing policies against the OECD's initiatives to ensure they are sufficiently robust to withstand any scrutiny of the tax authorities in the jurisdictions in which they operate. The impact of the action plan is likely to result in:
- increased disclosure obligations on taxes;
- more scrutiny of transfer pricing methodologies particularly where payments are not taxed at all and closer scrutiny of transactions with tax haven jurisdictions; and
- more attention being paid to whether payments of dividends, interest and royalties qualify for the benefit of lower withholding tax rates under double taxation agreements.
The OECD's review of BEPS should not have an adverse impact on Hong Kong's status as an international financial centre. Hong Kong will remain a global financial centre due to its geographic location, business friendly environment and stable rule of law. However, the worldwide tax environment is undergoing change and there is a debate about jurisdictions receiving a fair share of tax revenues as part of the wider corporate social responsibility agenda. To the extent a company's tax strategies are viewed by the public as overly aggressive or unfair, a company may also risk suffering reputation damage.
The action plan relies heavily on the ability to build a consensus-based framework. Given the number of jurisdictions involved and the historic use of fiscal policies to attract foreign direct investment, achieving success will be an ambitious task.
As a member of the global forum, Hong Kong should take an active role in the discussions and in formulating the recommendations from the review. Hong Kong is an open economy, a well established international financial centre, and a jurisdiction in which many multinationals have established their regional operations. It is therefore imperative that the government engages with the international community in this debate.
One interesting question for Hong Kong is whether the work on BEPS will lead to any change to Hong Kong's territorial basis of taxation. Is it possible that in the future a territorial basis of taxation would be regarded as a harmful tax practice in the new global landscape? And what will be the impact on the application of benefits under Hong Kong's double taxation agreements benefits?
Tax Partner in Charge of Hong Kong SAR
Ayesha Lau is a partner with KPMG China and is the partner in charge of tax services in Hong Kong. She has been a specialist in the tax field for more than 20 years, initially with KPMG in London before joining KPMG in Hong Kong.
Ayesha is a regular speaker and writer on tax matters and is the co-author of "Hong Kong Taxation: Law and Practice" (Chinese University Press), a leading textbook on Hong Kong taxation.
Ayesha was the chairperson of the Hong Kong Institute of Certified Public Accountants' Taxation Faculty executive committee and its former taxation committee. She is a member of the Joint Liaison Committee on Taxation. She was elected as a member of the 2011 Election Committee for the Accountancy subsector.
Ayesha is passionate about community service and has been appointed by the Hong Kong SAR Government as a member of various advisory bodies. Ayesha has served on the Lump Sum Grant Independent Review Committee, the Taskforce on Economic Challenges, the Women's Commission and the Financial Reporting Review Panel of the Financial Reporting Council.
Darren Bowdern is a partner in corporate tax. For more than 19 years, he has been involved in developing appropriate structures for investing into the Asia Pacific region, tax due diligence reviews in connection with M&A transactions and advising on cross-border transactions.Many of these projects comprise tax effective regional planning including consideration of direct and indirect taxes, capital and stamp duties, withholding taxes and the effective use of double taxation agreements. He also advises on establishing direct investment, private equity and other investment funds in Hong Kong.
Darren has a bachelor of commerce degree from the University of Melbourne and is a fellow of the Hong Kong Institute of Certified Public Accountants and a member of the Institute of Chartered Accountants in Australia.
Senior Tax Adviser
Garry Laird is a senior tax adviser with KPMG. Before joining the firm he was a tax specialist for over 30 years, initially with the Australian Taxation Office before joining the Inland Revenue Department (IRD) in Hong Kong. His responsibilities with the IRD included the preparation of departmental interpretation and practice notes, examination of advance clearance applications, negotiation of double taxation agreements and assisting in the introduction of new tax legislation.
Garry advises clients on a wide range of technical issues and has assisted clients in obtaining tax clearances from the IRD on a range of issues, such as Islamic financing, source of profits and the deductibility of interest expenses.
He is the co-author of Hong Kong Taxation Law & Practice. Garry holds a bachelor of economics degree from the University of Tasmania.