In recent years, the OECD's BEPS project has been one of the fundamental drivers for countries to revise their tax policies. This will have a substantial impact on how businesses and multinational enterprises (MNEs) operate, and creates additional tax uncertainty for taxpayers. In addition, major economies such as the US and the UK are cutting their corporate tax rates to make their regimes more competitive globally. As a result of these trends, Hong Kong cannot rely on its simple and low-tax regime to attract investment.
The most important change to Hong Kong tax law in recent years is the introduction of the new BEPS and TP regime. The new TP regime codifies the OECD's arm's-length principle and documentation requirements, and affirms Hong Kong's commitment to implementing the measures set out under the OECD's BEPS project.
Over the past year, the Hong Kong government has stepped up its roll-out of tax policies to enhance Hong Kong's competitiveness, as promised in Chief Executive Carrie Lam's policy address in October 2017. One of the important changes in this direction is the introduction of a proposed enhanced R&D tax regime. This represents an important move by the Hong Kong government to encourage more R&D activities to be carried out in Hong Kong.
In this article, we will discuss the various tax changes in Hong Kong and the impact they have on businesses.
Transfer pricing regime
On July 13 2018, Hong Kong's new TP regime was enacted. It introduces a formal TP regime and TP documentation requirements, and will have retrospective application for years of assessment commencing on or after April 1 2018. The key points most worth noting are:
- Certain domestic transactions have been excluded, subject to certain conditions being fulfilled; and
- The documentation thresholds (in particular, the thresholds on the business size test) have been relaxed to alleviate the burden on smaller Hong Kong businesses of proving their compliance with the arm's-length principle.
While TP is still relatively new to Hong Kong, most of Hong Kong's trading partners have already implemented and updated their own TP rules since the OECD's BEPS Action Plan deliverables were finalised in 2015. The Inland Revenue (Amendment) (No 6) Ordinance 2018 (BEPS and TP Ordinance) is lengthy and relatively complex, which leads to uncertainties in interpretation and practical application.
Specific provisions defining a permanent establishment (PE) have also been introduced. Transfer pricing rules would apply to any non-resident who has a PE that carries on a business in Hong Kong. The authorised OECD approach (AOA) will be used to determine the income or loss attributable to a PE. However, only profits attributable to the PE that have a Hong Kong source will be subject to tax. The AOA will give the Inland Revenue Department (IRD) the power to assess a Hong Kong branch of a foreign corporation on the income attributed to the branch as if it is a distinct and separate entity. This is particularly relevant to financial institutions and insurance companies that typically maintain branches in Hong Kong. Given that PE profit attribution is rather complex, the application of the principle is deferred until the year of assessment commencing on or after April 1 2019. The IRD will clarify uncertain issues in an upcoming departmental interpretation and practice note (DIPN).
Another key change is the introduction of a deeming provision to target situations where a person in Hong Kong carries out value creation activities, such as development, enhancement, maintenance, protection or exploitation (DEMPE) functions in Hong Kong in respect of intellectual property (IP) but the income accrues to a non-resident. Local tax authorities will seek to put a value to DEMPE contributions by people in their own jurisdictions, against those elsewhere in the supply chain of the group. Differences of opinion between tax authorities may lead to double taxation. The existing wording of the deeming provision also creates a potential risk of double taxation, even though the IRD has reiterated that a person would not be subject to double tax in respect of the same income from any IP. The deeming provision remains silent on this.
Given the complexity surrounding its application, the effective date of this rule is deferred until April 1 2019. Clarifications by the IRD will be provided in due course. In the meantime, Hong Kong taxpayers will need to get prepared and have a clear view of where they think the value-added DEMPE functions are performed and how these functions contribute to the value of intangible assets.
Going forward, as taxpayers will be required to provide additional information to tax authorities, this may lead to cross-border tax disputes and result in substantial tax adjustments and potential double taxation. Global and Hong Kong businesses must have the flexibility to accommodate BEPS-related and TP changes in the coming years. In particular, the area of related-party transactions is one that is frequently scrutinised by tax authorities in Hong Kong and the region. Hong Kong taxpayers must therefore carefully revisit their TP policies and their related-party transactions with respect to their supply chains and related-party use of intangibles, to ensure that these remain appropriate for their group in Hong Kong and abroad, before deciding how to comply with the new TP regime.
The MCAA and MLI
In recent years, international tax cooperation has greatly intensified. As a result, effective from September 1 2018, the Multilateral Convention on Mutual Administrative Assistance in Tax Matters (Convention) will enter into force to allow Hong Kong to effectively implement the automatic exchange of financial account information in tax matters (AEOI) and to combat BEPS on a multilateral basis. Hong Kong has now become a signatory to both the MCAA on AEOI and the MCAA on country-by-country reporting (CbC MCAA), both of which have their legal basis in the Convention. By becoming a party to the MCAA, Hong Kong will be able to select other signatories with which it intends to enter into automatic exchange of information relationships (rather than having to negotiate individual agreements with states bilaterally).
In addition, many of the BEPS action points cannot be implemented without amending the tax treaties. As such, the multilateral instrument (MLI) was developed to swiftly modify bilateral tax treaties to implement tax treaty-related BEPS recommendations, such as the measures on treaty abuse set out in the BEPS Action 6 report. These include the principal purpose test (PPT), a simplified limitation on benefits (LOB) article, or a more complex LOB accompanied by either an anti-conduit rule or a PPT. Hong Kong has opted, through the MLI, to adopt the PPT only. The PPT denies treaty benefits if it is reasonable to conclude that obtaining a treaty benefit was one of the principal purposes of a transaction.
As of today, Hong Kong has entered into comprehensive double tax agreements (DTAs) with 40 tax jurisdictions (with the most recent being Finland). In June 2017, China became a signatory of the MLI and Hong Kong has obtained endorsement of the central government to extend the application of the MLI to Hong Kong's DTAs. It is expected that most of Hong Kong's DTAs will be covered by the MLI. However, the number of DTAs to be covered by the MLI will depend on whether Hong Kong's treaty partners are parties to the MLI and whether they will place their DTAs with Hong Kong under the coverage of the MLI.
In light of these changes, as Hong Kong is a common jurisdiction for MNEs to set up their regional holding companies, MNEs will need to ensure that their holding companies in Hong Kong have reasonable business purposes in order to enjoy the benefits under the Hong Kong DTA. Further, Hong Kong companies with cross-border transactions should also revisit their existing operating structures in Hong Kong, taking into account the MLI positions adopted by Hong Kong but also those adopted by Hong Kong's tax treaty partners.
R&D tax incentives
To boost Hong Kong's competitiveness and to promote more R&D activities being carried out in Hong Kong, the Hong Kong government proposed an enhanced R&D tax deduction. Once enacted, the new R&D tax regime will have retroactive effect for any expenditure incurred on or after April 1 2018.
This is a welcome tax incentive that will provide Hong Kong with a competitive advantage in promoting R&D activities to be carried out in Hong Kong. There are, however, a number of conditions that need to be satisfied in order to qualify for the enhanced tax deduction.
In order for the taxpayers to qualify for the enhanced R&D tax deduction, the bill broadly categorises R&D expenditure into two categories (Type A and Type B expenditures), which are deductible subject to meeting certain conditions. The bill is awaiting the Legislative Council's final approval.
Type B expenditure qualifies for the enhanced two-tiered tax deduction:
- A 300% tax deduction for the first HK$2 million ($255,000) of qualifying expenditure incurred by the enterprise, i.e. expenditure incurred by enterprises for in-house qualifying R&D, and payments made to 'designated local research institutions', i.e. outsourced qualifying R&D; and
- A 200% tax deduction for the remaining amount.
The critical element required to qualify for Type B expenditure is that the R&D activity is wholly undertaken in Hong Kong and generally only applies to those R&D activities that seek to achieve scientific or technological advancement and involve the resolution of some scientific or technological uncertainty.
Broadly, in order for expenditure on a qualifying R&D activity to be deductible, it must be incurred in relation to the Hong Kong taxpayer's business and must be:
i) paid to a designated local research institution; or
ii) an expenditure in relation to an employee engaged directly and actively in a qualifying R&D activity.
However, there are some exclusions where no R&D deduction is allowed. This includes where the R&D expenditure is undertaken for another person, where any rights generated from the R&D activity are not fully vested in the person who pays for it, or the costs are met by the government or another person. Certain activities are also excluded from qualifying as Type B expenditure, such as feasibility studies or market, business or management research.
Type A expenditure qualifies for a basic 100% tax deduction and includes a wider range of expenditure including payments to third parties, activities undertaken outside Hong Kong and capital expenditure.
Going forward, many Hong Kong companies will find that they are conducting quality R&D activities as part of their product and process improvement activities. It is important that there are systems and processes in place to correctly identify projects and classify their R&D expenditure in order to claim the new benefit. In addition, Hong Kong companies that are planning to engage in R&D activities in and/or outside Hong Kong should plan ahead and assess how to best structure their R&D arrangements in order to benefit from the enhanced R&D tax deductions.
Open-ended fund company (OFC) regime
The Hong Kong government recognises that the asset management industry is a fast growing sector within the financial services industry. The OFC regime will provide fund managers with the option of setting up a fund in the form of a Hong Kong company and is a key initiative to help diversify Hong Kong's fund domiciliation platform.
Broadly, an OFC is an open-ended collective investment scheme that is intended to operate as an investment fund vehicle managed by a professional investment manager. The OFC is set up in the form of a limited liability company but with the flexibility to create and cancel shares for investors' subscriptions and redemptions (which is not possible at the moment in the case of conventional companies).
However, the rules surrounding the OFC regime are complex and have a number of issues. Some of the key challenges include:
- The ordinance is silent on the stamp duty implications associated with an OFC. Under the prevailing Hong Kong stamp duty law, the allotment and cancellation of Hong Kong stocks (e.g. shares of an OFC) are not subject to stamp duty. However, the transfer of stocks of an OFC would be subject to stamp duty;
- The OFC must continue to pass the non-closely held test for 24 months after the first 24-month grace period beginning from foundation of the company. If not, the OFC will be taxable retrospectively from its start-up date;
- For carried interest distributions, there is a provision that deems dividends from a non-exempt OFC to be taxable to the extent they are in relation to services rendered in Hong Kong. It does not take into account any circumstances giving rise to a carry distribution in connection with an investment in the OFC; and
- The exemption does not apply to transactions in certain tainted assets, including gains on shares in companies where the underlying value includes Hong Kong real estate or substantial 'short-term assets'.
Given the relatively onerous and complex conditions that must be satisfied to qualify for the benefits, this is a missed opportunity and we expect little application of the regime in practice. Further enhancements are therefore required to make the regime more business friendly.
Two-tier profits tax regime
As part of the Chief Executive's promise to put tax reform on her agenda, the beginning of 2018 saw the introduction of a two-tier profits tax regime. Under the two-tier profits tax system, the first HK$2 million of assessable profits of corporations and unincorporated businesses will be taxed at one-half of the prevailing standard rates (i.e. 8.25% and 7.5% respectively), and the remaining profits will continue to be taxed at the prevailing tax rates of 16.5% and 15%. There are anti-fragmentation measures where only one company in the group of companies can be nominated to benefit from the progressive rate for a given year of assessment. This tax incentive is particularly aimed at small and medium-sized enterprises to help relieve their tax burden.
Taxpayers who have elected into other preferential half-rate tax regimes (e.g. professional reinsurance companies, captive insurance companies, corporate treasury centres and aircraft leasing companies) are excluded from the two-tier tax regime.
Shipping lease incentive
The maritime industry has traditionally been one of the pillar industries of Hong Kong but this has changed in the past decade. Given the importance of the Belt and Road and the Greater Bay Area initiatives, the development of the maritime industry should be a key focus for the Hong Kong government. In order to revive this industry and to further enhance Hong Kong as a location for shipping business, some of the key recommendations that have been proposed by the Financial Services Development Council include:
- Capture more commercial principals, capital providers and lessors who are willing to base meaningful activities in Hong Kong by allowing qualified investors to access market-ready credit and liquidity enhancement products;
- Encourage the growth of shipping and maritime-related support and management services by providing tax concessions (such as a reduced tax rate of 8.25%) where relevant businesses activities such as maritime and ship leasing management and maritime and shipping-related supporting services activities are carried out in Hong Kong; and
- Conclude more double tax agreements with major shipping jurisdictions, in particular, with Brazil and Australia.
Further tax incentives and proposals
The Hong Kong government has introduced various tax changes this year. Some of these affirm Hong Kong's commitment to boosting Hong Kong's competitiveness and set the scene for further changes to come in the near future.
While the Hong Kong government is committed to introducing tax policies, the IRD may not always implement tax rules which are in line with the spirit of the Hong Kong government's policy, which may present difficulties for businesses to overcome. In view of further tax changes to come, businesses must review and assess their current capabilities and remain flexible to adapt to change.
Various industry and professional bodies in Hong Kong have also called for the government to introduce tax incentives to promote and diversify the economic development of Hong Kong. Some of the key tax proposals include:
- Using tax measures to foster the ship leasing business in Hong Kong and providing tax relief to promote the development of marine insurance and the underwriting of specialty risks in Hong Kong;
- Tax incentives to boost the specialty insurance and reinsurance industry including a new offshore profits tax exemption with details to be released later;
- In September 2017, the Financial Services Development Council introduced a proposal to introduce a group tax loss relief regime that would serve to encourage entrepreneurial risk taking and innovation; and
- In October 2017, KPMG prepared a report, 'The case for a Hong Kong RHQ tax incentive', proposing to introduce a regional headquarters (RHQ) tax regime in Hong Kong to enhance Hong Kong's competitiveness as an RHQ location in the Asia Pacific region.
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