Hong Kong Financial Secretary, John Tsang delivered his eighth budget speech on 25 February 2015.

Key Points:

  • ƒƒExpansion of tax exemption for certain offshore investment funds
  • ƒTax concession for treasury centre activities on the way
  • ƒƒFull steam ahead with implementation of OECD automatic exchange of tax information standard
  • ƒƒAddressing Hong Kong’s narrow tax base ƒƒ Risks to Hong Kong’s tax competitiveness

Offshore Funds Tax Exemption

The Administration will table a Bill in the Legislative Council (LegCo) in the next months to “expand” the non-resident fund profits tax exemption to include private equity funds. The changes are intended to clarify the muddled interpretation of the Inland Revenue Department (IRD) of the existing statutory provisions.

By way of background, non-Hong Kong fund vehicles1 managed and controlled from outside Hong Kong (nonresident funds) are exempt from profits tax on their Hong Kong sourced trading profits arising from most transactions arranged by a "specified person" (i.e., firms licensed by the Securities & Futures Commission (SFC) or institutions authorized by the Monetary Authority) involving seven common types of financial assets.

One of those financial assets is “securities”. The present provisions carve out “securities” which are “shares…of a company that is a private company within the meaning of… the Companies Ordinance…." The result is that Hong Kong sourced trading gains on shares in a Hong Kong incorporated private company are outside the scope of the tax exemption. That was never in dispute.

The difficulty for fund sponsors and managers is that the IRD has “interpreted” the term “securities” to include shares in all private companies, whether incorporated in Hong Kong or not. It is difficult to find much support for the IRD's view in either the literal words of the statute, or a broadly based purposive interpretation of the same.

More conservative tax advisors identified the gulf between the proper scope of the exemption and the IRD's published (mis) interpretation of the same, as indicating that, generally, there was doubt as to the tax exemption's utility for non-resident funds in the private equity industry; the implicit conclusion of this approach being that it's all too risky, and we better just do what the IRD says. This echo chamber of cumulative error deprived Hong Kong of much private equity management business and resulted in the implementation of rather cumbersome operating protocols for certain transactions effected by private equity focused non-resident funds.

To address the situation, the Administration’s Bill will amend the definition of “securities” such that a transaction in securities in a private company incorporated outside Hong Kong (i.e., a portfolio company)2 will be a “specified transaction.” In other words, a non-resident private equity fund (or a special purpose vehicle owned by such a fund) will enjoy a profits tax exemption on Hong Kong sourced gains arising from the disposal of a non-Hong Kong portfolio company if arranged by a “specified person.”

In addition, it is understood that the Bill will relax the requirement for transactions to be arranged by “specified persons” where the non-resident private equity fund is a “qualifying fund”. This is intended to reflect that some fund managers are not, and do not need to be, licensed by the SFC. The criteria for “qualifying fund” include:

  1. at all times after the “specified transaction” has closed – (i) there are five or more investors (who are not associates of the originator of the fund); (ii) the capital commitments made by investors exceed 90% of the aggregate capital commitments; and
  2. the originator’s associate-inclusive net proceeds do not exceed 30% of the net proceeds arising from the fund’s transactions. Extensive specific anti-avoidance measures will also be introduced to prevent so-called “round tripping” by Hong Kong resident investors. Overall, although the proposed changes are technically unnecessary, they are nevertheless welcome. It remains to be seen how the IRD adjusts its assessing practice to give effect to these measures. As usual, uncertainty regarding revenue practice is the greatest tax risk.

Treasury Centre Tax Concession

The Administration proposes to offer a tax concession for qualifying corporate group treasury centre activities in Hong Kong, in an effort to attract multinational and PRC companies to set up in Hong Kong.

There are no thin capitalisation rules in Hong Kong. However, for interest to be deductible, it must meet at least one of six specified conditions, in addition to satisfying the general test of being incurred in the production of assessable profits.

Of the six specified conditions, condition three typically limits Hong Kong’s attractiveness as a treasury centre. Condition three requires that, where money is borrowed from a person, other than a financial institution, the interest receipt must be chargeable to Hong Kong tax. Hence, interest expenses on borrowings from offshore related-parties do not qualify for deduction (unless the offshore party is itself subject to Hong Kong profits tax).

The proposal is to enable, under certain conditions, a Hong Kong group treasury centre to deduct interest expenses (which it presently cannot) from its profits for tax purposes. In addition, Hong Kong sourced income arising from qualifying corporate group treasury centre activities in Hong Kong will be subject to an effective 8.25% profits tax rate.

Any relaxation in Hong Kong’s deeply restrictive interest deductibility rules is welcomed. The Administration will introduce the relevant Bill to the LegCo in the 2015/16 legislative session.

Automatic Exchange of Tax Information

According to the Financial Secretary, Hong Kong will “step up” its efforts in combating cross-border tax evasion in accordance with the latest global standard. This is a reference to the OECD’s automatic exchange of tax information policies in which financial institutions will be required to report to the IRD specified financial account information on a regular basis, and for that information to be exchanged with other jurisdictions by end-2018. The Administration indicated that it will consult the industry in the second quarter of this year and introduce a Bill to amend the Inland Revenue Ordinance for the same purpose in 2016.

Arguably, Hong Kong’s approach to these matters is to be among the most radical and aggressive. The recent changes to rules for obtaining a tax residence certificate for tax treaty purposes highlight this strategy. For example, all companies, partnerships, and trusts claiming Hong Kong tax resident status must now annually submit to an abridged tax-audit examination when making an application to the IRD for a certificate of Hong Kong resident status.

Narrow Tax Base

A Hong Kong budget speech would not be complete without a reference to Hong Kong’s narrow tax base. This year, the Financial Secretary indicated that among the working population only 40 per cent pays salaries tax, and 60 per cent of the revenue comes from the top five per cent of salaries tax payers. As for profits tax, only ten per cent of the registered corporations pay profits tax, and over 80 per cent of the revenue comes from the top five per cent of profits tax payers.

The Administration launched an extensive consultation on the introduction of a goods and services tax in 2006. Although the then Administration’s proposals were innovative, the Administrative ultimately failed to build a consensus for reform. The Financial Secretary indicated that Hong Kong needs to explore the feasibility of broadening the tax base “in due course” with the aim of stabilising government revenue and creating room for direct tax concessions.

Hong Kong cannot continue to “kick the can down the road” on this front. The past failure to reform the tax base has rendered Hong Kong unable to respond to falling headline income-rates elsewhere. This, combined with the practical necessity of bolstering tax revenue to meet societal demand for increased public expenditure, continues to exert sustained pressure on Hong Kong’s competitiveness.

Risks to Hong Kong’s Tax Competiveness

Historically, the IRD has been one of the world’s most effective tax administrations. Indeed, for the vast majority of taxpayers, the IRD continues to be user-friendly and efficient.

That said, it is no secret that many of Hong Kong’s largest and most successful companies and individuals are leaving or planning to leave, for tax purposes at least, largely in response to the IRD’s increasingly unreasonable approach.

For the top five per cent of the salaries and profits tax payers, the IRD has become worryingly aggressive.

Disputes between the IRD and taxpayers are growing in number and taking more time to resolve because the IRD no longer accepts the tax law as the LegCo intended and enacted it, and as the courts have interpreted it. Instead, the strong impression is that the IRD is starting to mimic the assessing practices of developing country tax administrations by seemingly making the rules up as they go along, and otherwise pretending that the rule of law doesn’t apply to tax. It is not for nothing that taxpayers prevail more often than not in tax appeals at the Court of Final Appeal, which remains a benchmark of judicial expertise and independence. It is also not for nothing that the Courts have repeatedly criticised the IRD in recent years for not understanding or properly administering Hong Kong’s tax laws (e.g., the Ngai Lik, ING Baring, Nice Cheer cases, to name a few).

Ultimately, there is no point in the Administration developing initiatives to improve Hong Kong’s tax competiveness if the IRD ends up undermining the initiatives by narrowly casting the scope of their implementation