Tax Hong Kong Client Alert Impact of Fourth Protocol to Hong Kong / China Double Tax Arrangement Following ratification by the respective governments of both sides, the Fourth Protocol to the double tax arrangement between Hong Kong and Mainland China (“HK-China DTA”) is now in retroactive effect as of 29 December 2015. The changes introduced under the Fourth Protocol are designed to realise two objectives: first, they are intended to boost Hong Kong’s attractiveness as a platform for investment into China via targeted tax incentives. Second, they counteract abuse of benefits under the HK-China DTA and facilitate information exchange by tightening anti-abuse provisions and expanding the scope of taxes covered under the information exchange provision. In this Alert we discuss the impact of the four key changes introduced by the Fourth Protocol. 1. Further Exemption for Capital Gains Article 13 of the HK-China DTA exempts China enterprise income tax on capital gains derived by a Hong Kong tax resident from disposal of shares in a Chinese company if: (a) Less than 50% of the company’s assets were comprised (directly or indirectly) of real property situated in China at any time within three years before the date of disposal; and (b) the Hong Kong tax resident held no more than 25% of the total equity interest (directly or indirectly) in such company at any time within 12 months before the date of disposal. The Fourth Protocol extends this exemption to gains derived by Hong Kong tax residents and “Hong Kong resident investment funds” from disposal of shares of China companies listed a on recognized stock exchange (inside or outside China), provided the shares were bought and sold on the same exchange. An investment fund is deemed to be a “Hong Kong resident investment fund” if: (a) the fund is constituted under Hong Kong law; (b) the funds is recognized by the Securities and Futures Commission and subject to its oversight; April 2016 Beijing Suite 3401, China World Office 2 China World Trade Centre 1 Jianguomenwai Dajie Beijing 100004, PRC T: +86 10 6535 3800 F: +86 10 6505 2309 Hong Kong 14/F Hutchison House 10 Harcourt Road Central, Hong Kong T: +852 2846 1888 F: +852 2845 0476 Shanghai Unit 1601, Jin Mao Tower 88 Century Avenue, Pudong Shanghai 200121, PRC T: +86 21 6105 8558 F: +86 21 5047 0020 2 Baker & McKenzie | April 2016 (c) the fund is managed by SFC licensed managers; and (d) more than 85% of the fund’s capital was raised through the Hong Kong market1 Practically, the additional benefits of this capital gains exemption may be limited. The existing capital gains tax exemption under the HK-China DTA already covers most trading in shares of Chinese listed companies (other than companies with significant real property holdings). Furthermore, Chinese domestic law currently offers temporary capital gains exemptions for the existing channels of investing and trading in shares of Chinese companies listed on recognized stock exchanges inside China. These channels include investments by qualified foreign institutional investor (“QFII”) / Renminbi foreign institutional investor (“RQFII”) and investments via the Shanghai-Hong Kong Stock Connect programme. Until these temporary tax exemptions are repealed, there would seem to be little need for Hong Kong tax residents and “Hong Kong resident investment funds” to rely on the capital gains exemption under the HK-China DTA and the Fourth Protocol for trading in A shares. 2. Reduced Withholding Rate on Aircraft/Shipping Lease Income The Fourth Protocol reduces the China withholding tax rate for leasing income of Hong Kong tax residents derived from aircraft leasing or ship chartering to 5% (versus the current rate of 7% under the HK-China DTA). This 5% rate would be lowest amongst all of China’s current tax treaties. Note that this reduced withholding rate would apply to aircraft leasing or ship chartering arrangements, such as dry leases. Certain other arrangements like wet leases would follow the treatment of income from sea, land and air transportation instead. Prior to the ratification of the Fourth Protocol, the Hong Kong Government had been evaluating legislative incentives in order to develop Hong Kong as an aircraft finance hub. In particular, Hong Kong is seeking to establish itself as the preferred finance hub for aircraft leasing transactions with China. While the lower withholding rate is helpful, Hong Kong still lacks the local tax incentives that would make it competitive against more established aircraft finance hubs such as Singapore and Ireland. 3. Anti-Abuse: “Main Purpose” Test The Fourth Protocol introduces an additional anti-abuse provision to the HK-China DTA. Claims for benefits on passive income (i.e. dividends, interest, royalties, and capital gains) may be denied if the “main purpose” of the claimant is to obtain such benefits. 1 For purposes of this test, the capital of a fund will be regarded as raised through the Hong Kong market if: (i) the fund is listed on the HKSE; (ii) the fund is sold or allotted through financial institutions with operational substance; (iii) the fund is directly sold or allotted to investors in Hong Kong; (iv) the capital of the fund is raised through any other means as agreed by competent authorities of both Hong Kong and China. April 2016 | Baker & McKenzie 3 However, this main purpose test may not actually change the anti-abuse position for Hong Kong tax residents seeking to claim benefits under the HK-China DTA. There are two key reasons for this: (a) The HK-China DTA already allows China to apply its domestic antiavoidance rules to counter any abuse of the arrangement. The test under China’s general anti-avoidance rule is also a main purpose test, which examines whether the main purpose of an arrangement is the avoidance, deferral or reduction of Chinese tax. (b) Hong Kong tax residents claiming benefits on dividend, interest or royalty income are already required to show that they are the beneficial owner of such income. Thus the claimant cannot be a conduit company, or otherwise constrained by any contractual or legal obligation to pass on the payment to another party. Chinese domestic law would additionally require the benefit claimant to have economic substance. It is interesting to note that this main purpose test imposes a lower standard than the anti-treaty abuse initiative proposed by the Organisation for Economic Cooperation and Development (“OECD”). Specifically, Article 6 of the OECD’s Base Erosion and Profit Shifting Action Plan recommends a principal purposes test whereby treaty benefits will be denied if one of the principal purposes of the claimant is to obtain treaty benefits (rather than the main purpose). 4. Broadening of Taxes Covered Under Information Exchange Article The Fourth Protocol extends the scope of the Exchange of Information (EoI) article under the HK-China DTA to cover information related to the following Chinese taxes: • value added tax • business tax • consumption tax • land value added tax • property tax The expanded scope allows Chinese tax authorities to request relevant information from their Hong Kong counterparts with respect to any of the above mentioned taxes. The expanded scope is consistent with the global trend of increasing cooperation between tax authorities in providing mutual assistance on various taxes. It is also safe to presume that, going forward, Hong Kong will amend more of its existing tax agreements (or sign new agreements) based on the expanded scope of EoI. In fact, Hong Kong has already engaged in discussions with the Japanese tax authorities on extending the taxes covered under the EoI article of the Hong Kong-Japan double tax agreement. In addition, newer agreements signed with Italy and South 4 Baker & McKenzie | April 2016 www.bakermckenzie.com Should you wish to obtain further information or want to discuss any issues raised in this alert with us, please contact: Steven Sieker +852 2846 1048 email@example.com Pierre Chan +852 2846 1560 firstname.lastname@example.org This publication has been prepared for clients and professional associates of Baker & McKenzie. 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This may qualify as “Attorney Advertising” requiring notice in some jurisdictions. Prior results do not guarantee a similar outcome. Korea already incorporate a provision in the Protocol accommodating a possible expansion of the scope of taxes covered under their respective EoI articles. 5. Other conclusions China is in the midst of a major economic restructuring that has seen declining foreign direct investment and record capital outflows. Nevertheless, the changes introduced under the Fourth Protocol suggest that Hong Kong remains committed to being the favoured gateway into China. Although favourable tax policies are only part of the picture, it is hoped that in the long-term Hong Kong will be ideally placed to reap the economic benefits of China’s next economic renaissance.