The Organization for Economic Co-operation and Development (OECD) issued the Standard for Automatic Exchange of Financial Information in Tax Matters (Standard for AEOI) in July 2014, which aims to prevent offshore tax evasion and maintain the integrity of tax systems. Over 100 jurisdictions have committed to comply with the Standard for AEOI, which entails the adoption of a set of local laws based on the Common Reporting Standard (CRS) published by the OECD, as well as the entering into of Competent Authority Agreements (CAA) with other jurisdictions for reciprocal exchange of collected tax information. The “early adopters” jurisdictions (e.g., the United Kingdom (UK), the Cayman Islands (Cayman), and the British Virgin Islands (BVI)) have already enacted the required laws, targeting to exchange information with their CAA partners in 2017.
Time Frame in Hong Kong
Hong Kong is one of the “second wave adopters,” having just passed the laws adopting CRS—the Inland Revenue (Amendment) (no. 3) Ordinance (Amendment Ordinance) was gazetted and came into effect on June 30, 2016. This means that starting from January 1, 2017, Reporting Financial Institutions (RFIs) in Hong Kong (as defined in the Ordinance) should not only implement the new customer onboarding process when new “financial accounts” are opened, but should also conduct reviews and due diligence for all pre-existing accounts (created before January 1, 2017). Information to be collected should include the tax residency status1 of the account holders (including, in some cases, the status of their “controlling persons”), as well as the balance/value of each account at the end of each calendar year. The first return by the RFIs (which should contain “reportable” information up to December 31, 2017) should be uploaded to the Inland Revenue Department’s (IRD) AEOI portal by May 2018. The IRD will then, in or around September 2018, forward the relevant information concerning the tax residents of particular jurisdictions to the respective jurisdictions which have signed CAAs with Hong Kong. As of the date of this article, Japan and the United Kingdom have signed CAAs with Hong Kong while negotiation with other jurisdictions is ongoing.
Rather than providing a general summary of the law, this article aims to examine how the law in Hong Kong will likely impact a typical family trust structure holding a family business in Hong Kong.
Who is responsible for the reporting, and what is reportable, in a case where there is a discretionary trust governed by Hong Kong law set up by a Hong Kong settlor holding shares in a BVI holding company (BVI holdco) that holds an operating Hong Kong company (HKco) engaged in family business with a Hong Kong Private Trust Company (PTC) (not registered as a trust company in Hong Kong and with Hong Kong persons as its shareholders and directors) as trustee, where the beneficiaries include Hong Kong and UK residents?
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CRS Status of the Entities Involved
An analysis should first be conducted to determine the status of each of the different entities involved. An entity is an RFI in Hong Kong if it is resident in Hong Kong (thus becomes a “reporting” entity) and if it meets the criteria of a “financial institution” (FI) as specified in the Amendment Ordinance, i.e. a) a custodial institution; b) a depository institution; c) an investment entity or d) a specified insurance company (s. 50A (1)). If an entity is resident in Hong Kong but does not qualify as an FI, it would be an NFE2, either an “active NFE” or a “passive NFE”. Generally, an entity is an “active NFE” if less than 50% of its gross income is passive income; otherwise, it is a “passive NFE”.
1. Is the trust considered as an RFI?
A trust is treated as resident in Hong Kong “if its governing law is Hong Kong” and, contrary to common law principles, it is also treated as an “entity” under CRS. It will thus be an RFI if it meets any of the above criteria for FI.
A trust may possibly qualify as an FI if it is:
a) a “custodial institution” (i.e., if it “holds, as a substantial portion of its business, financial assets for the account of others,” which is further defined to mean that more than 20% of its gross income is attributable to such activities (s50A(9)) (“custodial business test” ) ; or
c) an “investment entity” which is further defined to include:
an entity that “primarily conducts as its business… investing, administering or managing financial assets or money on behalf of others… for its customers” (i.e., having more than 50% of its income attributable to such activities, as defined in s50A(13)(a) and (14)) (“managing investment business test”) ; or
an entity that has gross income primarily attributable (i.e., having more than 50% of its own income (s50A(13)(b)) “to investing, reinvesting, or trading in financial assets” and “is managed by another entity that is a financial institution” (“managed investment entity test”).
Unlike the Foreign Account Tax Compliance Act (FATCA) treatment of looking through to the ultimate business or assets held by an underlying holdco, the CRS rules look to the type of assets held directly by the entity in question. Hence, the trust would be treated as holding “financial assets”, i.e. the shares in the BVI holdco, rather than holding the underlying active business.
Once established that the trust holds or invests in “financial assets,” it becomes important to consider the nature of its activities and the income which may flow to the trust. The trust is likely to be receiving dividends from the BVI holdco, which should be considered as the trust’s own income. Such income is not income which the trust holds for “others”, unlike the case of the trustee (see below). The authors' view is that the trust is not “holding” or “investing in” assets for “others” or “its customers”, especially since a trust is treated as an entity under CRS - the beneficiaries are just its “controlling persons” and should not be treated as the “others” vis-à-vis the trust. As the trust is also not receiving any “service fees” nor income for any of its activities performed for “others”, it should not pass the “custodial business test” nor the “managing investment business test”. However, since it is “investing” in “financial assets”, the income derived from such assets is its own income, which should satisfy the first limb of the “managed investment entity test”. As such, it may qualify as an FI if it is “managed” by a PTC which is an FI.
2. Is the PTC considered as an RFI?
Assuming that the PTC is operated by family members who act as both shareholders and directors having discretion to manage and distribute the trust assets, it is unlikely that the PTC would receive income for providing trustee services. The nature of the income received by the PTC, i.e., dividends from the BVI holdco, is considered as income it holds for “others”, on behalf of the trust rather than its own income. For accounting purposes, this income would be booked under the trust’s account rather than the PTC’s own account.
It may be mentioned that the threshold for a company to be deemed to be “carrying on business” in the Hong Kong profits tax context is rather low: a company only needs to have actions which go beyond “mere passive acquiescence” and have repetition in its activities, even though there may be long periods of inactivity in between (see CIR vs Bartica Investment Ltd  4 HKC 599). However, for CRS purposes, the wording of the Amendment Ordinance specifically classifies an entity as conducting a “business” only if certain income thresholds are met (see s. 50A(9) and (13), the “custodial business test” and the “managing investment business test” above).
Therefore, from the plain wording of the Amendment Ordinance, a PTC that derives no service fees or income from its activities should not be classified as an FI under the “custodial business test” or “managing investment business test”. In addition, even if the PTC hires a trust service company to assist with trust management, or has a professional trust company holding its shares as trustee of a purpose trust, which may satisfy the second limb of the “managed investment entity test”, the first limb would still not be satisfied because the PTC would have no income attributable to the investments in the BVI shares (the income being that of the trust rather than that of the PTC). Thus, the PTC would not qualify as an FI.
Interestingly, despite the wording of the legislation (other jurisdictions also have similar provisions), there has been quite a lot of debate by practitioners and academics on whether PTCs should be treated as FIs. The guidance notes issued by various authorities are not particularly helpful. For example, the Cayman authorities (in its FATCA guidelines) were of the view that PTCs licensed or registered in Cayman may be considered as FI3, whereas the BVI authorities noted that unremunerated PTCs may not be considered as such. The OECD CRS handbook purely commented that much depends on the activities undertaken by the PTC (e.g., if it is just an administrative role, it is not an FI).
Since this topic appears to remain controversial and the interpretation or practices by each enforcement authority may deviate from the wording of the legislation, the authors have approached the IRD for clarification on the treatment of PTCs. The IRD simply answered that “trust company” and “trust” are both treated as “entities” under CRS, and either may qualify as an FI if the conditions specified are satisfied, including the income thresholds. If the gross income derived by the trust company from its activities is lower than the threshold, the trust company would likely not be an FI for the purpose of s. 50A of the Ordinance.
If the PTC is not an FI, then nor is the trust it “manages”. Hence, both the trust and the PTC would be NFEs. Since the trust’s income is only composed of dividends (passive income) from the BVI holdco, it would qualify as a passive NFE. As the PTC has no income, it would also qualify as a passive NFE.
3. Is the BVI holdco considered as an RFI or NFE?
Although the BVI holdco is not incorporated in Hong Kong, it may be “managed or controlled in Hong Kong” if its shareholders (the trust) and directors (who will likely be the family members) are in Hong Kong. Therefore, it may still be an RFI in Hong Kong.
The BVI holdco holds the HKco shares and a bank investment account (to invest the accumulated dividends received) as its “financial assets”, hence receiving income (dividends, interest, investment gains, etc.) rather than service fees in its bank account. As per the same analysis above, the BVI holdco would not have any service fees to meet the income threshold required for an FI under the “custodial business test” or “managing investment business test”. It would therefore only be treated as an FI if it is a “managed investment entity,” which may be the case if another FI has a discretionary mandate to invest the funds in its account. Otherwise, if the family members (as directors of the BVI holdco) retain control of the investment and have a limited power of attorney (LPOA) given by the bank to deal with the BVI holdco’s account, then the BVI holdco would still not be an FI—it will more likely be a passive NFE.
4. What about the HKco?
The HKco holds the operating business as well as a bank account for business receipts and expenses. It is likely that less than 50% of its gross income is passive income (assuming that most of its income would be generated from the business rather than the account), in which case the HKco would be an “active NFE.”
Due Diligence and Reporting Implications
1. Implications for the trust and the PTC:
If the PTC and the trust are treated as passive NFEs, and the trust just holds shares in the BVI holdco (but no bank account), then there is no need for any due diligence or reporting to be done directly by the PTC at this level.
2. Implications for the BVI holdco and the operator of its account:
If the BVI holdco is also a passive NFE holding a Hong Kong bank investment account (that exceeds the account balance threshold of HK$1.95M as of December 31, 2016), then the third party RFI operating its account will have to conduct due diligence on the account. The RFI will have to not only collect information on the tax residency status of the BVI holdco, but also on its “controlling persons”. A “controlling person” of a corporation is an individual “who owns or controls, including through a trust, not less than 25% of the issued share capital of the company”. Since the BVI holdco is 100%-owned by a trust, “those beneficiaries who are entitled to a ‘vested interest’, the settlor, the protector or persons who exercise ultimate control over the management of the trust” are considered its “controlling persons” (s50A(6)).
In relation to the conduct of due diligence on controlling persons of passive NFEs, the IRD has issued guidance to FIs (the Guidance) in line with the OECD handbook which includes specific compliance measures beyond the wording of the legislation. When passive NFEs are held by a trust, RFIs are also required to check and report on any discretionary beneficiaries who do not receive any distributions during the relevant year. This can be burdensome, since discretionary beneficiaries are often not named but described as a class (which may be open), and may not even know of their status as beneficiary. Fortunately the Guidance allows for RFIs to opt to only report on beneficiaries who have received distributions, provided that the RFIs have proper systems in place.
In this case, assuming that the above option may be adopted, the bank RFI would only need to report to the IRD annually on the tax residency status of its account holder, i.e. the BVI holdco, and its account balance, based on the self-certified information provided by the the BVI holdco and the relevant controlling persons. Such information may then be exchanged by the IRD with the BVI authorities. The reporting by the bank RFI of the status of and the distributions to the UK beneficiaries to the IRD (who will then report to the UK authorities) will only be required in the years subsequent to the distributions being made. Other than these, there is no need for the bank RFI to make any further reporting to the IRD since the other controlling persons of the trust are all Hong Kong residents.
3. Implications for HKco and the operator of its account:
The third party bank RFI holding the HKco’s bank account would also need to conduct due diligence on the HKco’s status. However, since the HKco is an active NFE, there is no need for the RFI to check the status of the HKco’s “controlling persons”. If the HKco remains a Hong Kong entity, there is even no reporting requirement by the RFI of the status of this entity to the IRD.
4. What if the PTC is considered as an RFI?
By comparison, if the PTC is deemed an FI, so will the trust. Therefore, the PTC would have to conduct the due diligence and make reports to the IRD directly (the trust would be exempted as a “trustee – documented trust” if reporting is done by the PTC).
The information to be reported extends to the “equity interest” held in the trust by “any settlor and beneficiary or any person having ultimate control of the trust” (s. 50A(1)), which entails the reporting of the shareholding value in the BVI holdco held by the above parties via the trust (which may exceed the value of the bank account held by the BVI holdco). The wording in the legislation also suggests that the interest of any beneficiary “who may receive directly or indirectly a discretionary distribution” (s. 50A (10)) ought to be reported, but the Guidance limited this to the reporting of the beneficiaries who have received distributions. Thus, if compliance with the Guidance is deemed sufficient, the PTC will only need to report to the IRD subsequent to the years when the PRC beneficiaries receive distributions.
There are criminal sanctions on the persons or entities holding accounts at an RFI, as well as on the controlling persons of such entities, for making false or incorrect self–certifications to the RFI. There are also sanctions on RFIs for failing to make proper returns.
It seems that pursuant to the plain wording of the Amendment Ordinance, none of the family-owned entities in the family trust structure above would be treated as FIs, nor do they—including the PTC—have any direct reporting obligations. Reporting of the controlling persons of such entities by a third party bank RFI would also not be required until the years when distributions to non-Hong Kong beneficiaries are made.
However, as illustrated above and not uncommon in Hong Kong tax matters, there is sometimes a dichotomy between the law and practice. Therefore, those who are involved in the planning or administration of a PTC trust structure are well-advised to continue monitoring the development of the laws and practical guidance in the CRS area. It should be noted that despite the large volume of materials and writings on the subject of CRS, the system has yet to become fully operational (the first exchange is to take place in 2017). There will likely be more guidance and case examples when enforcement actions and sanctions begin to take place.