The Inland Revenue (Amendment) (No. 4) Bill 2015 (the "Bill") was gazetted on Friday, 4 December 2015 (link). The Bill seeks to amend the Inland Revenue Ordinance ("IRO") and the Stamp Duty Ordinance to:

  • alter the interest deduction rules for profits tax for intra-group financing and provide a concessionary profits tax rate for qualifying Corporate Treasury Centres; and
  • provide certainty on the debt treatment for profits tax and stamp duty purposes of capital instruments complying with Basel III.

While the introduction of these amendments had been foreshadowed by the Financial Secretary in the 2015/16 Budget in respect of Corporate Treasury Centres (link) and in a recent speech to the Hong Kong Association of Banks in respect of Basel III capital instruments (link), certain amendments contained within the bill have not been widely announced. This alert focuses on these particular amendments as they are likely to cause the most confusion amongst taxpayers.

Section 17G

Outline of provision

The first provision of interest to us is what (if it is enacted) will become section 17G of the IRO entitled 'Financial institution: non-resident financial institution's Hong Kong branch treated as separate enterprise'. This section imports the authorised OECD approach to profit attribution to permanent establishments for all foreign banks in Hong Kong that have raised capital through the issue of Regulatory Capital Securities ("RCS"). It does this by determining the profits that the Hong Kong branch would have made if it were a distinct and separate enterprise that engaged in the same or similar activities under the same or similar conditions; and dealt wholly independently of the non-resident financial institution (ie, the foreign bank having its head-office outside of Hong Kong).

This provision appears to have been modelled on the United Kingdom's provision that sets out the basis on which profits are attributable to an UK permanent establishment of a non-UK resident company (section 21 of the United Kingdom Corporation Tax Act 2009).

The methodology for calculating the profits under this 'separate enterprise' principle is complex for banks and you should consult your professional adviser for assistance. However, as the provision is so closely modelled on the United Kingdom's provision, reference can usefully be made to Her Majesty's Revenue and Customs Inspectors' Manuals, which contain detailed guidance on the approach to take (link).

Effect of provision

The effect of this provision is that, instead of determining the assessable profits of a Hong Kong branch of a foreign bank based on the profits shown in its branch accounts in accordance with Inland Revenue Rule 3., the profits of the branch are determined based on the separate enterprise principle outlined above.

In practice, a majority of foreign banks will be applying arm's length principles in determining the income that is attributable to their Hong Kong branches as part of their global transfer pricing policies as a matter of course. This is consistent with the Inland Revenue Department's ("IRD") assessing practices regarding transfer pricing as set out in Departmental Interpretation and Practice Note No. 46 ("DIPN 46"). As a result, the impact of the introduction of section 17G is mainly going to be in respect of the allocation of free capital to a Hong Kong branch and the impact on a branch's tax-deductible funding costs. However, this is a complex calculation that may involve preparation of a regulatory capital balance sheet (ie, riskweighted assets) for the branch or finding suitable local bank comparables, which will give rise to a significantly increased compliance burden for these branches.

For the majority of banks, this legislative amendment will result in additional equity capital being allocated to their Hong Kong branch and displacing debt capital and the associated tax-deductible funding costs. However, in some rare cases it may result in greater debt capital being allocated to the Hong Kong branch and an increase in associated tax-deductible funding costs (for example where the head-office is largely equity funded or cannot issue tax-deductible regulatory capital in its home jurisdiction).


Some professional advisers have suggested this change may affect Hong Kong's territorial system of taxation. However, we do not consider this to be the case. Both Inland Revenue Rule 3. as currently drafted and proposed section 17G merely determine the profits that are attributable to the Hong Kong branch of the foreign bank. These profits are then subjected to the provisions of the IRO to determine assessable profits, and those assessable profits are chargeable to profits tax where they arise in or derive from Hong Kong and are not excluded profits of a capital nature under section 14 of the IRO. Therefore, there should be no impact on the territorial system of taxation as a result of the amendment introducing section 17G into the IRO.

It is interesting to note that section 17G only applies to financial institutions that have raised capital through the issue of RCS. However, in practice this is likely to be all financial institutions with Hong Kong branches as RCS include Basel III capital instruments issued abroad and most international banks will at least have some Tier 2 capital issuances.

A final thought on the proposed introduction of section 17G is that the drafting is very peculiar and the section has not been given very much prominence in the Bill. Section 17G is buried within a number of anti-avoidance provisions dealing specifically with the taxation of RCS, when arguably section 17G is of greater interest and wider applicability than the rules it is buried within. In addition, the Legislative Council Briefing on the Bill gives little mention of the move to a separate enterprise principle for the taxation of Hong Kong branches of foreign banks, only briefly mentioning it in the context of an anti-avoidance provision in respect of the rules on RCS.

Section 17H

Outline of provision

The second provision of interest to us is what (if it is enacted) will become section 17H of the IRO entitled 'Arm's length and separate enterprise principles not prevented from application in other circumstances'. The provision states that:

"Sections 17E and 17G do not prevent principles similar to those provided for in those sections from applying to a person, or in circumstances, other than the persons or circumstances mentioned in those sections."

Proposed section 17E introduces an arm's length principle for determining the profits of associates in connection with a RCS and proposed section 17G is explained above. We understand that some professional advisers have suggested that this provision means that the arm's length and separate enterprise principles in section 17E and 17G respectively are also to be applied to non-financial institutions and that, in effect, transfer pricing and the authorised OECD approach to branch profit attribution will be brought into the IRO by stealth. We do not agree with this interpretation.

Effect of provision

The natural reading of section 17H is that it provides clarity that if a person does not fall within the specific requirements of section 17E or 17G it does not mean that they are excluded from any other instances of the arm's length or separate enterprise principles, where there are other such instances. At present there are no other instances of the arm's length principle or separate enterprise principle in the profits tax provisions of the IRO (although we note the IRD's assessing practice as discussed in DIPN 46). Section 17H does not go so far as creating rules applying the arm's length and separate enterprise principles to non-financial institutions. To say something 'does not prevent application of a thing' is not the same as to say 'that thing applies'. There are a number of factors that support this natural reading of the provision:

  • If it was the intention to adopt the separate enterprise principle for all Hong Kong branches (and not just those of financial institutions), Inland Revenue Rule 5. would need to be repealed in a similar manner to that which Inland Revenue Rules 3. and 5. will be amended to apply for banks only to the extent section 17G does not apply.
  • Section 17H refers to 'principles similar to those provided for in [sections 17E and 17G]', ie, the arm's length and separate enterprise principles. If it was the intention to apply those principles to all taxpayers, then the word 'similar' would not be necessary.

Furthermore, it seems highly unlikely that the Government would attempt to pass such a fundamental change to the Hong Kong tax system 'through the back door'. Such a fundamental change would need to be clearly highlighted in the Legislative Council Briefing and Explanatory Memorandum to the Bill. Also, the Government has previously indicated that it intends to consult on the adoption of the arm's length and separate enterprise principles into the legislation in the near future and introducing such principles 'through the back door' flies in the face of this. For these reasons, we consider that proposed section 17H does not extend the arm's length and separate enterprise principles to all taxpayers.


As there is limited information on section 17H in the Legislative Council Briefing or the Explanatory Memorandum to the Bill and the consultation on the Bill was not public, we can only speculate as to why the Government included this section. There are a number of possible reasons we can conceive of:

  • As mentioned above, the Government has indicated it may consult on the introduction of the arm's length and separate enterprise principles in the future and, as such, may have put in this provision to 'future-proof' the legislation.
  • It is possible that the IRD is trying to protect its existing assessing practices where it considers that the arm's length principle should be applied to transactions between associates (see DIPN 46) even though at present there is no statutory requirement to apply the arm's length or separate enterprise principles and the IRD may only challenge transactions not complying with these principles within the confines of other provisions such as sections 16 and 17 (to deny excessive deductions) or section 61A (where there is a sole or dominant tax avoidance purpose).

In conclusion, we are of the view that, at present, the arm's length and separate enterprise principles in sections 17E and 17G respectively only apply in the circumstances in those sections and not more generally to all taxpayers. However, we would encourage the Government to issue clarification on the purpose and intent of section 17H prior to the readings of the Bill in LegCo.