Hong Kong considers new intragroup tax loss rules

 by Stefano Mariani and James Tong, Deacons, Hong Kong

A high-level government advisory panel on September 11 proposed that Hong Kong adopt a new intragroup tax loss transfer regime. If adopted, these new tax rules would have significant impact on business and investment decision-making in Hong Kong, especially in the context of large corporate groups.

The regime, proposed by the Financial Services Development Council (FSDC), a cross-sectoral advisory body, is modelled on the Singaporean intragroup tax loss transfer regime.

It would modify current Hong Kong tax rules which provide that unrelieved losses may be carried forward indefinitely only by the lossmaking company.

The proposed regime would apply only to corporations within the same wholly-owned group. In essence, the transfer of losses would be restricted to current year unrelieved losses transferred from one wholly-owned group company to another.

Adjustments for tax rates

The proposal also adopts an adjustment approach, similar to rules implemented in the Singaporean regime, to take into account proposed Hong Kong tax changes that would result in a two-tier corporate tax system and may cause corporations within the same group to face different profits tax rates.

Under the FSDC proposal, the transfer of tax losses is permitted regardless of the difference in tax rates of the transferor and claimant companies, subject to rules that would adjust the unutilised tax losses pro-rata to reflect the differences in the effective rate of taxation.

Specifically, where the tax rate of the lossmaking company is lower than that of the profitmaking company, the tax benefit of losses transferred would be capped at the corporate tax rate of the lossmaking company.

On the other hand, where the tax rate of the lossmaking company is higher than the profitmaking company’s rate, the tax benefit of losses would be multiplied by an adjustment factor, being the ratio of the higher profits tax rate to the lower rate.

Specific anti-abuse and anti-avoidance measures may need to be introduced to supplement the existing general anti-avoidance provisions in sections 61A and 61B of the Inland Revenue Ordinance (IRO) to counteract aggressive tax planning.

Commercial implications

An intragroup loss relief regime would enable corporate groups to function on a more closely integrated basis.

For example, in the case of two companies being wholly-owned subsidiaries of a third holding company jointly carrying on the same business (or allied businesses), the taxpayers would no longer be at a disadvantage relative to single company carrying on the same activities for having losses arisen to one company and profits to the other.

Under the proposed regime, the lossmaking company could, all other things being equal, surrender those losses to the profitmaking company, thereby providing, from a fiscal standpoint, a truer reflection of the economic performance of the undertaking comprised in the two companies.

The impact of the proposed regime on the financial services industry is particularly significant because businesses in that sector often operate through multiple legal entitles for risk management purposes or otherwise by virtue of regulatory requirements.

More broadly, the proposed regime would likely encourage more entrepreneurial risk-taking and innovation by wholly-owned groups as costs arising from a commercial failure of one arm of a wholly-owned corporate group could, in principle, be mitigated by the generation of utilisable losses to be set-off against the same year profits of a profitmaking sister company.

As regards the enactment of the proposed regime, the FSDC has argued convincingly that it would be relatively straightforward to implement in the IRO and would, crucially, not displace the fundamental assumption of Hong Kong tax law that each company should be assessed to tax on a solus basis.

Further, by restricting the scope of application to wholly-owned corporate groups – i.e., applying a 100% shareholding test in lieu of Singapore’s 75% test – the proposed regime would be more conservative, with a view to assuaging concerns of its impact on Hong Kong’s infamously narrow tax base.

Hong Kong’s current tax system

Under existing Hong Kong law, each corporation within a corporate group is a separate fiscal entity and so taxed on a solus basis. Unrelieved tax losses may neither be carried back nor set-off against the profits of any company but the company to which such losses originally arose.

Since the introduction of a court-free company amalgamation regime in 2014, the only way to utilise unrelieved tax losses in a lossmaking company is to amalgamate it with a profitmaking company, though the Hong Kong Inland Revenue Department has sought, in published guidance, to discourage the use of amalgamation as a tax planning tool through the imposition of various onerous and extra-statutory conditions.

Both the government and the business community in Hong Kong have historically been fixated with the mantra of ‘low and simple’ taxation.

Nevertheless, the global economic environment has become increasingly competitive such that Hong Kong is now under pressure to modernise its tax code. Many competing jurisdictions now offer similar or even lower corporate tax rates: for instance, the UK government announced reduction of corporate tax rate to 19% from 1 April 2017 whereas Singapore has a current corporate tax rate at 17%. Both the UK and Singapore have group loss relief and loss carry-back provisions.

Hong Kong intragroup tax loss debate

Hong Kong has debated the introduction of an intragroup tax loss relief regime since the 1960s.

In the 2006/2007 Budget, the then Financial Secretary justified the government’s stance against introducing any intragroup tax loss relief regime in Hong Kong, citing four main grounds of opposition, namely: the volatility in tax revenue collections especially during economic downturns; the possible abuse of the regime to avoid or evade tax; the potential administrative complexity of the rules; and the regime would likely be of limited benefit for small and medium-sized enterprises.

In March 2011, the government confirmed that it remained opposed to the introduction of any intragroup tax loss relief.

Regarding the mechanics of allowing mobility of unrelieved losses between corporations within the same group, there are three common methodologies, or hybrids thereof, employed in comparator jurisdictions: group consolidation, intragroup tax loss transfer, and consortium relief.

A group consolidation regime treats corporate group entities as a single economic unit and the taxable profits and trading losses of such entities would be cumulated to compute the group’s overall tax position. This mechanism, however, would likely involve extensive structural amendments to the IRO and import a higher level of administrative complexity for taxpayers.

Conversely, an intragroup tax loss transfer regime would enable tax computation to remain on a solus basis but allow the transfer of unutilised tax losses from a lossmaking corporation to a profitmaking corporation within the same corporate group for set-off against the latter’s taxable profits.

The transfer rules under this mechanism are generally simpler and easier to administer as they would require only modest amendments to the existing laws.

Finally, a consortium relief regime would provide for the transfer between a consortium company and its consortium members, which is more complicated than a direct loss transfer system. As set forth above, the intragroup tax loss transfer regime is the preferred methodology for the proposed regime.

Singapore’s intragroup tax loss transfer relief

Given the common genesis and similarities of the Hong Kong and Singapore tax codes, the Singaporean experience serves as an important source of guidance for the trajectory of tax reform in Hong Kong (though the Singaporean group loss relief regime is, in turn, derived from the UK model).

Singapore adopted the tax loss transfer system of group relief from the year of assessment 2003; the Income Tax Act enables a company in a corporate group (a transferor company) to transfer its qualifying deductions to another member company within the same group (a claimant company) for set-off against the latter’s profits. Qualifying deductions include the transferor company’s current year: (i) unabsorbed capital allowances; (ii) unrelieved business losses; (iii) and donations.

The loss transfer relief is not automatic. In other words, eligible companies are required to make a written election to transfer or claim the qualifying deductions. To qualify for group relief, both the transferor and claimant companies must be Singapore-incorporated companies with the same accounting year-end which belong to the same group.

Two companies are members of the same group if they fulfil a two-level 75% shareholding test. The first-level test, also known as the ordinary shareholding requirement, is that: (i) at least 75% of the ordinary share capital in one company is beneficially held, directly or indirectly, by the other; or (ii) at least 75% of the ordinary share capital in each of the two companies is beneficially held, direct or indirectly, by a third Singaporean company.

The second-level test, also known as the profits and assets test, requires a Singaporean company to be beneficially entitled, directly or indirectly, to at least 75% of the residual profits and residual assets of the other company.

Holdings of any foreign companies are disregarded for the purpose of the shareholding test.

Conclusions

The FSDC proposed regime is an important contribution to the very pressing discussion of tax reform in Hong Kong. It is time that the uncritical assumption that ‘low and simple’ tax means a static and unresponsive tax regime be challenged both by stakeholders and the legislature.

Specifically in the field of tax reform, Singapore has blazed a trail for Hong Kong to follow and there is little doubt that, as matters currently stand, the Lion City has a clear edge in terms of fiscal legislation and policy relative to Hong Kong, which must, if it is to remain Asia’s pre-eminent global financial centre, adapt and respond accordingly.