By Stefano Mariani and Mona Yip, Deacons, Hong Kong
Hong Kong’s Chief Executive, Carrie Lam, in her 2017 policy address, proposed various new tax measures, most notably a new two-tier profits tax system and additional tax deductions for research and development (R&D) expenditure.
Tax reform responsive to the needs of businesses and to the government’s commitment to diversify the economy are certainly vital to the city’s competitiveness. Singapore, Hong Kong’s longstanding competitor – though the government customarily demurs from referring to the ‘S-word’ – has shown the effectiveness of targeted incentives in maintaining a dynamic, high-valued added industrial component to its economy.
The question is, therefore, whether a similar outcome will occur in Hong Kong.
The two-tier profits tax system
Under Lam’s proposal, enterprises can expect a tax cut from 16.5% to 8.25% for the first HK$2 million profits.
With a view to avoiding arbitrage and abusive practices – for example, the artificial fragmentation of a group structure to procure that each company earn less than HK$2 million in profit – each corporate group will only be able to nominate one member company to be eligible for the lower tax rate.
It is expected that the two-tier tax system should be particularly useful for SMEs, which account for over 98% of the city’s total business units and employ a workforce of nearly 1.3 million. Lam predicted that tens of thousands of SMEs could benefit from a reduction in tax payments of at least 40%.
Nonetheless, the response of local SMEs has been cool, with many commenting that they expected little practical benefit. Many local start-ups are struggling to pay their rents and other expenses and therefore make modest profits or are at the early stages of their business cycle lossmaking.
There is a sense that the government missed an opportunity to introduce tax reforms that might have had a greater structural impact, such as group loss relief or amortisation for intangible capital assets.
Comparing Singapore’s tax initiatives
Twelve years ago, Singapore introduced a tax exemption scheme for new start-ups, with a view to supporting innovation and entrepreneurship.
For each of the first three tax filing years of a newly incorporated company, a zero tax rate is applicable to the first S$100,000 taxable income for Singapore tax resident companies; for taxable income from S$100,001 to S$300,000, a tax rate of 8.5% is applicable; and for taxable income exceeding S$300,000, the usual flat 17% tax rate will be applicable.
The graduated tax rates are applicable to all new companies except for companies whose principal activity is that of investment holding or developing properties for sale, investment or both.
In this regard, the policy of the Singaporean legislature is clear: only companies operating in the ‘real economy’ should avail themselves of the incentive, thereby discouraging rent-seekers in the over-heated Singaporean property market.
The applicability of the new Hong Kong tax initiatives to these industries, whose incomes are primarily passive and generally from dividends and interests, is yet to be addressed, though the authors are not optimistic, in view of the political strength of vested interests in the real estate and investment management sectors in Hong Kong.
All other companies can also enjoy a tax rate of 8.5% for their first S$300,000 of taxable income under the “partial tax exemption regime”.
Despite the success and generally positive reception of a graduated tax regime in Singapore, the implementation of a similar two-tiered profits tax system in Hong Kong is unlikely to be a panacea for the ills afflicting SMEs.
High costs, in particular, spirally rents, vertiginous salaries, and a relatively restricted pool of skilled personnel are far more pressing concerns for most SMEs. Similarly, a two-tiered tax system is unlikely to be of material interest to large multi
national enterprises since its scope would be limited to a single company in a given corporate group. Such larger undertakings would likely have preferred the implementation of meaningful reform to Hong Kong’s outdated loss transfer regime – there is to date no group loss relief and no loss carry-back.
Super tax deduction for research and development
As of 2016, a number of major economies, including 29 of the 35 OECD members and 22 out of 28 EU Member States, give preferential tax treatment to R&D expenditure.
In this context, the most striking observation to be made is that Hong Kong’s R&D expenditure does not exceed 0.8% of its GDP, a proportion that is considerably lower than regional competitors such as Taiwan, South Korea, and even China. Those jurisdictions have expended between 2% to 4% of their GDP on R&D.
In response to de-industrialisation, and the loss of Hong Kong’s historically prominent role in innovation, the government emphasised the private sector’s role in the development of innovative products and services. Under the new proposal, the first HK$2 million of eligible R&D expenditure will enjoy a 300% tax deduction, with a 200% deduction on the excess.
The prior question in understanding the impact of this new measure is ascertaining the breadth of the definition of R&D. Under the Singapore Income Tax Act, an R&D activity is defined as a systematic, investigative, and experimental study that involves novelty or technical risk carried out in the field of science or technology with the object of acquiring new knowledge or using the results of the study for the production or improvement of materials, devices, products, produce or processes.
Specific exclusions to this definition include activities like quality control or routine testing, market research or sales promotion, and development of computer software not intended to be used for other parties. This ensures focus on bona fide R&D in the fields of science or technology, and more importantly, serves to distinguish R&D from routine technical improvement and maintenance which forms part of the costs profile of most taxpayers.
Further expenditure eligible for the main R&D tax allowance includes staff costs, consumables, and contracted R&D expenditure, net of government grants or subsidies.
Singapore’s statutory R&D initiatives have been in place for over four years and will likely exercise a profound influence on Hong Kong’s R&D super-deduction regime, when this is enacted. Hong Kong has in the past looked to Singaporean legislation for inspiration, especially in the field of targeted tax incentives for, among other things, corporate treasury centres and aircraft leasing, and there is reason to suppose that it will adopt a similar approach for R&D expenditure.
That being said, R&D incentives are only a partial solution to the stated government priorities of promoting innovation and economic diversification in Hong Kong. Start-ups, for example, do not in general make large profits in their early years of operation, limiting the appeal of an R&D super-deduction that would not in practice be utilisable.
One may therefore query how effective the super-deduction would be in encouraging new entrants in high value-added and high technology industries in Hong Kong. If economic diversification is the goal, and Hong Kong is in this respect in a much weaker position vis-a-vis Singapore, more radical measures aimed at creating a full suite of fiscal incentives and disincentives would be required. To date, however, the government has preferred the adoption of a piecemeal approach.
What to expect
A bill containing the abovementioned tax measures will be submitted to be Legislative Council with a view to implementing the proposals in 2018.
It is to be expected that restrictions and anti-avoidance measures will be put in place to prevent abuse. In light of concerns relating to Hong Kong’s narrow tax base, those measures are expected to be conservative and aggressive.
When compared with other jurisdictions, Hong Kong has been a follower rather than a leader in fiscal adaptation. Whereas Hong Kong’s tax system remains highly competitive, tax practitioners and industry stakeholders at the Tax Summit held under government auspices on 23 October were univocal that more needed to be done to ensure long term and sustainable growth.
The mantra ‘low and simple’ is nothing more than a convenient soundbite. For Hong Kong to remain competitive, the government must grasp the nettle of tax reform for the first time since the Third Inland Revenue Ordinance Review Committee was convened in the late 1970s – the general sentiment is that now is not the time for complacency.
– Stefano Mariani, Counsel, Head of Tax and Trusts at Deacons, has a broad advisory and contentious tax practice, ranging from corporate taxation and group reconstructions to personal taxation and trusts and estate planning. He advises on all matters of Hong Kong and international revenue law, including tax-efficient structuring and restructuring, and appeals before the Board of Review and the higher courts.
– Mona Yip is an Associate of Corporate Commercial Group at Deacons. Her principal practice areas include corporate and M&A, commercial advisory and corporate governance.