Introduction
Hong Kong’s Inland Revenue (Amendment) (No. 4) Bill 2015 (the “2015 Bill”) was gazetted on 4 December and introduced for first reading before the Legislative Council on 16 December. If, as is expected, the 2015 Bill is ultimately passed, the Hong Kong Inland Revenue Ordinance (“IRO”) will be amended to enable qualifying corporations operating as corporate treasury centres[1] (“CTCs”) to benefit from a preferential tax deductions regime and enjoy a reduced rate of profits tax[2] for profits arising from specified corporate treasury activities and transactions. [3] The interest deductions regime and the reduced rate of profits tax regime are separate limbs of the concessionary CTC regime. It should be noted that a CTC must independently satisfy the discrete conditions of each limb in order to qualify.
The 2015 Bill is a remarkable legislative development, reflecting Hong Kong’s increasing use of tax incentives to encourage the development of strategic sectors, and is doubtless a conscious attempt to emulate the resounding success of Singapore in this ambit.
The incentive regime for CTCs is envisaged to operate in synergy with Hong Kong’s geographic and cultural advantages as the traditional gateway to China and to capitalise on its broad pool of financial and entrepreneurial talent and expanding network of double taxation agreements. To date, 33 such agreements have been signed.
The deduction of interest expense
Turning first to the deduction element of the tax incentive, it is helpful to situate this in its legislative context. Under the IRO as currently in force, interest payable to financial institutions[4] is generally deductible; however, if a corporation obtains a loan from a non-financial institution in the ordinary course of its intragroup financing business, the interest expense is deductible only if the corresponding interest income of the lender is chargeable to Hong Kong profits tax.
This requirement for tax symmetry between deductions and the receipt or accrual of interest placed a Hong Kong CTC borrowing from an associated corporation at an evident disadvantage, because, in light of Hong Kong’s territorial system of taxation,[5] an offshore associated lender not carrying on a trade or business in Hong Kong would not typically be chargeable to Hong Kong profits tax.
The 2015 Bill proposes to remove this restriction for CTCs subject to the following specified conditions:
- The borrower is a corporation, carrying on in Hong Kong an intragroup financing business;
- The deduction claimed must be in respect of interest payable by the borrower on money borrowed from a non-Hong Kong associated corporation in the ordinary course of that business;
- The lender must be, in respect of the interest, subject to[6] a tax of substantially the same nature as profits tax[7] in a jurisdiction outside Hong Kong at a rate not lower than 16.5 percent or 8.25 percent; [8] and
- The lender’s right to use and enjoy that interest must not be constrained by a contractual or legal obligation to pass that interest to any other person, unless that obligation arises from an arm’s length transaction.[9]
Of these conditions, the third is perhaps the most noteworthy. It is an all or nothing provision: if corporation tax were payable by the lender in another jurisdiction at a rate of, say, 8 percent, no deduction would be available for the Hong Kong CTC. It is further evidently symptomatic of the overzealous response by the Hong Kong government to the new OECD guidelines on base erosion and profit shifting.
In practice, however, this requirement will have the effect of restricting structuring options for groups using Hong Kong as a CTC hub by eliminating offshore jurisdictions (or potentially jurisdictions, which, like Hong Kong, have territorial systems of taxation) as options for the place of operation of the lender.
Reduced rate of profits tax for CTC profits
The second limb of the incentive is a reduced rate of profits tax on CTC profits. Currently, the rate of profits tax in Hong Kong for corporations is 16.5 percent. CTCs eligible for the concessionary regime will benefit from a reduced rate of 8.25 percent to the extent to which those profits are derived from specified intragroup financing services and transactions.[10]
At this stage, it is crucial to set out a brief, and necessarily reductive, summary of the conditions for the reduced rate of profits tax. First, only corporations, which are broadly speaking defined as bodies corporate, may avail themselves of the regime. Second, the corporation must be centrally managed and controlled in Hong Kong – in other words, it must be resident in Hong Kong for tax purposes.[11]Third, the CTC must exclusively carry out corporate treasury activities in Hong Kong or, if it carries out some other kind of activity, it must fall within the prescribed safe harbours.
Under the safe harbour rules, the concessionary regime will apply if a CTC both derives at least 75 percent of its aggregate profits from all sources from corporate treasury activities or transactions and the aggregate value of its corporate treasury assets is at least 75 percent of the aggregate value of all its assets. The safe harbour may be reached either by reference to a single year, or by reference to the average of profits and assets over multiple years – either two or three, depending on how long the CTC has been active in Hong Kong.
In the alternative, the Commissioner of Inland Revenue will have statutory discretion to deem a corporation to be a CTC if he is satisfied that a safe harbour would, in the ordinary course of the corporation’s business, be reached.
Interestingly, and for the purposes of determining whether a CTC has carried out any activity other than a corporate treasury activity, only activities generating income (as opposed to capital transactions) are to be taken into account. This provision seems to derive from Hong Kong’s historic policy of generally treating capital disposals and acquisitions as tax neutral.
Source of intragroup financing interest and profits
To secure symmetry between the concessionary deduction and taxing machinery, the 2015 Bill further amends the deeming provisions in the IRO, bringing within the charge to profits tax specified forms of income:[12] It will now be made clear in the statute that the source of certain profits arising from the carrying on in Hong Kong by a corporation (other than a financial institution) of an intragroup financing business will be determined by reference to the “operations test.”
It is the published position of the Hong Kong Inland Revenue Department that interest is sourced in Hong Kong and therefore taxable in Hong Kong if the lender carries on a trade or business in Hong Kong and the “provision of credit test” is met namely, if the funds in respect of which the interest was paid were made available in Hong Kong.[13]
The “provision of credit test” is not however applicable where the taxpayer carries on the business of borrowing and lending money, as opposed to accruing and receiving interest in the course of its business. In the 1997 Orion Caribbean case,[14] the Privy Council [15] held that in the case of a money borrowing and lending business carried on in Hong Kong, the profits arose from the business transacted in Hong Kong, such that it was inappropriate and misleading to rely on the “provision of credit test.” If the money borrowing and lending business was carried on in Hong Kong, the Committee considered that the profits of that business should ordinarily be regarded as Hong Kong source.
The distinction between the “provision of credit test” and the “operations test” is therefore that the first is used to determine the chargeability of interest income for companies not, in the ordinary course, carrying on a trade or business of borrowing and lending money; conversely, the second is to be applied where such a trade or business is carried on. Hence, the effect of the 2015 Bill will be to codify the Orion Caribbean decision in the IRO for corporations other than financial institutions, specifying that the source of profits arising from the designated intragroup financing activities will be analysed under the “operations test” alone.
Under the 2015 Bill, both interest received by the CTC and gains or profits arising from the sale or other disposal of certain instruments, such as certificates of deposit, bills of exchange, and regulatory capital securities, will therefore be regarded as taxable in Hong Kong in the hands of a CTC if the relevant intragroup financing operations are conducted in Hong Kong, irrespective of where the funds in respect of which the interest was paid were made available or where the sale or disposal of the financial instruments in question was effected.[16]
Some practitioners have expressed concerns that the new deeming provisions are redundant, arguing that, as a Privy Council decision, Orion Caribbean is binding authority in Hong Kong, and thus the provisions governing the general charge to profits tax[17] must be construed in a manner consistent with it. This author is of the view that this particular observation does little to progress the debate. Decided authority is not a perfect substitute for statutory clarity, especially when it comes to determining the complex and often vexed issue of how to source profits.[18]
Some final thoughts
The policy underpinning the introduction of the 2015 Bill is impeccable. It is in the general interest of Hong Kong to follow Singapore’s lead in developing clear and robust legislative machinery to attract investment.
It is nevertheless the case that the draftsmen of the 2015 Bill betray the Hong Kong government’s longstanding, and to date wholly unresolved, preoccupation with the narrowness of its fiscal base and the inevitable risks of tax leakage and abuse of incentives.
The qualification requirements for both the interest deduction and reduced profits tax limbs of the concessionary regime are complex as compared to Hong Kong’s historically minimalist tax legislation and will likely engender a great deal of due diligence, whilst simultaneously placing an even greater strain on the Hong Kong Inland Revenue Department to apply the terms of the legislation with rigour and consistency.
In particular, it has been a matter of some consternation to practitioners that the concessionary profits tax regime fundamentally creates exempt persons (i.e., corporations that are eligible CTCs for the purposes of the concessionary regime), and not exempt income (i.e., and by way of contrast, profits from CTC activities that would be taxed at a concessionary rate, irrespective of the principal business carried on by the recipient).
Although this approach is consistent with other statutory exemption regimes in Hong Kong, such as the offshore funds exemption, it effectively requires a Hong Kong CTC to be a special purpose treasury vehicle and nothing else to qualify for concessionary treatment, thereby limiting structuring options for multinational groups evaluating whether to install a treasury function in Hong Kong. In marked contrast, the Singaporean concessionary regime is available to departments or divisions of companies providing treasury, investment, or financial services in Singapore for its offices or its associated companies.[19]
This author is not, however, of the view that the 2015 Bill is inconsistent with Hong Kong’s stated policy of low and simple taxation. Certain elements of the tax community in Hong Kong have an apparently fetishistic attachment to the mantra of ‘simplicity’ whilst neglecting to acknowledge that the prior requirement of an efficient taxing regime is that the statutory infrastructure remain fit for purpose.
Assuming that the 2015 Bill is passed, it nevertheless remains to be seen whether the new concessionary regime for CTCs will enable Hong Kong to compete with Singapore as a regional hub for treasury functions.
[1] In the broad sense, a corporate treasury centre as understood in the 2015 Bill is a company performing, among other things, the functions of intragroup financing, multiple currency cash management, conducting transactions for financial or treasury-related risk management, and supporting the raising of external capital by the group.
[2] There is no general income tax in Hong Kong.
[3] The rules for qualifying for the CTC regime are complex and readers should in any event refer to the legislation and consult with their tax advisers to determine whether a corporation is eligible.
[4] Essentially, banks.
[5] As a general rule, only profits of a trade, profession or business carried on in Hong Kong and having a Hong Kong source are taxable in Hong Kong.
[6] This author considers that the better view is that “subject to tax” should be understood to mean that the person must actually pay tax in its jurisdiction of residence in respect of the interest income, subject to allowances or reliefs. A person is “subject to tax” notwithstanding it has in fact paid no tax if it would have been taxable but for the availability of reliefs or the absence of taxable income (e.g., where it is loss-making). Conversely, a person is not subject to tax if it is like, for example, a charity in Hong Kong, statutorily exempt from tax. For a useful summary of the debate surrounding this phrase, see the recent UK First-tier Tribunal decision in Weiser v RCC [2012] UKFTT 501 (TC).
[7] e.g., corporation tax on income.
[8] If the borrower is eligible for the reduced rate of profits tax on qualifying CTCs the reference rate is 8.25 percent; otherwise, the reference rate is 16.5 percent, being the standard rate of corporate profits tax in Hong Kong.
[9] This is, in substance, a beneficial interest requirement, restricting the ambit of the concessionary deductions regime for back-to-back loans.
[10] Contrast the concessionary Singapore rate of 10 percent.
[11] Residence, in this context, refers to residence for the purposes of the various double taxation agreements to which Hong Kong is party. With a few exceptions (notably, for the purposes of eligibility for the offshore funds tax incentive), the concept of fiscal residence is irrelevant in Hong Kong in light of its territorial system of taxation.
[12] In section 15 of the IRO.
[13] See, Commissioner of Inland Revenue (NZ) v. N V Philips Gloeilampenfabrieken, 10 ATD 435 and CIR v. Lever Brothers & Unilever Ltd (1946), 14 SATC 1, and Departmental Interpretation and Practice Notes No. 13, paragraph 2, accessible at: http://www.ird.gov.hk/eng/pdf/e_dipn13.pdf.
[14] Orion Caribbean Limited v Commissioner of Inland Revenue, 4 HKTC 432.
[15] At that time, the court of final appeal in Hong Kong.
[16] The source of profits arising from the sale and purchase of an unlisted security is generally regarded as the place where the sale and purchase was effected. See, Departmental Interpretation and Practice Notes No. 21, paragraph 45, accessible at: http://www.ird.gov.hk/eng/pdf/e_dipn21.pdf.
[17] Section 14 of the IRO.
[18] The case law on point in this regard is complex, extensive, and, in places, not entirely consistent.
[19] See section 43G of the Income Tax Act. The concessionary regime is contingent on the CTC activities of the relevant department or division being segregated from existing non-CTC activities of the Singaporean company or office in question.
— Stefano Mariani is a solicitor and barrister admitted in England and Wales, and a part-time lecturer at Hong Kong University. He may be reached at [email protected].
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