Question

Hong Kong Taxation

River Co is a company incorporated and carrying on business in Hong Kong. River Co is principally engaged in the sales of luxury silk clothing through approximately 100 department stores. The procurement staff of River Co liaise with overseas suppliers in different countries and source new suppliers by going to trade exhibitions around the world. The procurement staff would preliminarily negotiate the purchase contracts with suppliers in the countries where the exhibitions are held, or the suppliers are located. However, the procurement team must seek advice from an in-house lawyer in Hong Kong and further negotiate the terms and conclude the purchase contracts with the overseas suppliers via exchange of emails after they return to Hong Kong. To facilitate the sales activities in the PRC market, River Co has sent its staff to have meetings with distributors in the Mainland to negotiate and conclude the sales contracts. Sales in Hong Kong market are however all made by River Co’s sales team in Hong Kong. River Co is also engaged in the business of investment holding in overseas subsidiaries. In view of the increasing trend for the demand of intra group financing and treasury services from its overseas subsidiaries, and with the profits tax concession granted under the relevant provisions of the IRO for these activities in recent years, the management of River Co plans to set up a treasury management function in 2020. Alternatively, River Co may establish an entity in Hong Kong specifically and exclusively for conducting corporate treasury activities for its overseas subsidiaries, on the basis that the entity can enjoy the profits tax concession.

Required:

(a) For River Co, explain the chargeability of its profits from sales made in the Hong Kong and Mainland markets. In particular, whether the Hong Kong and Mainland sales profits should be subject to, or exempt from, Hong Kong profits tax with reference to relevant provisions and case laws.

(b) By reference to the information about the sales made in the Hong Kong and Mainland markets, discuss the general deducibility of related expense, whether there are any major potential offshore tax risks, and any major potential non-tax risks.

(c) In the contexts of the relevant IRO provisions, explain advantages of being a ‘qualifying corporate treasury center’ (QCTC) and whether it is appropriate for River Co to apply for QCTC status.

Answer 1

a.ANS :

Under Article 108 of the Basic Law of Hong Kong, the taxation system in Hong Kong is independent of, and different from, the taxation system in mainland China. In addition, under Article 106 of the Hong Kong Basic Law, Hong Kong enjoys independent public finance, and no tax revenue is handed over to the Central Government in China. The taxation system in Hong Kong is generally considered to be one of the most simple, transparent, and straightforward systems in the world.Taxes are collected through the Inland Revenue Department (IRD).

Since the Common Law System is applied in Hong Kong, judgements by the Courts and Boards of Review in tax law cases are resorted to assist the interpretation of taxation rules and concepts. Furthermore, the Inland Revenue Department also issues Departmental Interpretation and Practice Notes (DIPNs) from time to time to clarify and elaborate on the tax rules and to smoothen the tax collection process.

Taxes collected in Hong Kong can be generally classified as:

1. Direct tax – including Salaries Tax, Property Tax and Profits Tax; the guiding statue is Inland Revenue Ordinance (Cap 112);
2. Indirect tax – including Stamps Duty, Betting Duty, Estate Duty (abolished on 11 February 2006) and others.

In the fiscal year 2013/14, Profits tax, an income tax on corporations constituted the largest source of tax collected by the government, followed by Salaries Tax, an income tax on individuals.Hong Kong Profits Tax is a tax levied on the net profits on business. Companies and individuals (sole proprietors) carrying out business in Hong Kong will be liable to Profits Tax provided that the profits are sourced in Hong Kong. The source of profits is one of the most controversial topics in the context of Hong Kong taxation. Principally, it is guided by an established set of tests and judgments in court cases. The Departmental Interpretation and Practice Notes provides viewpoints from IRD's perspective but these are subject to revision if major inconsistencies with court judgments are subsequently found. Certain kinds of deemed trading receipts are taxed irrespective of the source rule. Tax on these deemed trading receipts are collected by agents or other persons on withholding basis. Tax liability may be measured by reference to gross income or turnover for deemed trading receipts and in case where profits cannot reliably ascertained. Capital gain is out of the scope of Hong Kong Profits Tax. However, whether a gain is in capital nature is debatable.

B ans : Under s.16(1), any expense or outgoing incurred in the production of assessable profits is deductible. However, expenditure which is capital in nature is not allowed under s.17(1)(c), although a tax depreciation allowance may be granted and certain specific deductions are available subject to conditions. In the case of HK-Co, the delivery trucks are for use in the provision of logistics services connected to its sales to Singapore customers, and thus in the production of assessable profits under s.16(1). However, the delivery trucks are obviously capital expenditure and, therefore, not allowed under s.17(1)(c). Depreciation allowances in respect of capital assets specified in Part 6 are allowable under s.18F unless expressly disallowed. As plant and machinery used in trading to earn profits assessable to profits tax, the delivery trucks should, prima facie, qualify for a tax depreciation allowance at 30% per annum. However, s.39E(1)(b) stipulates that a tax depreciation allowance will be denied to the taxpayer where there is a lease of machinery or plant in which the taxpayer is a lessor and the asset is used by a person other than the taxpayer wholly or principally outside Hong Kong. ‘Lease’ in relation to any machinery or plant is defined in s.2 as including ‘any arrangement under which a right to use the machinery or plant is granted by the owner of the machinery or plant to another person’. In the case of HK-Co, the delivery trucks are to be transferred to its Singapore subsidiary for use outside Hong Kong. Regardless of whether any rental is charged, these trucks would be regarded as ‘leased assets’ and thus a tax depreciation allowance would be denied to HK-Co. The IRD takes this position as stated in the preceding sentence in DIPN No. 15. Nor will HK-Co be eligible for a 100% deduction under s.16G on the expenditure, as the delivery trucks will not qualify as prescribed fixed assets: either because based on the definition the delivery trucks are under a ‘lease’, as in Braitrim (Far East) Limited v CIR, the Court of Appeal held that the term ‘lease’ in s.16G(6) should follow the statutory definition under s.2(1); or because motor vehicles are prescribed as item 25 in the Inland Revenue Rules and HK-Co’s business is not one of manufacturing. In conclusion, no tax deduction or tax depreciation allowance can be claimed by HK-Co in respect of the cost of the delivery trucks.

C ANS :

The Hong Kong government gazetted the Inland Revenue (Amendment) (No. 2) Ordinance 2016 (the Ordinance) on June 3 2016, bringing into law a concessionary profits tax rate for qualifying corporate treasury centres (QCTCs). The new rules deem certain interest income and other gains as sourced and taxable in Hong Kong. Amendments to the earlier interest deduction provisions were also made to allow deductions for interest incurred on certain intra-group lending transactions.

The QCTC regime provides Hong Kong with an opportunity to compete with other treasury centre initiatives offered in the region, most notably Singapore.

With the release of Departmental Interpretation and Practice Note No. 52 on the Taxation of Corporate Treasury Activity (DIPN 52) on September 9 2016, the Inland Revenue Department (the IRD) has clarified a number of areas relating to the QCTC regime and the interest deduction provisions.

While some of the IRD's comments are helpful, the provisions remain complex and could hamper the usefulness of this initiative. The key comments disclosed in DIPN 52 are summarised below.

For an interest deduction to be obtained on money borrowed from associated corporations, the Ordinance requires that:

a) The deduction is claimed in respect of interest payable by a corporation (i.e. the borrower) on money borrowed from a non-Hong Kong associated corporation (i.e. the lender) in the ordinary course of an intra-group financing business;

b) The lender is, in respect of the interest, subject to a similar tax (i.e. paid or to be paid) in a territory outside Hong Kong at a rate not lower than the reference rate (16.5% or 8.25%); and

c) The lender's right to use and enjoy that interest is not constrained by any contractual or legal obligation to pass that interest to any other person. (This requirement will not be breached where the obligation arises as a result of a transaction between the lender and a person other than the borrower dealing with each other at arm's length).

DIPN 52 provides guidance and a number of examples on the IRD's interpretation of the terms highlighted above.

Specific anti-avoidance provisions

Notwithstanding that the interest expense may fall within the requirements for a deduction, the interest is also subject to two specific anti-avoidance measures.

The first test examines whether the interest is ultimately paid to a person related to the borrower, who pays no tax or tax at a lower rate than the Hong Kong reference rate (i.e. 16.5% or 8.25%).

The second test looks at whether the main purpose, or one of the main purposes, of the borrowing of money is to utilise a loss to avoid, postpone or reduce any tax liability, whether of the corporation or another person. Where such purpose exists, no deduction will be allowed in respect of the interest payable on that money borrowed.

Operations test v provision of credit test

DIPN 52 confirms that the "operations test" will apply regardless of whether or not a corporation carrying on an intra-group financing business in Hong Kong is a QCTC or not. Further, DIPN 52 confirms that the "provision of credit test" will continue to apply to simple inter-company loans not made in the ordinary course of an intra-group financing business.

DIPN 52 provides guidance and a number of examples on the IRD's interpretation of how the above two measures will be applied.