News Flash Hong Kong Tax. November 2015 Issue 10. In brief. In detail.

Transcription

1 News Flash Hong Kong Tax Understanding the IRD s views on emerging corporate tax issues, in particular the practice on processing Hong Kong tax resident certificate applications November 2015 Issue 10 In brief In the 2015 annual meeting between the Inland Revenue Department (IRD) and the Hong Kong Institute of Certified Public Accountants (HKICPA), the IRD expressed its views on various emerging tax issues in the domestic as well as cross-border context. This News Flash summarises the more important profits tax and international tax issues for corporations discussed in the meeting, including: (1) taxation of royalties from licensing of intellectual property rights (IPRs); (2) the IRD s assessment of Hong Kong tax resident certificate (HKTRC) applications; (3) application of tax treaties to non-resident partnerships; (4) foreign tax credit claims of Hong Kong branches of overseas banks and (5) Hong Kong s responses to the Organisation for Economic Cooperation and Development (OECD) s Base Erosion and Profit Shifting (BEPS) project. While the meeting minutes are not law and are not legally binding, the minutes serve as a good reference of the IRD s stance on various emerging tax issues. In particular, this year s minutes have shed some light on the impacts of the BEPS project on the tax regime in Hong Kong, which are mainly in the areas of consideration of corporate tax incentives, preventing treaty abuse and transfer pricing. Companies with business operations in Hong Kong or doing business with Hong Kong should take into account the views expressed by the IRD in the meeting minutes in both of their tax planning and tax filing processes for an effective management of their tax matters. In detail The IRD and HKICPA held their 2015 annual meeting in February this year to discuss and exchange views on various tax issues that were raised by the Institute and the Department respectively. The minutes for the meeting have recently been published. The IRD s views on a number of more important profits tax and international tax issues discussed in the meeting are summarised below. For a full list of tax issues (including salaries tax issues) discussed in the meeting, please refer to the meeting minutes available on the HKICPA s website 1. Profits tax issues discussed Taxation of royalties from licensing of IPRs in crossborder operations The IRD expressed its views on the taxation of royalty income in the licensing arrangements depicted in Scenarios 1 and 2 in the Appendix. In Scenario 1, the IRD takes the view that even though the IPR was used outside Hong Kong, the royalties received by Company A from Company B may be regarded as onshore and taxable under section 14 of the Inland Revenue Ordinance (IRO). In determining the source of the royalties, the IRD will take into account: (1) whether Company A performed any functions relating to the maintenance, enhancement, protection and exploitation of the IPR in Hong Kong, (2) the fact that Company A did nothing offshore to earn the royalties, (3) the licensee (i.e. Company B) was a Hong Kong company, (4) the contractual rights against Company B could be enforced in Hong Kong and

2 (5) the royalties remained payable to Company A regardless of whether Company B successfully sub-licensed the IPR for use outside Hong Kong. In Scenario 2, it seems that the IRD takes the view that even though Company C and its Hong Kong branch should be regarded as the same legal entity, if it can be demonstrated that the licence fee was not attributable to the business carried on by the branch in Hong Kong and that the Hong Kong branch was not responsible for any functions mentioned above, there may be argument that the licence fee should not be taxable under section 14 of the IRO. However, such licence fee will then be taxable under the deeming provisions in section 15(1)(a) or (b) (if the IPR is for use in Hong Kong) or section 15(1)(ba) (if the licence fee is deductible for Hong Kong profits tax purposes) of the IRO. In addition, since Hong Kong Subsidiary is an associate of Company C and the IPR was owned by Company C which carried on business in Hong Kong (via its Hong Kong branch), 100% of the licence fee will be deemed taxable, resulting in an effective tax rate of 16.5% instead of 4.95%. PwC s comment: The source rule for royalties derived from licensing of IPRs has become a contentious issue in recent years. In July 2012, the IRD issued Departmental Interpretation and Practice Notes (DIPN) No. 49 to state, among others, its views on the source of royalties derived from a selfdeveloped IRR, a purchased IPR and from licensing and sub-licensing of an IPR. According to the examples in DIPN 49, royalties derived from licensing an IPR purchased by a taxpayer will generally be regarded as non-hong Kong sourced and not taxable if the IPR is for use outside Hong Kong under the licensing arrangement. However, the IRD has recently emphasised that what has been stated in DIPN 49 is a general statement only and that the source of royalties is a question of fact depending on the nature of the transaction. In particular, the IRD will look at where the maintenance, enhancement, protection and exploitation functions relating to the IPR are performed in determining the source of the royalties. It appears that the IRD is trying to align the source rule of royalty income with the approach of allocating profits from an IPR recommended by the OECD under Action 8 of the BEPS project, which dealt with aligning the transfer pricing outcomes with value creation, maintenance, protection and exploitation in respect of intangibles. Going forward, even in the situation where the IPR is licensed for use outside Hong Kong, taxpayers will need to get prepared for the IRD s close examination of where the other value creation functions of the IPR and activities related to the licensing of the IPR take place when lodging an offshore claim on the royalty income. Other profits tax issues discussed in the meeting Below are comments made by the IRD on other profits tax issues discussed in the meeting: Amendments to the IRO are required to provide tax certainty for corporate amalgamation although the timetable for the legislative changes is yet to be fixed. The IRD is studying the specific tax legislation dealing with corporate amalgamation in Singapore and New Zealand as references. One of the major concerns of the IRD is whether the amalgamation is tax-driven. In the absence of any tax motives, the IRD will likely agree that the amalgamated entity will be treated as the continuation of the amalgamating entities. Companies that carry on a business in Hong Kong but only derive nontaxable capital gains or offshore profits are regarded as chargeable to profits tax (but without assessable profits) so the dividends paid out from these companies will be exempt from profits tax. The legal rights and obligations created by perpetual notes (which are hybrid instruments exhibiting both debt and equity features) will be the starting point for the IRD to determine whether they are debt or equity. The IRD has provided a list of factors that are critical to the analysis of the true nature of hybrid instruments. A DIPN may be issued to provide more guidance taking into account the OECD s work in this area under the BEPS project. PwC s comment: In the meantime, advance ruling can be used to provide tax certainty for corporate amalgamation and the Commissioner mentioned in the meeting that there have already been a few applications for advance ruling. Based on our experience, we understand that it is possible for tax loss of the amalgamated entity to be carried forward to offset the profits generated from businesses of both the amalgamating and amalgamated entities as long as the amalgamation is mainly for business purposes and the two entities are of the same trade. So far as the tax treatment of hybrid instruments is concerned, it is understood that amendments to the IRO will be proposed by the HKSAR Government to clarify the tax treatment for regulatory capital securities issued by authorised institutions for the purposes of complying with the Basel III framework. Cross-border tax issues discussed The IRD s assessment of HKTRC applications The following concerns were expressed by the Institute in the meeting with respect to the tightening approach recently adopted by the IRD in assessing HKTRC applications: 2 PwC Factors other than the definition of Hong Kong tax resident in the relevant double tax agreement (DTA) are taken into account (e.g. whether the applicant is the beneficial owner of the passive income concerned and has any commercial substance in Hong Kong, and whether treaty abuse is involved) in determining Hong Kong tax residence status. For non-hong Kong incorporated companies, clarification from the IRD on the factors to be considered in determining the place of management or control is necessary. There are cases where the non- Hong Kong incorporated holding company (i.e. the listing vehicle) of a Hong Kong listed group with major business operations in China would like to apply for a HKTRC. This group holding company does not necessarily have many business activities or employees in Hong Kong as its only business is investment holding and its board members usually have multiple roles in the group and spend more time in China than in Hong Kong managing the operating entities. However, the management and control of the holding company is

3 exercised in Hong Kong through board meetings held in Hong Kong. The IRD s view on what constitute commercial substance in such cases was sought. The IRD reiterated its views expressed in the 2014 annual meeting that Hong Kong has the obligation to administer the terms of DTAs in good faith and in accordance with international law, to uphold the purposes for which the DTAs were signed and to prevent treaty abuse. These explain why the IRD has to look at factors beyond tax residency in assessing HKTRC application. In particular, the IRD revealed/confirmed the following practice in processing HKTRC applications: Place of management or control: In determining the place of management or control of a non- Hong Kong incorporated company, the IRD mentioned that there is no exhaustive list of factors to consider but indicated that it will take into account: the nature of business and the mode of operation; whether the company has a permanent office and employs any staff in Hong Kong; whether Hong Kong is the place where its board of directors met to exercise the management and control of the company (e.g. formulate business and strategic policies, choose business financing and evaluate business performance) and where decisions by top management are implemented. In addition, whether business registration has been performed in Hong Kong is not a conclusive factor. consider that the holding company itself should be looked at alone. PwC s comment: Taxpayers should take notice of the IRD s stance as expressed in the minutes regarding processing of HKTRC applications. Given that preventing treaty abuse is one of the 15 action points in the OECD s BEPS Action Plan (i.e. Action 6) and the issue is currently high on the international tax agenda, HKTRC applicants could expect that the IRD will continue to take a stringent approach in assessing HKTRC applications. While it is debatable whether commercial substance and beneficial ownership should be taken into account by the IRD in assessing tax residency, those wishing to claim a treaty benefit from the treaty partners of Hong Kong would nevertheless need to be prepared to demonstrate to the relevant overseas tax authorities that they are the beneficial owner of the passive income concerned and that they are not conduit or paper company set up for treaty shopping purposes. The IRD practice perhaps echoes the recent changes in handling treaty benefit claims in China effected by Public Notice [2015] No. 60 (PN 60) 2 issued by the State Administration of Taxation in August this year. Effective 1 November 2015, PN 60 removes the issuance of a referral letter for applying a HKTRC and requires a HKTRC for treaty benefit claims made by both Hong Kong and non-hong Kong incorporated corporations. Following the issuance of PN 60, a new set of HKTRC application forms for claiming a treaty benefit under the China-HK DTA was released by the IRD on 1 November The new application forms no longer require the applicants to produce an original referral letter but request certain additional tax administrative information in China (i.e. the Tax Identification Number of the applicant in China and the Chinese in-charge tax authorities). the relevant DTA(s) provided that all of the following conditions are met: 1. The Royalties article in the relevant DTA(s) adopts the wording of paid to a resident of the other Contracting party ; 2. The partnership is not considered as a resident of Hong Kong; 3. All partners are residents of DTA jurisdiction(s); and 4. The relevant DTA jurisdiction adopts a similar approach as Hong Kong. For a multi-layered partnership structure where a partner of the partnership is another partnership, the IRD would look through two layers of partners in a fiscally transparent partnership. The IRD advised that if the Hong Kong payer would like to withhold tax at the reduced treaty rate, it could write to the IRD in advance with the TRC issued by the relevant DTA jurisdiction for each partner and other relevant information and the IRD would confirm whether the treaty benefit claims are acceptable. PwC s comment: A similar question on eligibility to treaty benefits for income derived by a foreign partnership was raised in the 2013 annual meeting and the above response of the IRD is consistent with that in the 2013 meeting. The additional clarity provided in the IRD s 2015 response is that the partners of the non-resident partnership can come from different DTA jurisdictions (since the wording used for condition 3 above is DTA jurisdiction(s) instead of the DTA jurisdiction as in the 2013 minutes). As expressed in the minutes, ALL partners should be residents of DTA jurisdiction(s). It is possible that reduced treaty rate(s) will be denied if only some of the partners are residents of DTA jurisdiction(s) and the remaining partners are not. Special purpose vehicle formed by a Hong Kong group for holding investment: The IRD confirmed that in the situation where a holding company holds a group of companies with operations in Hong Kong, the group as a whole would be looked at in considering the commercial Application of tax treaties to nonresident partnerships substance of the holding From a practical perspective, if a Hong company. In such case, the IRD Kong royalty payer wishes to apply the will probably consider the holding Where royalty payment is made by a reduced treaty rate(s) for tax company as a Hong Kong tax Hong Kong payer to a non-resident withholding and lodge a treaty benefit resident even though it does not partnership that is treated as a fiscally claim on behalf of the partners of a have any staff in Hong Kong given transparent entity for tax purposes in non-resident partnership in the tax the whole group has operations in the home jurisdiction of the return filed, it would need to collect Hong Kong (assuming that the partnership, the IRD will generally the relevant information and holding company is managed or adopt the OECD approach and accept supporting documents (e.g. the TRC of controlled in Hong Kong). applications for treaty benefit by the each partner) from the partnership in However, the IRD noted that some partners (which can consist of both advance and provide the same to the of the Hong Kong treaty partners individuals and corporations) under IRD with the tax return filed. may take a different view and 3 PwC

4 Foreign tax credit claims of Hong Kong branches of overseas banks In determining the tax residency of a Hong Kong branch of an overseas bank, the IRD s current practice is to look at the management and/or control of the bank as a whole instead of the branch itself. Based on this approach and in a triangular situation where the Hong Kong branch of an overseas bank in a DTA jurisdiction (e.g. France) receives passive income from a third state (e.g. China), the Hong Kong branch cannot claim a credit of the Chinese withholding tax paid on the passive income in Hong Kong under the DTA between China and Hong Kong as the Hong Kong branch will not be regarded as a Hong Kong tax resident but a French tax resident. Against this background, a question was raised as to whether the denial of foreign tax credit to the Hong Kong branch of the French bank is inconsistent with the provisions in the Non-discrimination article under the DTA between France and Hong Kong, which requires Hong Kong to treat a permanent establishment of French company as favourable as a Hong Kong company. The IRD takes the view that it would not be appropriate for Hong Kong to take a position on this issue unilaterally without reaching an agreement with France since the DTA provisions are expected to be applied on a reciprocal basis. However, both Hong Kong and France did not consider this situation during the DTA negotiations and no agreement has been reached with France so far. The IRD did not indicate whether any action will be taken to resolve this issue in respect of the existing Hong Kong DTAs but said that it would need to consider introducing a provision to clarify such triangular cases in future treaty negotiations. Hong Kong s responses to the BEPS project In response to the OECD s BEPS project, the IRD indicated that when more concrete details and recommendations were made available, the HKSAR Government would need to review the domestic tax regime, including the application of existing taxation principles, provision of tax concessions and enforcement of anti-avoidance mechanism, and assess to what extent Hong Kong could meet the emerging international expectations and standards. In particular, the IRD mentioned that transfer pricing and preventing treaty abuse appear to be the pressure points for Hong Kong. For transfer pricing, Hong Kong may be expected by its treaty partners to formally adopt the latest international transfer pricing standards and documentation requirements (including the countryby-country (CbC) reporting recommended under BEPS Action 13). For preventing treaty abuse, it is expected that Hong Kong will be requested by the other jurisdictions to incorporate the OECD s proposed changes to the OECD Model Tax Convention under BEPS Action 6 in future treaty negotiations. However, the IRD takes the view that extensive research and consultation will be required before considering any changes in legislation and/or practice in Hong Kong. Currently, there is no prescribed timeline for implementing the OECD s recommendations on transfer pricing documentation under BEPS Action 13. PwC s comment: Further to the above comments, the IRD recently indicated in a public forum 3 that (1) going forward, there needs to be a balance between offering attractive corporate tax incentives and maintaining a global level playing field; (2) Hong Kong has already been approached by some treaty partners in respect of modifying the Hong Kong tax treaties to implement some of the changes recommended under BEPS Actions 6 and 7 (Action 7 deals with, among others, changes to the Permanent Establishment article) and (3) Hong Kong will have to review the need of exchanging CbC reports with other jurisdictions as well as participate in multilateral agreement for automatic exchange of information. The takeaway While the meeting minutes are not law and are not legally binding, the minutes serve as a good reference of the IRD s stance on various emerging tax issues. In particular, this year s minutes have shed some light on the impacts of the BEPS project on the tax regime of Hong Kong, which are mainly in the areas of consideration of corporate tax incentives, preventing treaty abuse and transfer pricing. Companies with business operations in Hong Kong or doing business with Hong Kong should take into account the views expressed by the IRD in the meeting minutes in both of their tax planning and tax filing processes for an effective management of their tax matters. Endnotes 1. The minutes of the 2015 annual meeting between the IRD and HKICPA can be accessed via this link: /section5_membership/professional %20Representation/pdf-file/taxb/26.pdf 2. Please refer to our Hong Kong Tax News Flash, September 2015, Issue 8 in the following link for a more detailed discussion of PN 60 and its implications for Hong Kong taxpayers: ktax_news_sep2015_8.html. 3. CTA Conference 2015: Positions of HK and China under the global tax development organized by the Taxation Institute of Hong Kong on 20 November PwC

5 Appendix 5 PwC

6 Let s talk For a deeper discussion of how this issue might affect your business, please contact a member of PwC s Hong Kong Corporate Tax Team: Reynold Hung reynold.hung@hk.pwc.com Oscar Lau oscar.lau@hk.pwc.com With over 2,200 tax professionals and over 140 tax partners in Hong Kong, Macao, Singapore, Taiwan and 19 cities in Mainland China, PwC s Tax and Business Service Team provides a full range of tax advisory and compliance services in the region. Leveraging on a strong international network, our dedicated Hong Kong Corporate Tax Team is striving to offer technically robust, industry specific, pragmatic and seamless solutions to our clients on their Hong Kong, PRC and international tax issues. In the context of this News Flash, China, Mainland China or the PRC refers to the People s Republic of China but excludes Hong Kong Special Administrative Region, Macao Special Administrative Region and Taiwan Region. The information contained in this publication is for general guidance on matters of interest only and is not meant to be comprehensive. The application and impact of laws can vary widely based on the specific facts involved. Before taking any action, please ensure that you obtain advice specific to your circumstances from your usual PwC s client service team or your other tax advisers. The materials contained in this publication were assembled on 27 November 2015 and were based on the law enforceable and information available at that time. This Hong Kong Tax News Flash is issued by the PwC s National Tax Policy Services in Hong Kong and China, which comprises of a team of experienced professionals dedicated to monitoring, studying and analysing the existing and evolving policies in taxation and other business regulations in China, Hong Kong, Singapore and Taiwan. They support the PwC s partners and staff in their provision of quality professional services to businesses and maintain thought-leadership by sharing knowledge with the relevant tax and other regulatory authorities, academies, business communities, professionals and other interested parties. For more information, please contact: Matthew Mui +86 (10) matthew.mui@cn.pwc.com Please visit PwC s websites at (China Home) or (Hong Kong Home) for practical insights and professional solutions to current and emerging business issues PricewaterhouseCoopers Ltd. All rights reserved. PwC refers to the Hong Kong member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see for further details.