3 March Issue No. 5

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1 Hong Kong Tax Alert 3 March Issue No. 5 Basel III compliant banking regulatory capital securities (RCSs) IRD states its interpretation of the tax treatment of RCSs Last week, the Inland Revenue Department (IRD) issued Departmental Interpretation and Practice Notes No. 53 (DIPN 53) setting out its views and practice on the application of certain recently enacted tax provisions for RCSs (RCS provisions) contained in the Inland Revenue Ordinance (IRO). Please refer to our Hong Kong tax alert issued on 27 May 2016 (2016 Issue No. 10) for details of the RCS provisions 1. Key points clarified by DIPN 53 include: I. distributions in respect of RCSs issued by a financial institution (FI) in Hong Kong and held by a specified connected person (SCP) of the FI would only be denied tax deduction to the extent the SCP does not fund the acquisition of the RCSs by way of their corresponding external RCSs or other debt instruments; II. III. the deemed notional capital structure under the distinct and separate enterprise principle prescribed by section 17G of the IRO will be invoked by the IRD as an anti-abuse provision to limit excessive interest deduction claims in relation to RCSs when computing the chargeable profits of the Hong Kong branch of a non-resident FI ; and the attribution of profits to the Hong Kong branch of a non-resident FI by way of hypothesising the Hong Kong branch as if it were a distinct and separate enterprise should not affect the application of the territorial source basis of taxation prescribed under section 14 of the IRO when determining the taxability of the profits so attributed. Notwithstanding the issuance of DIPN 53, the application of the RCS provisions in certain situations could still be a complicated matter. Where necessary, clients should seek professional tax advice. 1.

2 Key provisions of the RCS provisions Sections 17A to 17G of the IRO enacted on 3 June 2016 via the Inland Revenue (Amendment) (No. 2) Ordinance 2016 specify that qualifying RCSs issued by an FI are to be treated as debt securities, notwithstanding that under the general rules such securities may be regarded as equity. As such, distributions (other than a repayment of the paid-up amount) made by an issuer in respect of qualifying RCSs are to be treated as an interest expense eligible for a tax deduction under the newly added provisions contained in section 16(2AA) taken together with sections 16(1)(a) and 16(2)(a) of the IRO. The deduction is however subject to certain restrictions as prescribed by sections 17E, 17F and 17G of the IRO. Section 17E prescribes that RCS transactions (carried out on or after 3 June 2016) between an FI and its connected persons have to be conducted on an arm s length basis, i.e., on terms that would be agreed between unrelated parties. Section 17F sets out the extent to which an issuer of an RCS can claim a deduction if the security is issued to, held by, or issued to or held for the benefit of a specified connected person (SCP) of the issuer. Section 17G precludes a non-resident FI from attributing more than the normal share of the funding costs relating to the RCSs of the FI to its Hong Kong branch in order to take advantage of the Hong Kong profits tax deduction on distributions of RCSs. The RCS provisions shall have effect from 3 June 2016 and the relevant transitional provisions are set out in Schedule 36 of the IRO. As clarified in DIPN 53, the transitional provisions shall apply to grant tax deductions for distributions made on or after 3 June 2016 in connection with RCSs issued prior to 3 June Clarifications made in DIPN 53 Section 17F distributions in respect of RCSs held by an SCP will be disallowed only to the extent the SCP does not fund the RCSs by way of their externally issued RCSs or other debt instruments Section 17F denies distributions on RCSs issued by an FI which would otherwise be tax deductible, if the RCSs are issued to or held for the benefit of an SCP of the issuing FI. Subject to certain exceptions, an SCP generally refers to an associated person of an FI who is not chargeable to tax in Hong Kong in respect of any sum payable in respect of an RCS. The denial however does not apply where an SCP s acquisition of the RCSs issued by the FI is entirely funded, either directly or indirectly, by the proceeds of a corresponding RCS or a debenture or a debt instrument that the SCP or an associated corporation of the SCP issues externally to independent investors. Based on a literal interpretation of section 17F as noted above, there were concerns that where an SCP does not entirely fund the acquisition of RCSs in the above manner, distributions in respect of the RCSs held by the SCP would be disallowed in full in Hong Kong. To address these concerns, Examples 12, 13 and 14 of DIPN 53 illustrate that the IRD would in practice interpret section 17F more liberally. The stated practice is that where an SCP does not entirely fund the acquisition of RCSs issued by an FI through a corresponding external issue, tax deductions in respect of the distributions made by the issuing FI will only be disallowed to the extent the RCSs are not so funded. Setting guidelines on what would not be regarded as market making activities In order to accommodate the holding of RCSs in bona fide commercial transactions, section 17D provides for certain exceptions to the definition of an SCP for the purposes of section 17F, including the case of a market maker. Such exceptions are regardless of whether the market maker is chargeable to tax in Hong Kong in respect of the RCSs. According to the definition provided under section 17D, a market maker is a person who in the ordinary course of conduct of the market maker s trade, profession or business in respect of market making and, in the context of section 17F, holds the RCSs for the purpose of providing liquidity for the RCSs. In this regard, DIPN 53 indicates that a holding of over 5% of an issue of an RCS for a period of over 3 months will not be taken as holding of the RCS in the ordinary course of conduct of market making activities, unless the Commissioner is satisfied that there are reasonable explanations for doing so. Section 17G being an anti-abuse provision should not normally affect the preparation of tax returns Section 17G applies to the Hong Kong branch of a nonresident FI which has issued RCSs. The provision stipulates that the chargeable profits of such a Hong Kong branch should be determined based on the distinct and separate enterprise principle. Under this principle, the Hong Kong branch would be regarded as if it were an independent enterprise separate and distinct from other parts of the non-resident FI. As such, the Hong Kong branch would be assumed to have its own notional banking regulatory capital (including RCSs). Tax deductions arising from an attribution to the Hong Kong branch of funding costs relating to RCSs that exceed those ascertained under the distinct and separate enterprise principle might be restricted under section 17G. 2

3 Previously, it was not certain whether the Hong Kong branch of a non-resident FI would be required as an annual exercise to make a comparison of its actual debt to equity ratio with the notional ratio ascertained under the distinct and separate enterprise principle and then make an adjustment in its tax returns accordingly. DIPN 53 now states that section 17G was primarily enacted as an anti-abuse measure seeking to preclude excessive allocation of RCSs by a non-resident FI to its Hong Kong branch in order to obtain tax deductions in respect of distributions on RCSs not otherwise available to the FI in any other manner. As such, DIPN 53 indicates that it is only where the Commissioner has reasons to believe that the Hong Kong branch of a non-resident financial institution is engaged in tax avoidance transactions, he may request information about the source of funds used by the Hong Kong branch to produce its chargeable profits and its risks weighted assets for calculating its notional regulatory capital ratios. There should be no change insofar as the preparation of the profits tax return of the Hong Kong branch of a nonresident financial institution is concerned. Indications of such a tax avoidance motive cited in DIPN 53 include (i) where the profit generating operations of the Hong Kong branch are funded wholly or substantially by money raised through RCSs so as to obtain a tax deduction in Hong Kong not available in the home jurisdiction of the non-resident FI or in any other jurisdictions in which the non-resident FI has a permanent establishment; or (ii) the funding structure of the Hong Kong branch differs materially from that of the nonresident FI as a whole. Distinct and separate enterprise principle contained in section 17G will not change the source rules of Hong Kong Under the distinct and separate enterprise principle, section 17G prescribes that the chargeable profits of the Hong Kong branch of a non-resident FI which has issued RCSs should be ascertained by reference to the functions performed, assets used and risks assumed of the Hong Kong Branch vis-a-vis other parts of the nonresident FI. This approach to attributing profits is also known as an AOA approach, i.e., the authorized approach under the transfer pricing methodology adopted by the Organization of Economic Cooperation and Development. A functions performed, assets used and risks assumed test may not necessarily align with Hong Kong s source principles for determining chargeable profits in Hong Kong which have been developed by the courts over many years. As such, this apparent new test prescribed by section 17G could potentially introduce fundamental changes to the existing territorial source rules of Hong Kong as currently applied to Hong Kong branches of nonresident FIs. DIPN 53 now confirms that application of section 17G should not change Hong Kong s territorial basis of taxation specified in section 14 of the IRO. First, section 17G will be applied to attribute profits to the Hong Kong branch of an in-scope, non-resident FI. The territorial source principle will then apply to determine the extent to which those attributed profits are chargeable to Hong Kong profits tax. The provisions of section 17G apply from the year of assessment 2017/18 and onwards. Tax treatment of a hedging instrument to hedge an RCS should follow that of the RCS DIPN 53 reaffirms that where a hedging instrument is entered into and designated as an offset to changes in the fair value of an RCS and the hedging relationship qualifies for hedge accounting and is accounted for as such, the tax treatment of the hedging instrument should follow that of the RCS. That means the corresponding changes in the fair value of the hedging instrument will be disregarded, just as the changes in the fair value of the RCS of an issuer are disregarded for tax purposes under section 17C(2) of the IRO. As a result, only net payments made or received under the hedging instrument and the related costs will be brought into account in determining the chargeable profits of the issuer. As an example, periodic net payments made under an interest rate swap would be taken into account in determining the net interest paid in respect of an RCS where the swap qualifies as a hedging instrument for the relevant interest flow, but the changes in the fair value of the swap during the period concerned would be disregarded for tax purposes. RCSs issued by a non-fi holding company of an FI may be regarded as debt securities By definition, RCSs can only be those issued by an FI for regulatory capital requirement purposes. As such, RCSlike instruments issued by a holding company of an FI, where the holding company is not itself an FI, cannot be regarded as RCSs under the new law, and may then have to be regarded as an equity for tax purposes under the normal rules. However, when the Financial Institution (Resolution) Bill is enacted, the Hong Kong Monetary Authority (HKMA) may extend the minimum capital requirements to cover such a Hong Kong incorporated non-fi holding company, requiring the RCSs be issued at the non-fi holding company level. 3

4 To accommodate possible claims for tax deductions by such a non-fi holding company for distributions made in respect of its RCSs, DIPN 53 states that the Commissioner may consider treating such instruments as debt securities provided that: a) the Commissioner is satisfied that the instruments are not issued for tax avoidance purposes; b) the instruments are issued solely for the purposes of providing regulatory capital to the FI concerned in strict compliance with the minimum capital requirements imposed on the non-fi holding company and the FI by HKMA; and c) the instruments would have fallen with the meaning of RCS if they had been issued by the FI concerned. Nonetheless, the non-fi holding company of an FI, not itself being an FI for the purposes of the IRO, will need to satisfy one of the conditions as specified in other subsections of section 16(2), i.e., other than section 16(2)(a) together with section 16(2AA) referred to above for FIs, in order to claim distributions on RCSs as tax deductible interest. DIPN 53 indicates that the non-fi holding company of an FI may apply for an advance ruling in respect of the tax treatment of such instruments and distributions if they wish to obtain further tax certainty. Commentary While most of the clarifications now made in DIPN 53 were previously indicated by the Government when the relevant legislative bill was scrutinised by a Bills Committee of the Legislative Council, we welcome the reiteration and elaboration of the same by way of a formal practice note. DIPN 53 does not however provide much elaboration on how an FI can prove that its SCPs entirely fund the acquisition of RCSs issued by the FI by way of a corresponding external issuance of RCSs (or a denture or a debt instrument). Given that money is fungible, the issue could pose problems especially when the internal and external RCSs are not on a one-to-one basis, or there is a time interval between the issuance of the internal and external RCSs. As an example of the proof of the nexus being established, DIPN 53 only employs the expression immediately before the issue of an internal RCS by an FI in Hong Kong, the SCP concerned issued an external RCS and used the proceeds from the externally issued RCS to subscribe for the internally issued RCSs. It is however unclear what constitutes immediately before and whether the proceeds of externally issued RCSs have to be kept in a separate bank account before the same is used to subscribe for internally issued RCSs, in order to prove the application of the proceeds concerned. Prior to an issuance, FIs are therefore recommended to review what information may be available to demonstrate the nexus between the two, such as documentation based on their periodic regulatory capital reporting requirements and internal documentation policies. In any case, it is to be hoped that the current general assessing practice of apportioning interest expense would also apply to ascertaining the extent to which an SCP funds their acquisition of internally issued RCSs, where the application of the funds involved cannot be directly traced. It would be advisable for Hong Kong branches of nonresident FIs which have issued RCSs to review how the relevant RCSs are allocated to the Hong Kong branches, based on the specific facts and circumstances, so as to optimize the interest deductions permitted by section 17G as explained in DIPN 53. Furthermore, FIs should review the terms and conditions of their RCSs so as to ensure that, subject to commercial considerations, they qualify as qualifying RCSs under the RCS provisions. The application of the RCS provisions to certain situations could be a complicated matter. We recommend professional tax advice be sought as required. 4

5 EY Contacts Financial Services Hong Kong office Ian McNeill Managing, Tax, Asia-Pacific Principal tax contact, Ernst & Young Tax Services Limited Florence Chan Business Tax Services Paul Ho Sunny Liu Executive Director International Tax Services James Badenach Jacqueline Bennett John Praides Adam Williams Transfer Pricing Services Justin Kyte Transaction tax Rohit Narula Indirect tax Liza Drew EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com Ernst & Young Tax Services Limited. All Rights Reserved. APAC No ED None. This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax or other professional advice. Please refer to your advisors for specific advice. ey.com/china Follow us on WeChat Scan the QR code and stay up to date with the latest EY news.