News Flash. Hong Kong Tax. One step forward in developing Islamic finance in Hong Kong. January 2013 Issue 1. A typical sukuk structure

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1 News Flash Hong Kong Tax January 2013 Issue 1 Our Hong Kong Corporate Tax Team Contacts Peter Yu Tel: peter.sh.yu@hk.pwc.com Tim Leung Tel: tim.leung@hk.pwc.com Reynold Hung Tel: reynold.hung@hk.pwc.com Florence Yip Tel: florence.kf.yip@hk.pwc.com David Smith Senior Advisor Tel: david.g.smith@hk.pwc.com Our Hong Kong Corporate Tax team provides a full range of integrated professional services in tax consulting and compliance. Our tax specialists provide technically robust, industry specific and pragmatic solutions to our clients on Hong Kong, PRC and international tax issues. One step forward in developing Islamic finance in Hong Kong In order to consolidate Hong Kong s position as an international financial centre and tap the fast growing market of Islamic finance, the HKSAR Government indicated in the 2009/10 Hong Kong Budget that it would work on improving Hong Kong s regime to facilitate the development of Islamic finance in Hong Kong. In March 2012, the HKSAR Government launched a two-month public consultation on the proposed legislative amendments to facilitate the development of the Islamic bonds (i.e. sukuk) market in Hong Kong. Following the consultation, the long-awaited draft legislation that provides the taxation framework for Islamic bonds, namely the Inland Revenue and Stamp Duty Legislation (Alternative Bond Schemes) (Amendment) Bill 2012 ( the Bill ), was finally gazetted on 28 December The Bill will be introduced to the Legislative Council on 9 January This is in line with the goal set for Hong Kong in the National 12th Five-Year Plan which supports Hong Kong to develop into an offshore RMB business centre and an international asset management centre. This News Flash highlights the key features of the proposed tax regime for Islamic bonds and discusses the implications of some of these features to taxpayers interested in the sukuk market. A typical sukuk structure Sukuk are one of the most prominent instruments employed in Islamic finance. Since the payment and receipt of interest is prohibited under the Islamic law (i.e. Shariah), Sukuk are often structured in a way so as to generate the same economic effects as conventional bonds but in a Shariah-compliant manner. Sukuk have more complex product structures than their conventional

2 counterparts as they are usually structured with special purpose vehicles, multiple transfers of assets and various contractual techniques. A typical sukuk structure involves three parties (i.e. a tripartite structure consisting of an originator, a sukuk issuer and sukuk holders) and two arrangements (i.e. a bond arrangement and an investment arrangement). Under the bond arrangement, the sukuk issuer (which is usually a special purpose vehicle) will issue sukuk certificates to the sukuk holders and undertake to make coupon payments and redemption payment to the sukuk holders during and at the end of the sukuk term. Under the investment arrangement, the sukuk issuer will use the proceeds received from the sukuk holders to acquire an asset and arrange for the management of the asset with a view to generating investment return during the sukuk term to fund coupon payments to the sukuk holders. Upon maturity of the sukuk, the sukuk issuer will dispose of the asset and use the proceeds from the disposal to redeem the sukuk certificates from the sukuk holders. Although the above sukuk arrangement is economically equivalent to a debt arrangement, the prohibition of interest payments and multiple transfers of assets would lead to additional Hong Kong tax exposures for the parties involved as compared to those of a conventional debt arrangement, thus resulting in an impediment to developing the sukuk market in Hong Kong. The proposed taxation framework Objective of the Bill The Bill aims at introducing amendments to the Inland Revenue Ordinance ( IRO ) and the Stamp Duty Ordinance ( SDO ) to level the playing field for the five most common types of sukuk in the global market vis-à-vis their conventional counterparts for profits tax, property tax and stamp duty purposes and provide the necessary clarity in terms of tax treatment for sukuk. Product coverage Mimicking a sukuk structure, the Bill provides that an alternative bond scheme ( ABS ) is a scheme comprising of a bond arrangement and an investment arrangement that meet the descriptions in section 2 of the proposed Schedule 17A. An ABS is a specified ABS if the investment arrangement in the scheme meets the descriptions in sections 5 to 11 of the proposed Schedule 17A. Further, these descriptions specify the following four types of investment arrangements (referred to as specified investment arrangements) that corresponds the different underlying structures by which investment return is generated in the five most common types of sukuk: A lease arrangement ( Ijarah ) A bond-issuer enters into a lease in respect of an acquired asset with an originator to generate an investment return; A profits sharing arrangement ( Musharakah and Mudarabah ) A bond-issuer enters into a business undertaking with an originator to carry on business activities to generate an investment return; A purchase and sale arrangement ( Murabahah ) A bond-issuer sells an acquired asset to an originator with a mark-up to generate an investment return; and An agency arrangement ( Wakalah ) A bond-issuer appoints an originator as its agent to manage an acquired asset to generate an investment return. In order to allow for flexibility to respond to evolving market developments timely, the Bill also contains a clause that empowers the Financial Secretary to expand the coverage of eligible ABS by way of subsidiary legislation in the future. Qualifying conditions The bond arrangement and the investment arrangement in a specified ABS will become a qualified bond arrangement and a qualified investment arrangement respectively if they meet certain qualifying conditions. In broad terms, both the qualifying bond arrangement and the qualifying investment arrangement will be regarded as debt arrangement for the purposes of the IRO and the SDO. The qualifying conditions for a bond arrangement in a specified ABS to be treated as a qualified bond arrangement are (1) the reasonable commercial return condition; (2) the bond arrangement as financial liability condition; (3) News Flash Hong Kong Tax 2

3 the Hong Kong connection condition; (4) the maximum term length condition; and (5) the arrangements performed according to terms condition. The qualifying conditions for the specified investment arrangement in a specified ABS to be treated as a qualified investment arrangement are: (1) the bond arrangement in the scheme is always a qualified bond arrangement and (2) the scheme always complies with the bond-issuer as conduit condition and the investment arrangement as financial liability condition. The details of the above qualifying conditions are spelt out in sections 12 to 19 of the proposed Schedule 17A. These qualifying conditions aim at ensuring that the ABS concerned is economically equivalent to a typical conventional bond structure, that reasonable safeguards are put in place to minimise tax avoidance, and that the proposed taxation framework would encourage sukuk to have a nexus with Hong Kong and hence promote Hong Kong s financial market development. A bond arrangement disqualifying event ( BA disqualifying event ) or an investment arrangement disqualifying event ( IA disqualifying event ) occurs when any of the above qualifying conditions is no longer complied with. Proposed tax treatments for the debt arrangements in a specified ABS The underlying principle of the proposed amendments to the IRO and the SDO is to treat the qualified bond arrangement and qualified investment arrangement under a specified ABS as debt arrangements for the purposes of the IRO and the SDO, and to apply the comparable tax treatments accordingly. This means the bond proceeds under a qualified bond arrangement will be regarded as money borrowed by the bond-issuer from the bond-holders and the coupon payments payable by the bond-issuer to the bond-holders will be regarded as interest payable on such money borrowed. It follows that the relevant provisions in the IRO regarding say, for example, the tax concession or exemption for qualifying debt instruments, the deeming of certain income from certificates of deposits as trading receipts, the deduction of interest expenses, and the treatment as bonds for the purpose of tax exemption under the offshore funds regime will be equally applied to the qualified bond arrangement. In addition, transfer of an alternative bond issued under a qualified bond arrangement will not be subject to stamp duty charged on transfer of Hong Kong stocks under the SDO in most cases. With regard to a qualified investment arrangement, the acquisition cost of the assets will be regarded as money borrowed by the originator from the bond-issuer and the investment return received by the bond-issuer will be regarded as interest on such money borrowed and repayment of the principal. In line with this, the asset transactions (i.e. acquisition, leasing, disposal and any other relevant transactions as may be specified by the Financial Secretary in the future) entered into between the originator and the bond-issuer for the purposes of establishing an ABS will be disregarded and the originator will be treated as the owner of such assets for profits tax purposes. It follows that any expenditure, profits or losses arising from the assets will belong to the originator and in particular, the originator will be entitled to depreciation allowances associated with the assets when applicable. In addition, instruments executed in relation to the transfer or leasing of these assets will be exempted from stamp duty under the SDO. However, the said stamp duty relief is subject to the condition that a security be given for the payment of the stamp duty amount that would otherwise be payable under the SDO for the instruments. Finally, any investment return (e.g. rental paid by the originator to the bond-issuer) under a qualified investment arrangement will not be regarded as a consideration payable in respect of the right of use of land and/or buildings under the IRO and therefore will not be subject to property tax. The occurrence of a BA disqualifying event or an IA disqualifying event will result in an arrangement that has formerly been a qualified bond arrangement or a qualified investment arrangement being regarded as never having been qualified, which may in turn lead to a withdrawal of the relief previously granted in its entirety under the IRO and the SDO. Implications to sukuk market players The introduction of the Bill represents one further step taken by the HKSAR Government in facilitating the development of sukuk market in Hong Kong. While this move should be welcomed by those who are interested in Islamic finance, sukuk market players need to pay attention to some of the uncertainties or onerous features in the proposed tax regime for sukuk. Below are some examples. Reasonable commercial return Under the reasonable commercial return condition mentioned above, both the maximum total amount of bond return (i.e. coupon payments and/or discount/premium) payable and the actual total amount paid to the bond-holders must not exceed an amount that would be a reasonable commercial return on money borrowed of the amount of the bond proceeds. This condition represents an additional News Flash Hong Kong Tax 3

4 requirement as compared to conventional bonds. However, the Bill does not lay down any objective means of testing whether this condition is met. Uncertainties will therefore arise as to the operation of this condition. To minimize uncertainty, taxpayers who are interested in Islamic finance may apply for advance ruling in respect of the application of the IRO as well as informal ruling in respect of the application of the SDO to an alternative bond arrangement. Maximum term length Although the maximum term length condition has been relaxed by extending the term length limit of the specified ABS from 10 years to 15 years and including a clause in the Bill that empowers the Financial Secretary to amend the limit in the future by way of subsidiary legislation, the condition again imposes an additional requirement as compared to conventional bonds. Record keeping and the extended time limit for raising additional profits tax assessments / recovering stamp duty For the purposes of the IRO, business records relevant to a specified ABS have to be kept until the expiry of seven years after the completion of the transactions, acts or operations concerned or the expiry of three years after the end of the ABS term, whichever is the later. For the purposes of the SDO, the relevant documents have to be kept until the expiry of one year after the end of the ABS term. Again, although the periods of which the documents relevant to a specified ABS have to be kept for both the IRO and SDO purposes have been shortened in response to comments received during the consultation, this record keeping requirement is considered more onerous than that for conventional bonds. In addition, the time limits for raising additional profits tax assessments / recovering stamp duty in cases of a disqualification from the special treatments under the tax regime for sukuk have been extended accordingly. The finalisation of the tax regime for Islamic bonds will be subject to the scrutiny and passage of the Bill by the Legislative Council as well as the issuance of interpretation and practice notes that clarify a number of issues arising from a sukuk arrangement for the purposes of the IRO and the SDO. We will keep a close watch on any further developments in this area and share with you our insights and observations. News Flash Hong Kong Tax 4

5 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 PricewaterhouseCoopers client service team or your other tax advisers. The materials contained in this publication were assembled on 3 January 2013 and were based on the law enforceable and information available at that time. To make enquiries about our Hong Kong tax and business advisory services, please feel free to contact the following lead specialist partners: Company Fiduciary & Administration Services John Wong Tel: john.cw.wong@hk.pwc.com Customs & International Trade Colbert Lam Tel: colbert.ky.lam@hk.pwc.com Entertainment & Media Colin Farrell Tel: colin.farrell@hk.pwc.com Financial Services Florence Yip Tel: florence.kf.yip@hk.pwc.com Industrial Products Medinah Ip Tel: medinah.ip@hk.pwc.com Info-Comms Suzanne Wat Tel: suzanne.wat@hk.pwc.com International Assignment Services Mandy Kwok Tel: mandy.kwok@hk.pwc.com International Tax Advisory Nick Dignan Tel: nick.dignan@hk.pwc.com Investigation Services Kaiser Kwan Tel: kaiser.kwan@hk.pwc.com Logistics & Transportation Reynold Hung Tel: reynold.hung@hk.pwc.com Merger & Acquisition Nick Dignan Tel: nick.dignan@hk.pwc.com Personal Financial Services John Wong Tel: john.cw.wong@hk.pwc.com Real Estate KK So Tel: kk.so@hk.pwc.com Retail & Consumer Products Tim Leung Tel: tim.leung@hk.pwc.com Tax Accounting Services Suzanne Wat Tel: suzanne.wat@hk.pwc.com Transfer Pricing Cecilia Lee Tel: cecilia.sk.lee@hk.pwc.com Value Chain Transformation Tim Leung Tel: tim.leung@hk.pwc.com Our regional contacts: Beijing Edward Shum Tel: +86 (10) edward.shum@cn.pwc.com Chongqing Robert Li Tel: +86 (23) robert.li@cn.pwc.com Dalian Rex Chan Tel: +86 (411) rex.c.chan@cn.pwc.com Guangzhou Daisy Kwun Tel: +86 (20) daisy.kwun@cn.pwc.com Hangzhou Jenny Chong Tel: +86 (21) j.chong@cn.pwc.com Hong Kong Peter Yu Tel: peter.sh.yu@hk.pwc.com Macao Grace Cheung Tel: grace.cheung@hk.pwc.com Nanjing Jane Wang Tel: +86 (25) jane.y.wang@cn.pwc.com Ningbo Ray Zhu Tel: +86 (21) ray.zhu@cn.pwc.com Qingdao Steven Wong Tel: +86 (532) steven.wong@cn.pwc.com Shanghai Peter Ng Tel: +86 (21) peter.ng@cn.pwc.com Shenzhen Charles Lee Tel: +86 (755) charles.lee@cn.pwc.com Singapore Lennon Lee Tel: lennon.kl.lee@sg.pwc.com Suzhou Linjun Shen Tel: +86 (512) linjun.shen@cn.pwc.com Taiwan Steven Go Tel: +886 (2) steven.go@tw.pwc.com Tianjin Kelvin Lee Tel: +86 (22) kelvin.lee@cn.pwc.com Xiamen Mike Chiang Tel: +86 (21) mike.chiang@cn.pwc.com Xian Elton Huang Tel: +86 (29) elton.huang@cn.pwc.com This Hong Kong Tax News Flash is issued by the 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 PricewaterhouseCoopers partners and staff in their provision of quality professional services to businesses and maintain thoughtleadership 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 Tel: +86 (10) matthew.mui@cn.pwc.com Please visit PricewaterhouseCoopers 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. In this document, PwC refers to PricewaterhouseCoopers Ltd. which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity.