Hong Kong. Tax Alert. Hong Kong

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1 Hong Kong Tax Alert 10 December Issue No. 20 Hong Kong introduces a legislative bill for enhancing its attractiveness as a corporate treasury centre to multinational corporations The bill 1 seeks to remove an impediment to multinational corporations setting up a corporate treasury centre (CTC) in Hong Kong. The impediment is an asymmetrical tax treatment of the interest income and expense of a CTC. In addition, the bill also proposes to tax qualifying profits of a qualifying CTC at a concessionary tax rate of 8.25% (i.e., 50% of the normal corporate tax rate of 16.5%). The asymmetrical tax treatment stems from the fact that under the current tax rules, a CTC would not be able to claim a tax deduction for interest paid on money borrowed from a non-hong Kong associated corporation (which is not a financial institution), whilst its interest income from the on-lending would normally be chargeable to tax in Hong Kong. To put the taxability of certain interest and related income of a CTC beyond doubt, the bill also contains two deeming provisions. Under these provisions, relevant interest income and profits in respect of certain debt instruments derived by a CTC which carries on an intra-group financing business in Hong Kong would be deemed profits of the CTC chargeable to tax in Hong Kong. This alert explains the major provisions of the bill. 1 The bill referred to is Inland Revenue (Amendment) (No. 4) Bill 2015 and is downloadable from In addition to containing the proposed legislation for CTCs, the bill also contains proposals that seek to clarify the profits tax and stamp duty treatments in respect of regulatory capital securities issued by banks in compliance with Basel III capital adequacy requirements.

2 Rectifying the asymmetrical tax treatment Currently, under section 16(2)(c) of the Inland Revenue Ordinance (IRO), interest paid by a CTC to a lender which is not a financial institution would only be tax deductible if the interest received by the lender is subject to tax in Hong Kong. As such, a CTC would generally not be able to claim a tax deduction in Hong Kong for interest paid to its overseas group companies which do not carry on business in Hong Kong. However, interest income derived from the on-lending by a CTC to other group companies would normally be chargeable to tax in Hong Kong, regardless of where those other group companies are located or where the funds are made available to those group companies. This is a major impediment for multinational corporations when considering Hong Kong for locating their CTC operations. In order to attract multinational corporations to establish CTCs in Hong Kong (including facilitating the drive of Mainland enterprises to go global under the Belt-Road initiative), the Financial Secretary announced in his 2015/16 Budget that the Government would amend the IRO, foretelling the introduction of the bill. Major provisions of the bill Additional new deduction section for interest paid to overseas associated corporations Under a new section 16(2)(g) to be introduced into the IRO, any corporation which carries on in Hong Kong a business of borrowing of money from and lending of money to its associated corporations, can claim a tax deduction for interest paid to a non-hong Kong associated corporation provided that the following conditions are satisfied: I. The money is borrowed in the ordinary course of the said intra-group financing business of the corporation; I The lender is, in respect of the interest, subject to tax overseas which is similar to the profits tax of Hong Kong, at a rate not lower than the reference rate (i.e., 16.5% or 8.25% as applicable). For this purpose, the lender would be considered as being subject to tax overseas where the Commissioner of Inland Revenue (CIR) is satisfied that the relevant overseas tax has been or will be paid; and The lender s right to use and enjoy that interest is not constrained by a contractual or legal obligation to pass that interest to any other person (unless 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). However, claims for tax deductions of interest under the proposed section 16(2)(g) would be denied where: Interest flow-back restriction (a) arrangements are in place by which any sum of the relevant interest, whether directly or through any interposed person, is payable to a related person; and (b) the related person is, in respect of the sum, subject to profits tax in Hong Kong or a similar tax outside Hong Kong at a rate which is less than the reference rate. Utilization of tax losses restriction the main purpose or one of the main purposes of the borrowing of the money by the corporation is to utilize a loss in order to avoid, postpone or reduce any liability, whether of the corporation or another person, to profits tax in Hong Kong. Concessionary tax rate for qualifying profits of a qualifying CTC A qualifying CTC can elect to have its qualifying profits taxed at the concessionary tax rate of 8.25%. Such an election, once made, is irrevocable for so long as the corporation remains as a qualifying CTC. Where a CTC has made an election but failed to qualify as a qualifying CTC for a particular year, the CTC will be denied the concessionary tax rate for the subsequent year of assessment. This provision is to discourage a CTC from deliberately rendering itself not qualifying as a qualifying CTC. Such deliberate act may be contemplated when the CTC expects to incur losses for a year in respect of what would otherwise have been half-rate CTC operations such that the losses could be offset against other full-rate taxable profits of the CTC on a dollar-for-dollar basis. Otherwise, such losses would have to be scaled down by half when used to offset against other full-rate taxable profits of the CTC. Qualifying profits Assessable profits of a CTC derived from the following transactions would be qualifying profits: Money lent in the ordinary course of the CTC s intragroup financing business to a non-hong Kong associated corporation. A corporate treasury service 2 provided by the CTC to a non-hong Kong associated corporation. A corporate treasury transaction 2 entered into by the CTC on its own account that is related to the business of a non-hong Kong associated corporation. 2 Please refer to the Appendix to this alert for the types of services and transactions that qualify as corporate treasury service and corporate treasury transaction under the bill. 2

3 Furthermore, to qualify for the concessionary tax rate, any sum paid to the CTC for the above three types of qualifying transactions cannot be tax deductible to the payer in Hong Kong. The Government s rationale for the above restrictions is to guard against revenue loss in circumstances where qualifying profits derived by a qualifying CTC are subject to half-rate taxation but associated corporations in Hong Kong claim a full tax deduction for the corresponding payments. However, counterparties to corporate treasury transactions of the third type of qualifying transactions e.g., transactions in respect of derivative contracts entered into by CTCs are often financial institutions unrelated to the CTC. As such, whether the unrelated financial institutions concerned would be able to claim the payments to the CTCs as being tax deductible in Hong Kong should not affect the eligibility of the CTCs for the concessionary tax rate in respect of the transactions. Qualifying CTC To qualify as a qualifying CTC for a year of assessment, (i) the central management and control of the CTC concerned for that year has to be exercised in Hong Kong; and (ii) the activities that produce the qualifying profits in that year have to be either (a) carried out in Hong Kong by the CTC itself; or (b) arranged by the CTC to be carried out in Hong Kong. The above business substance in Hong Kong requirements are to ensure that the proposed tax incentive in the form of the concessionary tax rate would not be regarded as a harmful tax practice by the international community, in the context of the initiative spearheaded by the OECD and the G20 countries in addressing base erosion and profits shifting 3. In any case, the business substance in Hong Kong requirements would also be compatible with the desire of many CTCs to claim tax benefits under the expanding tax treaty network of Hong Kong. The bill also stipulates that, subject to certain safe harbor rules, a CTC would be a qualifying CTC only if, for a year of assessment in question, it is a standalone corporate entity dedicated to conduct one or more of the following corporate treasury activities and no others: Carrying on an intra-group financing business of borrowing money from and lending of money to its associated corporations; Providing a corporate treasury service; or Entering into a corporate treasury transaction. In determining whether a corporation has carried out any activity other than the above specified corporate treasury activities, the bill provides that only activities that generate income to the CTC are to be taken into account. Safe harbor rules A CTC not dedicated solely to one or more of the above specified corporate treasury activities, would nonetheless be regarded as a qualifying CTC under the following two safe harbor rules: 1. Both the aggregate amount of the corporate treasury profits (CTP) and the aggregate value of the corporate treasury assets (CTA) for the year of assessment in question are not less than 75% of the total amount of the profits and value of the assets of the CTC concerned. The 75% threshold can be determined by either (i) the CTP and CTA percentage of the subject year of assessment alone; or (ii) the average CTP and CTA percentage over three relevant years of assessment - i.e., the subject year of assessment and the two preceding years; or (iii) where the CTC concerned carries on business in Hong Kong for less than 2 consecutive years immediately before the subject year of assessment, the average CTP and CTA percentage over the subject year and the preceding year of assessment. 2. Where a CTC fails to qualify as a qualifying CTC on the above, the CTC concerned may nonetheless make an application to the CIR requesting the CIR to determine it as being a qualifying CTC. The CIR may make such a determination only if he is of the opinion that the CTC, not being a financial institution, would have qualified as a qualifying CTC in the ordinary course of business of the corporation concerned (i.e., something out of the ordinary had happened that made the corporation not qualifying). If the safe harbor rules are enacted in its current form, it is hoped that the tax administration would provide guidance on how the CTP and CTA percentages are to be determined. The guidance required includes whether the CTP refers to accounting or taxable profits and the method for determining the value of the assets under the CTA formula, e.g., historical cost or fair market value, particularly the apportionment method where the assets concerned are used for both CTC and non-ctc operations. 3 Base Erosion and Profit Shifting (BEPS) refers to tax planning strategies that exploit the gaps and mismatches in tax rules of different jurisdictions so as to artificially shift profits to low or no-tax locations where there is little or no economic activity, resulting in little or no overall corporate tax being paid. 3

4 Putting beyond doubt the taxability of relevant income of CTCs The bill proposes to add two new deeming sections in the form of 15(1)(ia) and (la) to the IRO. Under these two deeming sections, interest income and relevant profits in respect of certificates of deposit, bills of exchange and regulatory capital securities derived by a CTC from its business of intra-group financing business in Hong Kong would be deemed profits chargeable to tax in Hong Kong. This would be the case regardless that the provision of credit of the loans may be made outside Hong Kong and that the relevant contracts for disposal, redemption or presentation of the instruments concerned were effected outside Hong Kong. Effective dates The proposed interest deduction rules and concessionary tax rate for qualifying profits of a qualifying CTC will apply to sums payable, received or accrued on or after 1 April The proposed deeming provisions for the relevant interest income and profits of a CTC will only apply to sums received or accrued on or after the date on which the bill is enacted into law. Our views We welcome this legislative proposal which together with other existing advantages Hong Kong offers, including its proximity to mainland China, large offshore RMB pool, abundant supply of legal and financial professionals and efficient capital markets, would enhance Hong Kong s attractiveness as a CTC to multinational corporations. Subject to the two safe harbor rules, the bill adopts an entity-based approach to granting the concessionary tax rate. This can be considered a good first step but many existing CTCs may not be able to benefit from the incentive. Given the safe harbor rules contained in the bill, large corporations that now conduct CTC activities as part of their wider operations would need to consider whether they would be able to qualify under the rules. If not, such large corporations may need to weigh the benefit of the half-rate taxation of the relevant profits against any inconvenience or costs of spinning off the CTC operations into a separate legal entity. In terms of tax costs, one may need to consider whether such a spin-off would give enough substance to the spinoff entity or weaken the substance of the original large corporation for tax treaty benefits. This may be a concern given that the substance e.g., in terms of headcount and activities would now need to be spread over the two entities concerned. If the bill is enacted into law, the Government may at an appropriate later date need to consider the desirability of relaxing the 75% safe harbor rule so as to cover more CTC operations. Many of the provisions of the bill are complicated. Clients who have any questions on this legislative proposal can contact their tax executives. 4

5 Appendix Corporate treasury services mean the following services provided to an associated corporation: a) managing the cash and liquidity position, including cash forecasting or pooling, of the associated corporation and providing related advice; b) processing payments to the vendors or suppliers of the associated corporation; c) managing the associated corporation s relationships with financial institutions; d) providing corporate finance advisory service, including I. activities supporting the raising of capital, such as by way of debt or equity, by the associated corporation; and capital budgeting for the associated corporation; e) advising on the management of the investment of the funds of the associated corporation; f) managing investor relations regarding the investors in the debt or equity instruments issued by the associated corporation; g) providing service in relation to I. the provision of guarantees, performance bonds, standby letters of credit or other credit risk instruments to or on behalf of the associated corporation; or remittances to or on behalf of the associated corporation; h) providing advice or service in relation to the management of interest rate risk, foreign exchange risk, liquidity risk, credit risk, commodity risk or any other financial risk of the associated corporation; i) providing assistance in the merger or acquisition of a business by the associated corporation; j) providing advice or service in relation to the associated corporation s compliance with I. accounting standards; I internal treasury policies; or regulatory requirements in relation to treasury management; k) providing advice or service in relation to the operations of the treasury management system of the associated corporation; l) providing business planning and co-ordination, including economic or investment research and analysis, for the associated corporation in connection with any of the activities specified in paragraphs (a) to (k). Corporate treasury transactions mean the following transactions entered into on a CTC s own account and related to the business of an associated corporation: a) a transaction in relation to the provision of guarantees, performance bonds, standby letters of credit or other credit risk instruments in respect of the borrowing of money by the associated corporation; b) a transaction investing the funds of the corporation or the associated corporation in any of the following financial instruments for managing the cash and liquidity position of the corporation or the associated corporation I. deposits; I IV. certificates of deposit; bonds; notes; V. debentures; VI. V money-market funds; other financial instruments (except securities issued by a private company as defined by section 20ACA(2)); c) a transaction in respect of any of the following contracts that are entered into for the purpose of hedging interest rate risk, foreign exchange risk, liquidity risk, credit risk, commodity risk or any other financial risk of the associated corporation a. contracts for difference; b. foreign exchange contracts; c. forward or futures contracts; d. swap contracts; e. options contracts; f. a factoring or forfaiting transaction. d) a factoring or forfaiting transaction. 5

6 Financial Services Hong Kong office Ian McNeill Managing, Tax, Asia-Pacific Principal tax contact Florence Chan Business Tax Services Paul Ho Michael Stenske Napson Hon Sunny Liu International Tax Services James Badenach John Praides Adam Williams David Allgaier Aaron Lam Transfer Pricing Services Justin Kyte Jonathan Thompson Brandan Wing Peggy Lok Rohit Narula 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