7 November Issue No. 14

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1 Hong Kong Tax Alert 7 November Issue No. 14 The IRD clarifies how it will interpret and administer the concessionary tax regime for qualifying aircraft leasing activities On 27 October 2017, the Inland Revenue Department (IRD) issued Departmental Interpretation and Practice Notes No. 54 (DIPN 54) addressing the new law that introduces a concessionary tax regime for qualifying aircraft lessors and qualifying aircraft leasing managers in Hong Kong. Please refer to our Hong Kong tax alert issued on 28 June 2017 (2017 Issue No. 10) for details of the concessionary tax regime. Taxpayers who wish to avail themselves of the concessionary tax regime should take particular note of the clarifications detailed in DIPN 54 as regards the following: (i) a qualifying leasing activity may include the leasing of aircraft to an aircraft operator indirectly via an intermediate lessor; (ii) how the substantial activity requirement will be considered satisfied; (ii) the application of a prescribed safe harbour rule applicable to aircraft leasing managers; and (iv) the limitation on deduction for payments made by a connected taxpayer to a qualifying aircraft lessor or leasing manager. DIPN 54 also provides guidance on the information and documents to be submitted when a taxpayer under the concessionary tax regime: commences an aircraft leasing activity in Hong Kong; applies for a certificate of residence (CoR) from the IRD confirming their residence in Hong Kong; or lodges an advance ruling application. Notwithstanding the issuance of DIPN 54, the application of the new law in certain situations could still be a complicated matter. Clients who wish to establish an aircraft leasing or management business in Hong Kong, or have any questions regarding either the new law or DIPN 54, should contact their tax executives.

2 Summary of the concessionary tax regime Corporations that meet the specified conditions may make an irrevocable election in writing to avail themselves of the concessionary tax regime. Under the concessionary regime: (i) qualifying profits 1 of qualifying aircraft lessors and qualifying aircraft leasing managers will be taxed at the concessionary tax rate of 8.25% (i.e., 50% of the current profits tax rate of 16.5%); and (ii) in lieu of tax depreciation allowances 2, the deemed taxable amount in respect of income derived from the leasing of aircraft to an aircraft operator by a qualifying aircraft lessor will be equal to 20% of the tax base of the lessor concerned, i.e., their gross rentals less deductible expenses, but excluding tax depreciation allowances. Clarifications detailed in DIPN 54 Leasing of aircraft to an aircraft operator indirectly via an intermediate lessor may still be eligible for the profits tax concession Under the literal meaning of the relevant provisions of the new law, it is only when a qualifying aircraft lessor leases their aircraft directly to an aircraft operator that such a lessor could qualify for the profits tax concession. Despite the strict law, if due to various commercial reasons a qualifying aircraft lessor leases their aircraft indirectly to an aircraft operator situated in another jurisdiction via an intermediate lessor (which is not itself an aircraft operator), DIPN 54 indicates that the IRD may still consider the lessor to be eligible for the profits tax concession. The commercial reasons cited in DIPN 54 in this regard appear to include an intermediate lessor being set up, in either the lessee jurisdiction or a third jurisdiction, in order to obtain: (i) preferential tax benefits offered by the lessee jurisdiction; or (ii) a reduction in withholding tax in respect of lease payments out of the lessee jurisdiction under a tax treaty between the third jurisdiction and the lessee jurisdiction. How the substantial activity requirement will be considered satisfied In addition to being a qualifying aircraft lessor or leasing manager as defined in the new law, such a lessor or manager must satisfy one of the specified conditions concerning the activities which produce their qualifying profits, namely said activities have to be either (a) carried out in Hong Kong by the lessor or manager themselves; or (b) arranged by the lessor or manager to be carried out in Hong Kong (i.e., the substantial activity requirement ). DIPN 54 explains that to satisfy the substantial activity requirement, the core income generating activities which produce the qualifying profits of a qualifying aircraft lessor or a qualifying aircraft leasing manager need to be carried out in Hong Kong. Such activities include: raising funds; agreeing funding terms; identifying and acquiring aircraft to be leased; soliciting lessees; setting the terms and duration of leases; monitoring and revising lease agreements; managing any risks and maintaining documentation. For lessors that are established as a special purpose vehicle (SPV) to hold an aircraft, DIPN 54 states that it may be necessary to consider whether such an SPV has sufficient nexus with the active conduct of aircraft leasing activity in Hong Kong, including the engagement of an aircraft leasing manager carrying on business in Hong Kong. In order to assist the IRD to consider whether the substantial activity requirement is satisfied, DIPN 54 states that it is important for taxpayers to submit a realistic business plan for carrying out their aircraft leasing activities in Hong Kong in the year in which the aircraft leasing activity commences. Taxpayers who wish to have certainty as regards their eligibility for the concessionary tax regime may apply for an advance ruling. Appendix 2 to DIPN 54 provides a detailed list of the required information and documents to be furnished in such a ruling application. Nonetheless, DIPN 54 states that the IRD would carefully examine the facts of each case in order to ascertain if a leasing arrangement involving the interposition of an intermediate lessor is one for which the profits tax concession was intended. 1. DIPN 54 states that qualifying profits include incidental income such as interest income, exchange gains or hedging gains, to the extent that the relevant transactions are ancillary to the qualifying activities. 2. Under section 39E of the IRO, a lessor would be denied tax depreciation allowances in respect of the cost they incurred on the acquisition of an aircraft if the aircraft is leased to an overseas aircraft operator. The lessor of an aircraft to a Hong Kong aircraft operator would normally be entitled to tax depreciation allowances. However, if tax depreciation allowances are claimed by a lessor in such situations, the lessor as a result will not be eligible for the concessionary tax rate and the deemed notional tax base. 2

3 Prescribed safe harbour rules applicable to aircraft leasing managers There are safe harbour rules under which a corporation not dedicated solely to carrying out one or more of the qualifying aircraft leasing management activities would nonetheless qualify as a qualifying aircraft leasing manager. One of the prescribed safe harbour rules requires that both the aggregate amount of the aircraft leasing management profits (ALMP) and the aggregate value of the aircraft leasing management assets (ALMA) for a year of assessment in question, are not less than 75% of the total amount of the profits and value of the assets of the corporation concerned. As regards the application of the above ALMP and ALMA tests, DIPN 54 states that in general, the accounting profits and asset values as reflected in the audited financial statements of a corporation will be relevant, regardless of the source of the profits and location of the assets concerned. DIPN 54 also indicates that apportionment of the value of an asset would be allowed in computing the value of the asset attributable to qualifying aircraft leasing management activity if an asset is used partly for such activity and partly for another purpose. In relation to cases where an aircraft leasing manager also acts as the holding company for a leasing group, DIPN 54 states, apparently as an extra-statutory concession, that the IRD is prepared to exclude from the denominators for the calculation of the ALMA and ALMP percentages both equity investments in group companies and dividends. By way of the IRD adopting this approach, such a corporation would more readily qualify as a qualifying aircraft leasing manager under the relevant safe harbour rule. DIPN 54 also contains an example indicating that a corporation can serve both as (i) an aircraft lessor and (ii) an aircraft leasing manager rendering services to third parties for a fee. In such a situation, the activities undertaken by the corporation in (i) and (ii) above may be considered separately in isolation when determining whether the two respective activities qualify for the concessionary tax regime (under the relevant sole dedication or safe harbour rules). Limitation on tax deduction in Hong Kong for payments made by a connected taxpayer to a qualifying aircraft lessor or leasing manager under section 16(1A) DIPN 54 states that section 16(1A) of the Inland Revenue Ordinance is enacted to prevent tax arbitrage through aircraft leasing transactions between connected persons. Were it not for the enactment of section 16(1A), tax arbitrage would have been achieved in certain situations. For example, while an aircraft operator in Hong Kong would be able to claim a deduction at the normal tax rate of 16.5% in respect of its payments made to a connected qualifying aircraft lessor, the recipient of such payments would only be taxed at the concessionary tax rate of 8.25%. In such a situation, section 16(1A) limits the tax deduction of the payer by reference to the amount of tax reduction enjoyed by the recipient under the concessionary tax regime. By way of the following illustrative example, DIPN54 explains how section 16(1A) works: Qualifying Aircraft Lessor- HK Tax deductible operating expenses: HK$7 million Lease of aircraft Lease payment of HK$12 million Connected Aircraft Operator-HK Profits tax payable by Qualifying Aircraft Lessor-HK: = (HK$12 million HK$7 million) x 20% x 8.25% = HK$1 million x 8.25% = HK$82,500 [Sum A] Reduction in the profits tax payable of Qualifying Aircraft Lessor-HK: = (HK$1 million x 16.5%) HK$82,500 (Sum [A]) = HK$82,500 [Sum B] Amount of the lease payment deductible by Aircraft Operator-HK: = HK$12 million ((HK$82,500 (Sum B) 16.5%)) = HK$11.5 million DIPN 54 also clarifies that section 16(1A) would have no application where the payer and the recipient are both taxpayers qualifying for the concessionary tax regime, where there would be no tax arbitrage. 3

4 Documents to be furnished in CoR application An aircraft lessor may be required to provide a lessee with a CoR evidencing the lessor s residence in Hong Kong in order to enjoy a reduction in withholding tax on aircraft rentals received from the lessee jurisdiction if that jurisdiction has concluded a comprehensive avoidance of double taxation arrangement (CDTA) with Hong Kong. DIPN 54 indicates that qualifying aircraft lessors that satisfy the CMC condition (i.e., that the central management and control of the corporation concerned is exercised in Hong Kong) and which have substantial activities in Hong Kong should be able to obtain a CoR from the IRD. Such a CoR application would however need to be supported by relevant documentary evidence, e.g., a copy of the management agreement entered into with a Hong Kong qualifying aircraft leasing manager. Where an applicant is newly established in Hong Kong, a five-year business plan may also need to be submitted. No tax credit available in Hong Kong where withholding tax is borne by lessee DIPN 54 indicates that as a rule, a tax credit would not be available to a qualifying aircraft lessor in Hong Kong if the overseas withholding tax on aircraft rentals is borne by the lessee pursuant to the lease arrangement, regardless of whether there is a CDTA in force between Hong Kong and the lessee jurisdiction. Commentary We welcome the clarifications and guidance provided by DIPN 54. The substantial activity requirement in Hong Kong may however pose some uncertainties for certain aircraft lessors or leasing managers as regards their eligibility for the concessionary tax regime. Hong Kong as yet may not have established a critical mass of aircraft leasing management expertise in certain overseas aircraft leasing markets. As such, an aircraft lessor set up as an SPV in Hong Kong may need to appoint related or unrelated overseas aircraft leasing managers to solicit lessees, negotiate lease terms and provide other lease management services including those relating to aircraft acquisition and disposal matters etc., whilst the ultimate investment and leasing decisions are evaluated and made by the SPV in Hong Kong. The apparent emphasis of DIPN 54 on the engagement of a Hong Kong leasing manager by such an SPV lessor as being an important test of whether the substantial activity requirement is satisfied, may create some uncertainty as to the eligibility of such an SPV for the concessionary tax regime. Similarly, a current lack of aircraft leasing expertise in Hong Kong may prompt a Hong Kong aircraft leasing manager to subcontract the delivery of part of its aircraft leasing management services to an overseas aircraft leasing manager. Whether such a Hong Kong aircraft leasing manager would then be eligible for the concessionary tax regime may also be unclear. Notwithstanding the issuance of DIPN 54, the application of the new law to certain situations could still be complicated. Clients who have any questions on the operation of the concessionary tax regime should contact their tax executives. 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 Adam Williams Transfer Pricing Services Justin Kyte Transaction tax Rohit Narula Global Compliance and Reporting Michael Stenske EY Assurance Tax Transactions Advisory Indirect tax Liza Drew 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.