Option 2: How to avoid double taxation? Tax treaty 101 Stefano Mariani TEP, Deacons Steven Sieker TEP, Baker & McKenzie Kindly sponsored by
Background of international taxation 1. The power to make tax legislation, and to levy tax is deeply bound with the notion of sovereignty 2. In an increasingly globalised economic context, different tax regimes may be incompatible, or produce un-commercial results, such as taxing the same income stream or capital gain twice or tax asymmetry 3. The solution is double tax treaties (DTTs) these are bilateral instruments governed by public international law that allocate taxing rights between jurisdictions 4. Hong Kong is not a sovereign state, but has delegated authority to make its own tax legislation (Article 106) and to negotiate international agreements in certain domains (Article 116) relevantly including taxation 2
Overview of DTTs Bilateral arrangement and cannot bind third parties Hong Kong has a common law system, which is dualistic Important concepts include: Treaty residence the DTT applies only to residents of one contracting party or the other Permanent Establishment where a person resident in one contracting party has a taxable presence in the other contracting party Transfer pricing arm s length principle Beneficial ownership of income and gains Withholding tax (WHT) tax withheld by the payor at source Dividends, royalties, and interest Lower rates of WHT can be provided for in the DTT Crucial aspect of tax planning through DTTs 3
Treaty residence Crucial concept: in order to avail oneself of the benefit of a DTT one must be a person (as defined) resident in one of the contracting jurisdictions of that DTT: Individuals: usually determined by reference to how long they spend in one jurisdiction as opposed to the other tie-breaker is in general: (i) permanent home; and (ii) centre of vital interests Bodies corporate: resident where they are tax resident or generally taxable under domestic law tie-breaker is place of effective / normal management and control Other entities (partnerships, trusts, hybrids etc.): usually follow the corporate test 4
Withholding tax (WHT) Taxes are at their origin territorial and levied on persons, who bear the principal payment obligation, within the jurisdiction of the tax authority WHT is an exception to this rule: it is tax withheld by the payor at source under compulsion of law: the payor is in effect an agent for the revenue authority, and pays a net sum to the payee, and accounts for a fixed portion of the payment to the tax authority WHT is in particular used to tax passive income (dividends/interest/royalties) Thus, a Hong Kong creditor of a UK debtor receiving yearly interest payments from the UK will, subject to the terms of the Hong Kong UK DTA, receive that sum net of UK withholding tax on yearly interest DTAs often have the effect of decreasing the effective rate of withholding tax the jurisdiction of the source of the payment can impose on payments to payees resident in the other contracting jurisdiction 5
Interpretation DTTs are creatures of public international law and must be construed as such and not as domestic legislation (see for example RCC v Anson [2015] STC 1777) Vienna Convention on the Law of Treaties (1969) Multilateral Instrument: uniform modification of DTTs to treaty prevent abuse / domestic tax avoidance Hong Kong is a signatory, but has not yet ratified it Entered into force in the jurisdictions that have ratified it on 1 July 2018 Limitation on benefits and principal purpose test 6
How DTTs operate (1) 7 DTTs allocate taxing rights between residents in one treaty jurisdiction deriving income or gains in the other treaty jurisdiction For example, an individual resident in Japan deriving interest and royalty income from Hong Kong should be able to avail himself of the benefit of the Hong Kong Japan Double Taxation Agreement The following items are in general subject to the terms of a DTT: Income from immovable property Business profits Shipping / air transport income Dividends Interest Royalties Income from employment / director s fees Capital gains Pensions
How DTTs operate (2) Conversely, the following taxes are not in general affected by the operation of DTTs: Stamp duties Property rates / land taxes Wealth taxes Indirect / turnover tax Excise duty Estate duty / inheritance tax (in HK s Double Taxation Agreements) 8
How DTTs avoid double taxation Double taxation occurs when the same income stream or gain is taxed twice DTTs avoid double taxation by establishing the extent to which the jurisdiction of residence and the jurisdiction of source can tax a given income stream or gain: Exemption method: only one jurisdiction can tax the income or gain Credit method: both jurisdictions may tax the income or gain according to their domestic laws; however, tax in the jurisdiction of source is to be allowed as a credit against tax in the jurisdiction of residence, thereby avoiding double taxation: the taxpayer pays, at most, the tax he would have paid in his jurisdiction of residence and is therefore not penalised for having derived overseas income or gains 9
Illustrative example 1 Mr Gardiner is a UK tax resident and owns a property on the Peak in Hong Kong, which he rents out for HK$2 million a year. His rental income is chargeable to property tax or profits tax in Hong Kong and is also chargeable to income tax in the UK because, as a UK domiciled and resident individual, he is in general chargeable to tax on a worldwide basis Article 6 of the Hong Kong UK Double Taxation Agreement provides that Hong Kong may tax the rental income as well as the UK, being the jurisdiction of Mr Gardiner s residence, but Article 22 provides Mr Gardiner with a credit for Hong Kong tax paid against any UK tax computation by reference to the same income stream Hence, Mr Gardiner is not double taxed 10
Illustrative example 2 Mr Eugenides is tax resident in Greece and the 100% owner of a company, WasteLand Ltd, which is incorporated in and centrally managed and controlled in Hong Kong, which owns 100% of the share capital of Sosostris Inc., a trading company incorporated, tax resident, and centrally managed and controlled in Canada. Sosostris Inc. declares a dividend of C$1 million to WasteLand Ltd and the standard rate of withholding in Canada is 25%: Article 10(2)(a) of the Hong Kong Canada Double Taxation Agreement reduces the rate of WHT to 5% (saving of 20%) Dividends declared by WasteLand Ltd to Mr Eugenides are not subject to WHT in Hong Kong But may be taxable in Mr Eugenides s hands upon receipt in Greece No Hong Kong Greece Double Taxation Agreement 11
International tax structuring DTTs are useful in tax planning: Minimise taxation, and avoid double taxation Provide legal certainty on the tax treatment of cross-border transactions Dispute resolution mechanism in most DTTs by way of Mutual Agreement Procedure and Exchange of Information clauses Hong Kong is an advantageous structuring jurisdiction: WHT of 4.95 (in general) on royalties and no WHT on interest and dividends Dividends not tax on receipt No capital gains tax Light-touch tax compliance regime But there are challenges: Need economic substance to obtain certificate of resident status from Hong Kong Inland Revenue Department Treaty abuse and treaty shopping OECD measures to counter Base Erosion and Profit Shifting Principal purpose test in art. 7 of the MLI 12
Some pointers on how to avoid double taxation Know your DTT network! Understand the terms of the relevant Articles and read these carefully DTTs are like snowflakes Research and understand the policy of tax authorities in many jurisdictions this can be as important as the technical content of the DTT More restrictive anti-avoidance and anti-abuse provisions may make treaty shopping less convenient than in the past 13
Hong Kong policy on certificates of resident status (CoR) Many jurisdictions require a CoR issued from the Hong Kong Inland Revenue Department (IRD) in order to enable a Hong Kong resident to access treaty benefits, such as a lower rate of WHT IRD is, like many other tax authorities, reluctant to issue CoRs to persons that, while technically resident on the terms of an agreement in Hong Kong, do not have sufficient economic substance Brass plate companies may therefore find it difficult to enjoy the benefits of an agreement practitioners and clients need to consider the evolving landscape of DTTs carefully 14
Current and future trends Multilateralism and the influence of the OECD From litigation to arbitration? Domestic and international anti-abuse and antiavoidance provisions Revenue authorities seeking to align tax with value creation (BEPS) 15
Discussion points How can DTT structuring assist in private client / wealth management structures? What will the likely effects be of the introduction of a comprehensive transfer pricing regime in Hong Kong? How will the attitude of the Government of Hong Kong to international taxation evolve and how does this compare with the approaches of other jurisdictions? Impact of the MLI? Can the territorial system of jurisdictions like Hong Kong, Singapore, and Malaysia survive? 16