Hong Kong Tax Update Reported by HO Chi Ming, FTIHK, CTA, Council Member 2015/16. Offshore Private Equity Funds 1. The Inland Revenue (Amendment) (No. 2) Ordinance 2015 ( the Amendment ) was enacted and gazetted on 17 July 2015. Exemption for offshore fund has already been conferred by s.20ac in respect of specified transactions carried out through or arranged by specified persons (see Departmental Interpretation and Practice Notes No. 43). Prior to the Amendment, the exemption did not extend to transactions in the securities in private companies. 2. The Amendment extends exemption to transaction in securities in an excepted private companies ie an offshore private company where at all times within 3 years before a transaction in securities, stock, debenture etc in the offshore private company is carried out, it: (a) did not carry on any business through or from a Permanent Establishment ( PE ) in Hong Kong; (b) falls within either of the following: (i) did not hold (whether directly or indirectly) share capital in one or more private companies carrying on any business through or from a PE in HK; (ii) held such share capital but the aggregate value of the holding is equivalent to not more than 10% of the value of its own assets; and (c) falls within either of the following descriptions - (i) neither held immovable property in Hong Kong, nor held (whether directly or indirectly) share capital in one or more private companies with direct or indirect holding of immovable property in Hong Kong; (ii) held such immovable property or share capital (or both), but the aggregate value of the holding of the property and capital was equivalent to not more than 10% of the value of its own assets. 3. To qualify for exemption, the offshore private equity fund must carry out specified transactions through corporations licensed by the Securities and Futures Commission or be a qualifying fund. To be a qualifying fund, at all times after the final closing of sale of interests - the number of investors exceeds 4; and the capital commitments made by investors exceed 90% of the aggregate capital commitments; and the portion of the net proceeds to be received by the originator and the originator's associates, does not exceed 30% of the net proceeds arising out of the transactions of the fund.
4. Exemption is extended to the profits of a special purpose vehicle ( SPV ) derived from a transaction in securities in an interposed SPV or an eligible private company (new S.20ACA). For this purpose, the SPV may be a corporation, partnership, trustee of a trust estate or any other entity incorporated, registered or appointed in or outside Hong Kong and must be wholly or partly owned by a non-resident person and does not carry on any trade or business except solely for the purpose of holding, directly or indirectly, and administering one or more excepted private companies. 5. To prevent tax avoidance by round tripping (ie tax avoidance by a resident person using a non-resident as a facade), if a resident person (alone or jointly with his associates) holds a beneficial interest of 30% or more in a tax-exempt offshore private equity fund or any percentage if the fund is an associate of the resident person and the offshore private equity fund has a beneficial interest in a SPV which is exempt from tax under s.20aca, the assessable profits of the SPV are to be regarded as the assessable profits of the resident person (new s.20af).
Report on Board of Review Decisions Volume 29 Third Supplement D14/14 Language of hearing The Taxpayer, a company, which was represented by solicitors and Counsel, expressed that it preferred to use Cantonese in the hearing. The Board pointed out that Cantonese is not specified as one of the official languages in s.3(1) of Official Languages Ordinance Cap 5 (which declares English and Chinese languages as the official languages of Hong Kong). For the purpose of the hearing before the Board, the oral element of Chinese in Hong Kong includes Cantonese or Punti and the written element in official communications in Chinese language is the written vernacular Chinese 白話 ie modern written Chinese, in contrast to Classical Chinese. This is not the written form of Cantonese colloquial style. In the instant case, the Commissioner's Determination, Submissions and Notice of Appeal were all in English. The taxpayer did not explain the reason for choosing the preference. The Board refused to adopt Cantonese as the language for the proceedings. Substantive Appeal The IRD disallowed interest payable by the Taxpayer to an associated company ( B ) for 1997/98 to 2002/03 which the Taxpayer contended was used to finance its property investment business. By a determination in 2007, the Commissioner confirmed assessments for some years ( the 2007 Determination ) disallowing interest payable to B. The taxpayer company did not appeal. Then for 2004/05 and 2006/07, the taxpayer claimed deduction of interest payable to a bank. The taxpayer company explained that: (1) as at 31 Mar 2003, the taxpayer company, a property investment company, owed B $30 million. the loan being used to finance its business (2) B demanded repayment of the loan (3) the taxpayer company was therefore forced to borrow $30 million from a bank to repay B. The Assessor disallowed the interest. The Taxpayer before the Board relied on Zeta Estates Ltd v CIR (2007) 10 HKCFAR 196 ( Zeta's Case ) to support that the interest fulfilled s.16(1)(a). In Zeta's Case, the taxpayer company paid interest to shareholders in respect of amounts due to them for dividends declared but remaining unpaid. The taxpayer contended that the said advances from shareholders obviated the need to sell profit earning assets, thus maintaining the profit earning capacity. The Court of Final Appeal eventually allowed deduction of the interest. The taxpayer's Counsel in the instant case contended that by merely looking at the quantum of current assets and liabilities of the balance sheet, one could determinate whether interest deduction would be justified. The Counsel also argued that by borrowing from the bank to repay B's loan, there was no need to sell profit generating assets. The CIR's Case was that there was no evidence that the loan from B was incurred in the production of chargeable profits of the Taxpayer. This case was therefore distinguishable from the Zeta Case where it was not disputed that the interest expenses were attributable to the payment of dividends. The failure to appeal against the 2007 Determination, although not constituting res judicata, argues the CIR's Counsel, by parity of reasoning, barred the Taxpayer to allege that the loan from B did exit or that it had been paying interest to service B's loans. There was no evidence that the loan from the bank was used to reply B's loan. The financial statement stated that B's loan was non-
interest bearing. No witness was called in the hearing. The Taxpayer failed to answer IRD's letters relating to the matters under appeal. The Board responded to the Taxpayers' Counsel's submission that deductibility of interest may be supported by merely looking at the balance sheet. It expressed that this formulation was too wide. For the instant case, one does not merely look at the balance sheet as suggested by the Taxpayer's Counsel. One still needs to ask why the loan was incurred. There was finding by the Board in Zeta Case that but for the dividend declaration the loans would not have been needed. S.61A The CIR identified the transaction as the borrowing of $30 million from B, the entering into of the loan agreement with the bank and the purported repayment of $30 million to B. Had B borrowed the loan from the bank itself, it could not have the immediate tax effect of interest deduction since it had an accumulated loss brought forward. The Taxpayer argued that the bank was not a member of the group. For every tax saving of 17.5 cents, the Taxpayer needed to pay $1 to the bank as interest. The Board stated Even applying the general principles one is confronted with the notion of whether it is artificial. We say it is. The Board found that the transactions were to be ignored by virtue of s.61 and s.61a. D4/14 The Assessor disallowed claims by the Taxpayer, a trading company, for deduction of directors' and shareholders' bonus, bonuses to directors' wives and payments to directors and overseas corporations owned by the directors, firstly described as sales commission and later loan interest. The bonuses to wives of directors and shareholders were classified as entertainment expenses in the accounts. Regarding the alleged loan interest, the Deputy Commissioner of Inland Revenue ( DCIR ) ruled that the interest failed to fulfill s.16(2)(c). The DCIR also applied s.61 and s.61a to disallow the deductions. At the Board appeal, the Taxpayer adduced witness statements of the Chairman and 3 other directors but did not call them to give oral evidence. The Taxpayer's Counsel explained that the Chairman was over 80 while the other 3 directors were very busy at the time of the year and they were outside Hong Kong. The Board refused to attach weight to the witness statements on the ground that the IRD had no opportunity to cross examine them. No medical evidence was adduced to support the inability of the Chairman to attend. The date of hearing was fixed months ago by both the IRD and the Taxpayer's Counsel so that there no excuse for the non-attendance of the 3 directors. The Board agreed with the IRD that the Taxpayer should call the auditor and its accounting staff to examine the accounting treatments but failed to do so (Chinachem Investment Co Ltd V CIR (1987) 2 HKTC 261 per Macdougall J at 273 and 282, Sir Alan Huggins VP at 308). For example, why payments to some directors was described as loan interest in the accounts. The Taxpayer called its general manager and the project administrator to give oral evidence but the Board did not find their evidence helpful. One reason was that they were not involved in accounting. The Board found that the Chairman's explanation on how the sales rebates were determined, essentially by him in respect of how much each of the overseas corporations was to receive, suggested more of a familial decision by a patriarch than a commercial decision by an experienced businessman. The sales rebate bear no correlation with the sale of the overseas corporation. The Board nor the IRD was able to seek elaboration or explanation from the directors of how the sales rebates were agreed upon and did operate for the purpose described. The Taxpayer's Counsel sought to amend the grounds of appeal after the close of evidence. The Board refused. One reason was that the amendments sought to attack the reasoning of the Commissioner's Determination. The Board pointed out that this was not a valid ground of appeal. The Board's role was to hear the case afresh, to determine whether the assessment was incorrect or
excessive, not to adjudicate on the Commissioner's reasoning. The Taxpayer's Counsel submitted that if an item of expenditure is treated as deductible under 'commercial accounting principles', the treatment would constitute evidence of the deductibility of the item under the IRO and that the audited accounts should not be outweighed by the supposed effect of some internal draft account records of the Taxpayer. The Board responded that tax appeals are decided by the Board, not by the professional accounts or audited accounts (Nice Cheer Investment Limited v CIR FACV 23 of 2012, per Lord Millet NPJ). The Board pointed out that there were shifting of the case of the Taxpayer. There were inconsistency between the explanation of its former tax representative and the next tax representative. For example earlier it was asserted that payments to one company was sales commission but before the Board, the nature was changed to financial guaranteed fees. Some payments to the overseas companies were asserted to be sales commission but later changed to sales rebates. The same amount of remuneration was paid to each director despite the explanation of the Taxpayer that their contributions were different. There were no documentation recording the duties of the family members in the Taxpayer, the terms of remuneration and how the remuneration were calculated. The business was done by the staff in Hong Kong, not by the directors. The Board found that the expenses failed to meet the requirements of s.16(1)(a). In such circumstances, s.61 and s.61a had no application since there was no tax benefits. Any tax benefit