1 Tutori ACY4401 Advanced Taxation Lecture 3 International aspects of current Hong Kong Taxation law and practice 1. Double Taxation Agreement (“DTA”) The HKSAR concludes DTAs with various other countries/tax jurisdictions. A DTA provides certainty to investors on the taxing rights of the contracting parties, helps investors to better assess their overall tax liabilities on their economic activities and provides a potential incentive for overseas companies to do business in Hong Kong, and likewise, for Hong Kong companies to do business overseas. Therefore, Hong Kong has tried to establish a comprehensive DTA network that minimizes potential double taxation exposure of Hong Kong residents and residents of the DTA partner. The framework of DTAs are based on the Model Double Taxation Treaties of the Organization for Economic Co-operation and Development ('OECD') and the United Nations ('UN'). OECD is an inter-governmental organization. For avoidance of double taxation, many countries (including members and non-members of the OECD) have entered into tax treaties that are based on the OECD Model and the UN Model. Broadly speaking, a tax treaty is to facilitate cross-border trade and investment by eliminating the tax impediments to these cross-border flows. The operational objectives of a tax treaty are: (1) elimination of double taxation; and (2) prevention of fiscal evasion. In addition, a tax treaty has the following objectives as well: (1) elimination of discrimination against foreign nationals and non-residents. (2) exchange of information between the Contracting States. (3) provide dispute resolution mechanisms. 2. Double Taxation Agreement between China and HKSAR The Mainland of China and HKSAR signed two arrangements for the Avoidance of Double Taxation on Income on 1998 and 2006. The purpose of the two DTA is to eliminate any situation of double taxation that a Mainland or Hong Kong investor may face when they carry out cross-border business activities. 2 Tutori ACY4401 Advanced Taxation Lecture 3 International aspects of current Hong Kong Taxation law and practice Article 1 – Persons covered The DTA is intended to cover “residents of the Mainland” and “residents of Hong Kong”. The definitions of “residents of the Mainland” and “residents of Hong Kong” are covered in Article 4 of the DTA. Article 2 – Taxes covered This article specifies what taxes are covered in the DTA: a. Hong Kong (Profits tax, Salaries tax, and Property tax) b. the Mainland (Individual income tax and Corporate income tax) Article 3 – General definitions a. Person The term “person” is widely defined in the DTA to include an individual, a company, a trust, a partnership and any other body of persons. b. Enterprise i. The term “enterprise” applies to the carrying on of business activities of any form. ii. An “enterprise of One Side” means “an enterprise carried on by a resident of One Side”. iii. iv. c. An “enterprise of the Other Sides” means “an enterprise carried on by a resident of the Other Side”. An “enterprise carried on by a resident” includes an enterprise carried on by a resident company, a resident individual, a resident partnership or a resident body of person. Business The term “business” includes the performance of professional services and other activities of an independent character. Article 4 – Residents a. Resident individual i. Definition of “resident individual” In Hong Kong, a resident individual means: (a) an individual who ordinarily resides in Hong Kong; (b) an individual who stays in Hong Kong for (i) more than 180 days during the relevant year of assessment, or 3 Tutori ACY4401 Advanced Taxation Lecture 3 International aspects of current Hong Kong Taxation law and practice (ii) more than 300 days in two consecutive years of assessment (one of which is the relevant year of assessment). ii. Definition of “ordinarily resides” An individual is regarded as “ordinarily resides” in Hong Kong if he has a permanent home in Hong Kong where he or his family lives. Other relevant factors in considering the status of “ordinarily resides”: (a) duration of his stay in Hong Kong, (b) whether he has a permanent place of residence in Hong Kong, (c) whether he owns any property overseas for residential purposes, and (d) whether he is primarily resident in Hong Kong or overseas. If an individual has a permanent home in both Sides (i.e., Hong Kong and the Mainland) concurrently, it is necessary to ascertain with which of the two Sides his personal and economic relations are closer. Consideration will be taken into account of his family and social relations; his occupations; political, cultural and other activities; his place of business; and the place from which he administers his property, etc. b. Resident company i. Definition of “resident company” In Hong Kong, a resident company is: (a) a company incorporated in Hong Kong, or (b) if incorporated outside Hong Kong, a company normally managed or controlled in Hong Kong. ii. Definition of “management” “Management” refers to management of daily business operations, or implementation of the decisions made by top management, etc. iii. Definition of “control” “Control” refers to control of the whole business at the top level, including formulating the central policy of the business, making strategic policies of the company, choosing business financing, evaluating business performance, etc. The board of directors usually exercises “control”. 4 ACY4401 Advanced Taxation Lecture 3 International aspects of current Hong Kong Taxation law and practice Article 5 – Permanent establishment Tutori a. Definition of “permanent establishment” i. A “permanent establishment” is a fixed place of business through which the business activities of the enterprise are carried on. ii. b. The term “permanent establishment” includes especially” a place of management; a branch; an office; a factory; a workshop; a mine, an oil or gas well, a quarry or any other place of extraction of natural resources”. Representative office A genuine “representative office” is not regarded as a permanent establishment subject to tax. In order to maintain a genuine representative office, the following have to be observed: i. the activities should be for the enterprise itself; ii. iii. c. the activities should not directly generate profits; and the function of the place of business should only be of a supportive nature. Business agent i. Dependent agent A dependent agent is an agent acting under the control and leadership of an enterprise of One Side. If a dependent agent in Hong Kong regularly acts on behalf of a Mainland enterprise and has, or habitually exercises, an authority to conclude contracts in the name of that enterprise, that Mainland enterprise will be deemed to have a permanent establishment in Hong Kong. In Hong Kong, a Mainland enterprise may still be treated as having a permanent establishment in Hong Kong if a dependent agent (though not a final signatory to a contract) participates in detailed negotiations and formulates the contract provisions on behalf of the relevant Mainland enterprise in Hong Kong. ii. Independent agent In the Mainland, a Hong Kong enterprise is not treated as having a permanent establishment in the Mainland if its activities in the Mainland are conducted through an independent agent who is acting in the ordinary course of its business. 5 ACY4401 Advanced Taxation Lecture 3 International aspects of current Hong Kong Taxation law and practice Tutori Article 6 – Income from immovable property Income derived by an enterprise of One Side from immovable property situated in the Other Side may be taxed in that Other Side, regardless of whether it has a permanent establishment in that Other Side. Article 7 – Business profits a. General principle The profits of an enterprise of One Side shall be taxable only in that Side (i.e. the Other Side has no right to tax) unless the enterprise carries on business in the Other Side through a permanent establishment situated therein, in which case its profits may be taxed in that Other Side, but only so much of them as is attributable to that permanent establishment. b. Definition of “business profits” “Business profits” does not only include profits derived from business activities, but also income from immovable property, dividends and interest. c. Payments between permanent establishment and its head office i. As a permanent establishment and its head office are one and the same legal entity, the DTA sets out three categories of payments which are not deductible in determining the profits of a permanent establishment: (a) payments such as royalties, remuneration or fee in return for the use of patents or other rights; (b) commissions for specific services performed or for management; or (c) interest on money lent to the permanent establishment (except in the case of a banking enterprise). ii. As the aforesaid three categories of expenses are not deductible in the permanent establishment on the Other Side, the income derived from those three categories is not included in the determination of the profits of the head office. Article 8 – Shipping, air and land transport a. DTA exempts shipping, air and land transport income derived from a Hong Kong company from China tax. 6 Tutori b. ACY4401 Advanced Taxation Lecture 3 International aspects of current Hong Kong Taxation law and practice Cross-border transportation income Revenue and profits derived by an enterprise of One Side from the operation of ships, aircraft or land transport vehicles in shipping, air and land transport businesses is exempt from tax in that Other Side if that income is derived from cross-border transport. For example, the income derived by a Hong Kong company’s Mainland permanent establishment from its cross-border transportation business is exempt from PRC income tax and business tax. Article 9 – Associated enterprises If the taxation authority on One Side finds that transactions done by enterprises at the Other Side with the associated enterprises on the original One Side are not carried out at an arm’s length, such as transfer pricing, the taxation authority of the One Side may make adjustments to profits of the associated enterprises. Article 10 – Dividends i. Double charge on dividend income Dividends paid by a company which is a resident of One Side to a resident of the Other Side, may be taxed in the Other Side. Thus, the same dividend income may be taxed in both Sides. ii. Relief in tax liability under DTA According to the DTA, the tax on dividend income shall not exceed: a. 5% of the gross amount of the dividend where the beneficial owner is a company directly owning at least 25% of the capital of the company which pays the dividends, b. 10% of the gross amount of the dividend in any other cases. c. No effect on Hong Kong As Hong Kong does not tax dividend income, the relevant DTA provisions do not affect the Hong Kong profits tax liability on the receipt of dividend income. Article 11 – Interest a. Source of interest i. The DTA is of the view that the source of interest is “the Side in which the interest arises”. ii. Interest is deemed to arise in a Side when the payer is the Government of that Side, a local authority thereof or a resident of that Side. 7 Tutori iii. ACY4401 Advanced Taxation Lecture 3 International aspects of current Hong Kong Taxation law and practice Interest is deemed to arise in the Side in which the permanent establishment, in connection with which the indebtedness on which the interest is paid is incurred, is situated. In short, the source of interest is at the Side in which the payer who effectively bears the interest is situated. c. Tax relief on interest received under DTA i. The limitations of tax rates in the Side in which the interest arises are in 2 tiers as follows: (a) The interest will not exceed 7% of the gross amount of the interest, except in the situation (b) below; (b) interest is exempt from tax in the Side of source if it is received by the Government of the Other Side or any other institutions mutually recognised by the competent authorities of both Sides (for example: China Development Bank, The Export-Import Bank of China and Agricultural Development Bank of China and the Hong Kong Monetary Authority). ii. Hong Kong taxes income on a territorial basis, and the limitation of tax rates does not have any practical application in Hong Kong deposit interest income. However, the 7% limitation is relevant to the income received by a Hong Kong enterprise from a Mainland entity. Article 12 – Royalties a. Charge of tax on royalty income Royalties arising in One Side and paid to a resident of the Other Side may be taxed in that Other Side. However, such royalties may also be taxed in the Side in which they arise and according to the laws of that Side. b. Tax relief on royalty received under DTA i. If the beneficial owner of the royalties is a resident of the Other Side, the tax so charged shall not exceed 7% of the gross amount of the royalties. ii. Royalty income chargeable at 30% under sections 15(1)(a),(b) and (ba) When a Mainland enterprise receives royalties from a Hong Kong company, and it is chargeable with assessable profits at the rate of 30% on the royalties received, the effective tax rate in Hong Kong would be as follows: (a) 4.5 in the case of an individual (30% x 15% = 4.5%). (b) 4.95% in the case of a corporation (30% x 16.5% = 4.95%) 8 ACY4401 Advanced Taxation Lecture 3 International aspects of current Hong Kong Taxation law and practice Tutori As 4.5% and 4.95% are lower than 7%, the Mainland enterprise is taxed on 4.95%, not 7%. iii. Royalty income chargeable at 100% under sections 15(1)(a), (b) and (ba) When a Mainland enterprise receives royalties from a Hong Kong company, and it is chargeable with assessable profits at the rate of 100% under Section 21A(1)(a) on the royalties received, the effective tax rate in Hong Kong would remain to be 15% for an individual or 16.5% for a corporation. The reason is that it is stated in Article 25 of the DTA that the articles in the DTA do not apply to tax avoidance provisions in the domestic tax law. iv. Royalty income chargeable under section 15(1)(d) Unlike the royalty income chargeable under section 15(1)(a), (b) or (ba) where the tax is charged on the gross income, section 15(1)(d) charges tax on the net income after deduction of the relevant expenses. Under the Fourth Protocol, the withholding tax on royalties paid to aircraft and ship leasing business will be capped at 5%. Example 1 Company A, a resident of the Mainland, derives from Hong Kong royalties (hire income of machinery) of $900,000 in the year ended 31.3.2018. After deducting allowable expenses and depreciation allowance in respect of the equipment: Assessable profits is $500,000 Profits tax payable is $500,000 x 16.5% = $82,500 The effective tax rate of assessable profits of $82,500 on $900,000 = 9.17% Applying the DTA, the tax rate charged on Mainland company on the royalty by Hong Kong profits tax is restricted to 7% of the gross income, i.e. $900,000 x 7% = $63,000 (not $82,500) The Hong Kong payer is required to deduct $63,000 only from the remittance made to Company A. 9 Tutori ACY4401 Advanced Taxation Lecture 3 International aspects of current Hong Kong Taxation law and practice Example 2 Company B, a resident of the Mainland, derives from Hong Kong royalties (hire income of machinery) of $900,000 in the year ended 31.3.2018. After deducting allowable expenses and depreciation allowance in respect of the equipment: Assessable profits is $350,000 Profits tax payable is $350,000 x 16.5% = $57,750 The effective tax rate of assessable profits of $57,750 on $900,000 = 6.42% As the effective tax rate on gross income is 6.42% which is lower than 7% the tax payable remains $57,750, and unaffected by the 2007 DTA. Article 13 – Capital gains a. General principle Article 13 states that gains derived by a resident of One Side from the alienation (“disposal”) of immovable property and situated in the Other Side may be taxed in that Other Side. b. Disposal of ships, aircraft or land transport vehicles Gains derived by an enterprise of One Side from the disposal of ships or aircraft or land transport vehicles operated in shipping, air and land transport or movable property pertaining to the operation of such ship, aircraft or land transport vehicles, is taxable only in that Side. c. Disposal of shares of a company mainly holding immovable property Gains derived from the disposal of shares in a company the assets of which are comprised, directly or indirectly, mainly of immovable property situated in One Side may be taxed in that Side. Paragraph 105 of the DIPN 44 specifies that 50% is the benchmark in determining whether the assets of a company comprised “mainly” of immovable property. d. Disposal of shares not holding 50% immovable property as its assets Gains derived from the disposal of shares, other than the shares of a company the assets of which are comprised, directly or indirectly mainly of immovable property situated in One Side, of not less than 25% of the entire shareholding of a company which is a resident of One Side may be taxed in that Side. 10 Tutori ACY4401 Advanced Taxation Lecture 3 International aspects of current Hong Kong Taxation law and practice Article 14 – Income from employment a. General principle Income derived from an employment by a resident of One Side is taxable only in that Side unless the employment is exercised in the Other Side. If the employment is exercised at the Other Side, the remuneration derived from employment may be taxed in that Other Side. b. 183-day rule of exemption Remuneration derived by a resident of One Side in respect of an employment exercised in the Other Side is taxable only in that One Side if all the following three conditions are satisfied: i. the recipient is present in the Other Side for a period or periods not exceeding in the aggregate 183 days in any 12-month period ii. iii. commencing or ending in the taxable period concerned; and the remuneration is paid by, or on behalf of, an employer who is not a resident of the Other Side; and the remuneration is not borne by a permanent establishment which the employer has in the Other Side. Article 15 – Directors’ fees Directors’ fee and other similar payments derived by a resident of One Side in his capacity as a member of the board of directors of a company which is a resident of the Other Side may be taxed in that Other Side. In other words, directors’ fee is not chargeable to tax twice. The fee is only chargeable at the place where the company is a resident. Article 16 – Artistes and sportspersons Income derived by a resident of One Side as an entertainer, such as a theatre, motion picture, radio or television artiste, or a musician, or as a sportsperson, from his personal activities as such exercised in the Other Side, may be taxable in that Other Side. The 183-day rule of exemption for employment does not apply to entertainer or sportsperson. Article 17 – Pensions Pensions and other similar remuneration (whether a payment in lump sum or by instalments) paid to a resident of One Side in consideration of past employment are taxable only in that Side (unless the pension is a public or a government or a 11 ACY4401 Advanced Taxation Lecture 3 International aspects of current Hong Kong Taxation law and practice government approved or recognised pension). In other words, the pension is taxable Tutori according to the resident status of the recipient. Article 20 – Other income Income of a resident of One Side, wherever arising, not dealt with in the other Articles of the DTA is taxable only in that Side. Article 21 – Methods of elimination of double taxation a. General principle Amount of tax credit available for set-off The amount of Hong Kong income tax paid by a Mainland resident is allowed as a credit against Mainland income tax imposed on that resident. Similarly, the amount of Mainland income tax paid by a Hong Kong resident is allowed as a credit against Hong Kong income tax imposed on that resident. However, the amount of tax credit is not to exceed the amount of home place income tax payable in respect of such income. b. Nature of tax credit Before a tax credit is allowed, the taxpayer has to prove to the satisfaction of the IRD that the tax has been paid and the tax so paid is not subject to any further adjustment. c. Time for making a claim for tax credit set-off A taxpayer may submit a claim for a tax credit within 2 years after the end of the relevant year of assessment. Example 3 12 Tutori ACY4401 Advanced Taxation Lecture 3 International aspects of current Hong Kong Taxation law and practice 13 Tutori ACY4401 Advanced Taxation Lecture 3 International aspects of current Hong Kong Taxation law and practice Article 23 – Mutual agreement procedure Any difficulties or doubts arising as to the interpretation or application of the DTA are to be resolved by the competent authorities of the Mainland and the HKSAR. Article 24 – Exchange of information (“EOI”) Article 24 allows taxation authorities of both Sides to exchange such information as is necessary for carrying out the provisions of the China-HK DTA or of the domestic laws of both Sides concerning taxes covered by the China-HK DTA. This Article requires the contracting parties, upon receiving a request for information, to exchange tax information foreseeably required for applying the China-HK DTA or the domestic law, even where the requested party does not need such information for its own tax purposes. The previous version of the EoI clause only allowed tax information to be exchanged where it related to the administration of taxes under the domestic law of the jurisdiction in which it was requested. Both parties are obliged to keep the information received confidential and can only disclose the information to persons involved in the assessment and determination of tax, including courts and state departments of administration.