The influence of China on Hong Kong from an unexpected angle: taxation

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Hong Kong has a worldwide reputation for being a semi tax heaven.  This reputation hangs mainly on the concept of territoriality for taxes, which in turn gave birth to the very interesting concept of the “offshore status”.

More can be learned (from a very technical point of view) by reading the Departmental Interpretation and Practice Note 21 (DIPN 21) of the Inland Revenue Department (IRD).

Basically, what this says, in layman terms, is that if a company does not have elements localizing the profit generation in Hong Kong, then it not liable to pay taxes in Hong Kong. When considering “profit generation”, the IRD generally looks at things like negotiating contracts, taking orders, shipping goods etc.

This is one of the aspects that has been used not so much by multinational companies, but rather by SME’s and (very) wealthy foreigners attempting to evade taxes in their own jurisdiction.

Growing restrictions

In recent years, and under the growing pressure of the OECD’s BEPS initiative (Base Erosion and Profit Shifting) however, the IRD has sensibly tightened the noose around the offshore claim, through various aspects.

One example of this growing restriction is a recent decision of the Board of Review of the IRD.  This decision rejected an appeal by the taxpayer based on the fact that the taxpayer, besides supplying metals from Taiwan to Japan, did as little in Hong Kong as merely presenting letters of credit to the bank. Obviously, in this case, there was factoring and an element of financing in Hong Kong, but it was quite limited. So far, we could merely say that such pressures are linked to the desire of Hong Kong of not being blacklisted as a tax heaven, but concerns with regards to China are also apparent, as a lot of the IRD practice focuses on operations where manufacturing was carried out in China out of offices in HK.

The issue of residence

In 2015, another move took place which is more important and enlightens the growing influence of China.

This involves international treaties aiming to the prevention of double taxation (often just shortened to double tax treaty). In such bilateral agreements between states, a more favorable withholding tax (WHT) rate is granted to individuals or companies residents of one state which receive revenues from the other state, compared to the national withholding rate. This is important, for example, if revenues from dividends are received.

Where a Hong Kong resident company might be paying 30 % withholding tax in the USA if it receives dividends paid from the USA, on the contrary a Swiss resident company could be totally exempt of US withholding tax. This mechanism allows to reduce significantly the burden of cross-taxation across countries and aims at favoring cross-border investment.

Between China and Hong Kong (for the purpose of international tax matters, Hong Kong is almost considered as a State, but it is China that signs the treaties on its behalf), there is a double tax treaty. The Treaty WHT of China is 10%, but it can further be reduced to 5% if the Hong Kong company displays sufficient “substance”.

The concept of substance is mainly an element of fact, but the tax authorities look mainly for sufficient decision-making elements in the country of incorporation. The Dutch criteria for substance provide an an example of what can be required. Normally, the country remitting the dividends examines this issue (in this case, China). The  Hong Kong IRD introduced another unusual twist to this in 2015.

2015: crackdown on HK’s companies

In 2015, out of the blue, the IRD decided to implement a sudden change in its requirements to issue a “Tax Residency Certificate” (TRC). In fact, even when having a double tax treaty with Hong Kong, some countries might ask for such a document which is delivered by the local tax authorities of the country of incorporation of a company.

All of a sudden, the form for issuing a TRC became more stringent and contained detailed questions on the operations of a company. From various reports, it appears that the IRD does now carry out detailed checks on the substance of companies in HK and its “beneficial ownership” of the revenues.

The real reason for the change: Chinese pressure

Where the details become interesting, is that according to local tax advisors, this sudden change was carried out at the demand of China’s authorities. In fact, Hong Kong has often served as a pathway for wealthy Chinese to exfilter wealth from China. With the issues of capital flight worrying the Chinese government, they immediately took aim at Hong Kong, where shell companies have been numerous as previously alluded at the beginning of this article.

Where Hong Kong has had a large autonomy, especially in taxation matters, it is clear that this is changing as on several other points. China is going to make its might be felt where and when it feels it needs to inflex the policies of its “Special Administrative Region”.  From the “gateway to China” as it was perceived, Hong Kong is now increasingly moving to be felt as a threat to China.

While the issue of tax residency may seem secondary and affecting only a minority of wealthy individuals, it is symptomatic of the new shortened leash which the Chinese masters continue to yank around the neck of Hong Kong.


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