BEPS and the increasing restriction on special tax statuses: Hong Kong’s case

The Base Erosion and Profit Shifting (BEPS) initiative of the OECD has been influencing a lot of the visible (changes in legislation) and less visible changes in the global tax environment. We already talked about it broadly here. Today, we are addressing the issues in the offshore status of Hong Kong .

The principle of territorial taxation

Hong Kong has long been reknown for its famous “offshore” status which is actually a derivation from its territorial taxation principle. This means that, as long as you didn’t have any profit-making operations in Hong Kong (contract negotiations, order taking, and of course, sales), you could be safe from taxation.

This principle is constantly affirmed by HK courts who always look at where the taxpayer has done the operations allowing it to book a profit (for example, where the contract was negotiated, where the products were manufactured, services carried out etc). This remains a question of fact for courts and IRD alike.

So far, there was no reversal in the case law of the HK courts on the offshore status.

A change by practices of the IRD

In theory, the Inland Revenue Department (IRD) officially still upholds the principles of the territorial taxation stated in its DIPN 21. Nevertheless, from the practice of tax professionals, a change has been observed in the practices of that department: more offshore claims are now scrutinized in depth.

This is done among others through a transfer of cases to the famous and feared “Unit 4” of the IRD, also called the Field Audit Unit. Among tax advisers, the rumor is that once a case has been transferred to Unit 4, nobody comes out without paying some taxes whether high or low. De facto, that means that there is a manner by the IRD to reduce the number of admitted offshore claims.

Furthermore, the IRD has also been finding more and more elements to attach taxability to operations, such as having offices in HK, bank accounts in HK (all elements considered as innocuous until recently and rather strange if you consider that it is a legal obligation to have registered offices in HK).

Beps and the search for tax revenues

The reason for the evolution by the IRD may be twofold. Before 1997 and right until 2009, the offshore status was mainly a manner of attracting capital and bringing businesses to Hong Kong as a gateway to China. Today, while investment happens directly in China through WOOFE’s (Wholly-owned foreign enterprises) or through joint-ventures, Hong Kong has become largely dependent on Chinese capitals investing into the city and much less on foreign money.

Hence, there is much less incentive to keep an offshore status which regularly threatens to get the city blacklisted as a tax heaven.

The second reason, is that with BEPS (and also thanks to China’s pressure), Hong Kong is feeling an increasing pressure to demonstrate it is not a tax heaven.

While the official interpretation is still that the law has not changed, the attitude of the IRD has changed and they now pursue actively offshore establishments when they are based on purely tax reasons.

In fact, in a remarked decision of the Board of Review dating from 2016 did recognize onshore nature to trading profits where the company didn’t do anything in Hong Kong else than being an intermediary between a Taiwan company and a mainland company.

A progressive evolution towards the end of the offshore status?

The practical consequence of this is that while the offshore status is officially reaffirmed in communications and in the legal texts of Hong Kong, unofficially, the practices has changed.

Today, obtaining an offshore status would require probably mainly being a services company; being subject to taxes in another jurisdiction (a question which becomes a staple nowadays); and having little to no presence in Hong Kong.

De facto, we are moving towards a progressive elimination of the offshore status for “newer” companies, while the ancient ones might be keeping it, albeit with more scrutiny at any change in operations, going forward.

An interesting evolution might be found in the evolution of the offshore status in Macao. Macao, just like Hong Kong, is another “Special Administrative Region”.  Apparently a few years ago, Macao has ceased authorizing offshore companies for the sale of goods. Hence there is a limited number of such companies remaining on the market often sold at very high prices when they are for sale. It is likely that this will be the final model of the offshore status in Hong Kong a few years from now.

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