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Fergus Wong and Anita Tsang National Tax Policy Services, PwC Hong Kong
Fergus Wong is Director and, Anita Tsang is Associate Director, National Tax Policy Services, PwC Hong Kong
Hong Kong's new taxation rules on intra-group treasury activities establish an attractive regime for setting up a corporate treasury center in the SAR. The following article explores the provisions in the Ordinance.
The Inland Revenue (Amendment) (No.2) Ordinance 2016 (the Ordinance) was gazetted on June 3, 2016. The amendments introduced by the Ordinance cover the following three main areas: (1) a concessionary profits tax rate for corporate treasury centers (“CTCs”), (2) new deduction rules for interest expenses incurred by an intra-group financing business and new deeming provisions on interest income and certain profits arising from such business, and (3) profits tax and stamp duty treatments in respect of regulatory capital securities (“RCSs”) issued by financial institutions (“FIs”).
The first and the second areas introduced by the Ordinance are important for multinational corporations (“MNCs”) in their consideration of using Hong Kong for their corporate treasury functions. The 8.25% tax rate, which is 50% of the existing corporate tax rate, is applicable to the qualifying profits of qualifying CTCs in Hong Kong while the new interest expense deduction rules and new deeming provisions on interest income for intra-group financing business will resolve the current potential mismatch in tax treatments of interest expenses and interest income of intra-group financing activities. The concessionary tax rate and the new interest expense deduction rules apply retrospectively from April 1, 2016 whereas the new deeming provision on interest income is applicable from June 3, 2016. A Departmental Interpretation and Practice Note (“DIPN”) will be issued to provide practical guidance on the new provisions on CTCs.
The new CTC tax regime puts Hong Kong in a competitive position when multinational corporations (“MNCs”) consider where in Asia to set up or relocate their regional CTCs. In considering where the best location is, MNCs should take into account both tax considerations and non-tax factors such as their own business needs and mode of operation as well as the regulatory environment, the financial and capital markets and the availability of finance talents in different locations. MNCs that would like to benefit from these tax incentives need to review their current corporate treasury operation in light of the new tax legislation and consider if any restructuring of such operation is necessary or desirable in order to fit into the requirements of the law.
In the 2014/15 and 2015/16 Hong Kong Budgets, the Financial Secretary proposed that the existing interest deduction rules in relation to corporate treasury activities should be reviewed and a concessionary profits tax rate for specified treasury activities should be introduced in order to promote Hong Kong as a location for setting up a CTC. On June 3, 2016, the Inland Revenue (Amendment) (No.2) Ordinance 2016 was gazetted. The Ordinance introduces the following tax measures:
This article summarizes the key profits tax treatments in relation to a CTC and an intra-group financing business and highlights some of the potential issues in interpreting and applying the new tax legislation.
In order to be a qualifying CTC, a corporation must satisfy one of the following conditions:
In addition, an FI will not eligible to be a qualifying CTC.
The “separate entity approach” is adopted in defining a qualifying CTC (i.e. the corporation must be one that is designated for carrying out only corporate treasury activities, subject to the safe harbor rule discussed below). This approach has been one of the major concerns raised during the HKSAR Government's consultation with various stakeholders, particularly because under a similar tax incentive in Singapore, it is possible for a qualifying corporation to carry out the specified corporate treasury activities as well as other business activities.
While the Ordinance has retained the “separate entity approach”, it has now specified that only income-generating activities are counted as “other activities”. This means that a Hong Kong headquarters of an overseas corporation could possibly qualify as a CTC even though it performs corporate treasury activities as well as other corporate supporting functions for its group companies, for example, when it does not recharge the group companies on the other corporate supporting functions performed. However, companies with such an arrangement have to consider whether it is sustainable from a transfer pricing perspective.
A corporate treasury activity as defined in the Ordinance means:
The scope of corporate treasury activities includes activities performed with or in relation to Hong Kong as well as non-Hong Kong associated corporations. This means that entering into a transaction with or in relation to a Hong Kong associated corporation will not jeopardize the status of a qualifying CTC but only profits derived from those activities with or in relation to non-Hong Kong associated corporations may be eligible for the concessionary tax rate ( see II.C. below). However, reading the Ordinance literally, a qualifying CTC cannot borrow from any unrelated third parties (e.g. a bank in Hong Kong).
Profits derived from the following transactions or services are qualifying profits where the concessionary tax rate may apply:
A non-Hong Kong associated corporation is defined as an associated corporation that does not carry on any trade, profession or business in Hong Kong.
A corporate treasury transaction can be entered into with a Hong Kong entity (e.g. placing a deposit with a Hong Kong bank, investing in notes/bonds and other financial instruments issued by a Hong Kong entity or entering into a forward exchange contract with a Hong Kong entity) as far as it is related to the business of a non-Hong Kong associated corporation.
The requirement that the qualifying profits have to be derived from transactions with non-Hong Kong associated corporations is an anti-avoidance provision to prevent circumstances where the qualifying profits of a qualifying CTC are subject to taxation at the concessionary tax rate whereas the corresponding payments are eligible for tax deduction at the normal tax rate by the payers.
If a corporation cannot satisfy the condition of only carrying on corporate treasury activities as mentioned above, it can still be a qualifying CTC if it satisfies either one of the safe harbors below:
The first two requirements reflect that the qualifying CTC must have sufficient business substance in Hong Kong. The CMC requirement should also better support the CTC's Hong Kong tax residence status should a benefit under a Hong Kong tax treaty be claimed.
The Ordinance suggests that the corporate treasury activities do not necessarily need to be performed by the qualifying CTC itself, and that it is possible for the CTC to arrange for another party to carry out such activities as far as that party carries out the activities in Hong Kong.
There are other provisions in the Ordinance that deal with issues such as: the definition of an associated corporation, the computation of the qualifying profits of a qualifying CTC when the amount paid to it is deductible for Hong Kong profits tax purposes and the tax treatment of tax losses sustained by a qualifying CTC, etc.
Another part of the Ordinance deals with the profits tax treatment of interest income and interest expense in respect of an intra-group financing business carried on by a corporation. Based on the Ordinance, the profits tax treatments apply to the intra-group financing business carried on by a corporation, regardless of whether the corporation is a qualifying CTC or carrying on other businesses in addition to an intra-group financing business.
Intra-group financing business is defined to mean, in relation to a corporation, the business of the borrowing of money from and lending of money to its associated corporations. However, the Ordinance does not elaborate on what constitutes a “business of borrowing money from and lending of money” and whether say, for example, a few intra-group money borrowing and lending transactions in a year or a company using only its equity for intra-group lending, will be regarded as a “a business of borrowing and lending of money”. The Inland Revenue Department (“IRD”)’s clarification of its view on this will be welcome.
Interest income that arises through or from the carrying on of an intra-group financing business in Hong Kong will be deemed as taxable trading receipts, even if the moneys in respect of which the interest is derived are made available outside Hong Kong. Similarly profits from the sale, disposal or upon redemption or maturity, etc. of a certificate of deposit, bill of exchange or RCS derived by a corporation (other than a FI) will also be deemed as taxable trading receipts even if the moneys for the acquisition of the certificate, bill or security were made available outside Hong Kong or the sale, disposal or redemption is effected outside Hong Kong.
The effect of the new deeming provisions is that even for a corporation that is not a FI, if it is carrying on an intra-group financing business as defined, the place where the credit is provided is no longer relevant to determining the source of interest derived therefrom (i.e. the “provision of credit test” is no longer applicable to intra-group financing business). Similarly, the place where the sale or disposal of certificate, bill or security will longer be relevant to determining the source of the profits derived therefrom (i.e. the “contract effected test” will no longer be applicable).
Although the new deeming provisions are applicable only to the interest income/profits derived from intra-group financing business, the business community and tax profession are concerned with such provisions. These deeming provisions (1) are regarded as unnecessary as the principle for determining the source of these incomes in a money borrowing and lending business in general has already been established by case law and (2) may undermine the attractiveness of the concessionary tax rate for CTCs and interest expense deduction for intra-group financing businesses.
A new condition for interest expense deduction is introduced for a corporation carrying on an intra-group financing business (i.e. the borrower). The new condition stipulates that interest expenses on money borrowed from a non-Hong Kong associated corporation (i.e. the lender) in the ordinary course of an intra-group financing business are deductible provided that all of the following conditions are met:
As in the case of the concessionary tax rate for CTCs, the new condition for interest expense deduction is not applicable to interest expense paid on money borrowed from unrelated third parties. However, it is possible for the other conditions in section 16(2) to be met so as to qualify for a deduction.
For the purpose of section 16(2)(g), a person is “subject to a tax” at a certain rate in a territory in respect of an interest or a sum if the Commissioner is satisfied that “… tax of that nature has been paid or will be paid… at that rate by that person in respect of the interest income or sum concerned in that territory as required by the laws of that territory” . This appears to suggest that the statutory tax rate, instead of the effective tax rate, will be used as the reference rate. In addition, based on this wording, a company in a tax loss position will not meet the “subject to tax” condition.
Based on the Ordinance, it appears that where a corporation carrying on an intra-group financing business borrows money from a non-Hong Kong associated corporation but only on-lends a portion of the money borrowed to another associated corporation, the whole amount of the interest expenses paid to the non-Hong Kong association may be deductible and no apportionment is required as long as the conditions under section 16(2)(g) are met. Clarification of the IRD on these issues will definitely be welcome.
Unlike some conditions for interest deduction in section 16(2), section 16(2)(g) is not subject to the security loan test and the interest flow back test similar to those stipulated in sections 16(2A) and 16(2B). Instead, the newly added sections 16(2CA) and 16(2CB) in the Ordinance are the anti-avoidance provisions to prevent the abuse of section 16(2)(g). The interest deduction is disallowed (or only partially allowed) under section 16(2)(g) if:
An issue arising from the Ordinance is that the deeming provisions on interest income/profits and the new interest expense deduction condition for a corporation carrying on an intra-group financing business in Hong Kong are independent of each other. Hence, it is possible that the interest income derived by the corporation from the intra-group financing business will be deemed as taxable trading receipts but at the same time, the related interest expenses payable to a non-Hong Kong associated corporation are not tax deductible because the specified conditions for deduction are not satisfied. Care should be exercised in examining the potential impact of these provisions on group treasury activities to be carried out in Hong Kong.
It is expected that the DIPN on the CTC tax regime and the new deeming provisions/interest expense deduction rules will clarify a number of issues pertaining to the interpretation and application of the new legislation, including (1) the application of the “operation test” on interest income arising from intra-group financing business, (2) the “subject to tax” and “beneficial ownership” requirements in the new interest expense deduction rules and (3) the meaning of “carrying on an intra-group financing business”.
Pending the issuance of a DIPN, the following HKSAR Government's responses 3 to the comments received in relation to CTC tax regime at the Bills Committee Stage shed some light on its views on the following issues that are of interests to taxpayers:
The “subject to tax” requirement —A company which has to pay tax in respect of an interest, after setting off its losses against the profits, will be considered as having been subject to tax in respect of that interest.
The meaning of “carrying on an intra-group financing business” —To fall within this meaning, a corporation will have to borrow money from and lending money to its associated corporations routinely as a line of business with a view to earning a margin. The deeming provisions will not apply to a corporation which borrows and lends money on a single transaction basis. A number of relevant factors such as the frequency of the borrowing and lending of money at commercial interest rates, whether there is borrowing of money from persons in addition to associated corporations at commercial interest rates and whether there is a degree of system and continuity of laying out and getting back of the loan of money by way of interest and principal payments will be taken into consideration.
The Ordinance, which introduces a concessionary (i.e. 8.25%) profits tax rate for the qualifying profits derived by a qualifying CTC in Hong Kong and allows a tax deduction for the interest expenses incurred on money borrowed from a non-Hong Kong associated corporation by a corporation carrying on an intra-group financing business in Hong Kong, demonstrates the HKSAR Government's intent to attract more foreign companies to set up their corporate treasury function in Hong Kong. There are, however, stringent conditions for the concessionary tax rate and the tax deduction for interest, complicated and overstretching anti-avoidance provisions and other issues pertaining to the commercial operating needs of a group treasury center. MNCs should seek professional advice in examining their current treasury functions in Hong Kong or in considering relocation of their treasury activities to Hong Kong.
Fergus Wong is Director and, Anita Tsang is Associate Director, National Tax Policy Services, PwC Hong Kong. They can be contacted at: firstname.lastname@example.org; and email@example.com. Reprinted with the permission of PricewaterhouseCoopers Ltd.,a Hong Kong incorporated entity. Copyright 2016 PricewaterhouseCoopers Ltd. All rights reserved. The information in this article, which was assembled on 1 June 2016 and based on the laws enforceable and information available at that time, is of a general nature only and readers should obtain advice specific to their circumstances from their professional advisors.NOTES
1 Please refer to Part 1 of Schedule 17B in the Ordinance for a list of services that are regarded as corporate treasury service.
2 Please refer to Part 2 of Schedule 17B of the Ordinance for a list of transactions that are regarded as corporate treasury transaction.
3 Please refer to the Hong Kong Legislative Council papers in the following links for more details: http://www.legco.gov.hk/yr15-16/english/bc/bc102/papers/bc10220160229cb4-647-1-e.pdfhttp://www.legco.gov.hk/yr15-16/english/hc/papers/hc20160408cb4-810-e.pdf
Copyright © 2016 The Bureau of National Affairs, Inc. All Rights Reserved.
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