The Inward Investment and International Taxation Review: Hong Kong
With a maximum corporate tax rate of 16.5 per cent, and no tax on sales, dividends or capital gains, Hong Kong is one of the most tax-friendly economies in the world. Foreign investments are not subject to any specific approval process, and the Hong Kong tax regime does not differentiate between foreign and domestic investors, except in relation to the acquisition of residential property. Hong Kong also promotes shariah investment, with the Hong Kong Monetary Authority indicating its aspiration for Hong Kong to be an Islamic finance hub.2 Since 2014, a number of banks have begun offering shariah-compliant funds. Coupled with its close proximity to and connection with mainland China, Hong Kong is a popular gateway for inward investment into mainland China by multinational corporations.
Although not an Organisation for Economic Co-operation and Development (OECD) member, Hong Kong is committed to supporting international efforts on base erosion and profit shifting (BEPS) and the Common Reporting Standard (CRS). Most recently, Hong Kong has committed to actively participate in and implement the BEPS 2.0 package put forward by the OECD, including Pillar Two of the package on a global minimum effective rate of 15 per cent. While the exact impact of BEPS 2.0 on Hong Kong's tax system remains unclear, the Hong Kong government has stressed that it will strive to 'maintain the strengths of Hong Kong's tax system and endeavour to minimise the compliance burden of . . . large MNE [multinational enterprise] groups'.3
In recent years, Hong Kong has also been actively negotiating tax treaties with its trading partners to improve its treaty network. Mostly notably, Hong Kong's tax treaty with Macao came into effect in 2020.
The principal tax legislation in Hong Kong is the Inland Revenue Ordinance (IRO).4
Common forms of business organisation and their tax treatment
The most common business entities used in Hong Kong are companies, partnerships and trusts.
A company incorporated under Hong Kong law may be limited by shares, limited by guarantee or unlimited, with a company limited by shares being the most common corporate form. If a company is limited by shares, the liability of the shareholders is limited to the amount unpaid on their shares. A company limited by shares may either be a public or a private company. Public and private companies mainly differ in their ability to offer their shares to the public for subscription. Private companies must also cap the number of shareholders at 50. Both types of company are required to appoint a company secretary who is a Hong Kong resident individual, or a company with a registered office or place of business in Hong Kong. However, a private company only needs to have one director, and at least one director must be an individual. Public companies, on the other hand, need at least two directors.
Profits tax is charged on every person carrying on a trade, profession or business in Hong Kong. A 'person' under the IRO is defined to include individuals, corporations, partnerships and bodies of persons. Profits tax would be charged on the assessable profits that arose in or were derived from Hong Kong during the basis period.
Corporations were previously taxed at a flat rate of 16.5 per cent on their profits arising in or derived from Hong Kong. Beginning from the year of assessment 2018/19, a two-tiered profits tax system will apply to corporations as well as other entities chargeable to profits tax in Hong Kong. Under the two-tiered system, the first HK$2 million of profits will be chargeable to a reduced profits tax rate of 8.25 per cent and any profits in excess of HK$2 million will be chargeable at the previous rate of 16.5 per cent.5
As the two-tiered system was introduced primarily for the benefit of small and medium-sized businesses, if an entity has one or more connected entities at the end of the basis period for a relevant year of assessment, then the two-tiered profits tax rate would only apply to one entity nominated by the group. An entity is connected to another entity if: (1) one of them has control over the other; (2) both of them are under the control of the same entity; or (3) in the case of the first entity being a natural person carrying on a sole proprietorship business, the other entity is the same person carrying on another sole proprietorship business.6
In this context, control means directly or indirectly owning more than 50 per cent in aggregate of the issued capital of another entity, an entitlement to exercise or control the exercise of more than 50 per cent of the voting rights in another entity, or an entitlement to more than 50 per cent in aggregate the capital or profits of another entity.
The two-tiered system applies to a natural person and a body of persons, as well as corporations, partnerships and trusts. Persons other than corporations were previously taxed at a flat rate of 15 per cent on their assessable profits. Under the two-tiered system, the first HK$2 million of profits would be taxed at the reduced rate of 7.5 per cent and the remaining at 15 per cent.
Under the Partnership Ordinance,7 a partnership is established when a group of persons carry on a business in common with a view to profit. Generally, no formalities are required to establish a partnership. However, a written partnership agreement is usually used to govern the relationships between the partners.
Limited liability partnerships are permitted under Hong Kong law. They must be registered with the Companies Registrar under the Limited Partnership Ordinance.8
The assessable profits of a partnership are charged as though the partnership is a single entity.9 A partner's individual tax liability is calculated by apportioning the partnership's assessable profits between each of the partners in the ratio in which the profits or losses of the basis period were divided. Thereafter, losses carried forward from previous years are deducted before applying the tax rate applicable to the individual partner to that partner's share of the assessable profits.
Trusts are commonly used in Hong Kong as an investment vehicle. A trust comes into existence when one person transfers a specific property to the trustee with the intention that it will be applied for the benefit of another person (i.e., the beneficiary).
A trustee is subject to profits tax on its own profits arising from the provision of trustee services. Because of the separation of legal and beneficial ownership, a trustee will not be personally liable for tax charged on profits of the underlying entities of the trust. To the extent that the trustee itself carries on business, those profits will be subject to tax. A corporate trustee will, therefore, be subject to tax at a rate of 8.25 per cent on the first HK$2 million of profits (subject to the connected-entity rules) and at 16.5 per cent on the remaining profits.
Direct taxation of businesses
i Tax on profits
Determination of taxable profit
Hong Kong has a territorial system of taxation. Three conditions must be satisfied before a charge to profits tax can arise: (1) the taxpayer must carry on a trade, profession or business in Hong Kong; (2) profits to be charged must be from the trade, profession or business carried on by the taxpayer in Hong Kong; and (3) the profits must be profits arising in or derived from Hong Kong.
Whether a person is carrying on a trade, profession or business in Hong Kong is a question of fact.
Six factors have emerged from case law in determining whether a taxpayer has engaged in trade, which collectively are referred to as the 'badges of trade', namely:
- the subject matter of the transactions;
- the length of ownership;
- whether there have been successive or frequent similar transactions;
- whether supplementary activities have been performed to make the assets marketable or to attract purchasers;
- the reason for the disposal or realisation of the subject matter; and
- the taxpayer's motives.
In addition, the taxpayer's intention to trade and the existence of a commercial purpose for the transaction are also relevant to such a determination. It is not necessary for all badges of trade to be present before a taxpayer will be found to be trading.
The definition of 'business' is much wider than 'trade'. A company incorporated for the purpose of making profits for its shareholders that puts any of its assets to any gainful use is presumed to be carrying on a business.10 Business can be more passive than trade, with the receipt of share profits and fixed annuities having been held to be business.11 Similarly, the receipt of income by a holding company and the mere activity of depositing have been held to be carrying on a business as well.12 One-off transactions may also fall under the definition of 'business' under the IRO. Having a registered office in Hong Kong itself will not necessarily amount to carrying on a business in Hong Kong.
A 'profession' is not defined in the IRO. Case law indicates that it refers to work requiring either purely intellectual skill or manual labour dependent upon purely intellectual skill.13 If a person practices a profession but is an employee, he or she is not considered to be carrying on a profession for the purpose of profits tax.
On the source of profits, the IRO defines 'profits arising in or derived from Hong Kong' to include 'all profits from business transacted in Hong Kong, whether directly or indirectly through an agent'.14 According to Commissioner of Inland Revenue v. Hang Seng Bank Limited,15 the process of determining the source of profit involves examining the gross profit of the transaction and what the taxpayer has done to earn the profit in question. However, the test outlined in this case is not consistently followed in subsequent case law, much of which reverts back to an operations test (i.e., an examination of the operations of the taxpayer that contributed to the generation of net profits).
To provide some guidance and clarity in this area, the Hong Kong Inland Revenue Department (IRD) issued Departmental Interpretation and Practice Note (DIPN) No. 21. DIPNs are not legally binding, but are indicative of the IRD's views on various legal issues. According to DIPN No. 21, transactions must be looked at separately and the profits of each transaction considered on their own. Where the gross profit from an individual transaction arises in different places, they can be apportioned as arising partly in and partly outside Hong Kong. Further, the place where day-to-day investment decisions are undertaken does not generally determine the locality of profits. The absence of an overseas permanent establishment (PE) of a Hong Kong business does not itself mean that all the profits of that business arise in or are derived from Hong Kong. However, practically, the IRD is less likely to accept an offshore profits claim in the absence of an offshore presence of the taxpayer.
All outgoings and business expenses incurred in the production of profits are deductible in the basis year in which they are incurred. Such expenses include:
- interest on borrowings for the purpose of producing profits, and other sums payable in connection with such borrowings, subject to the limitations outlined in Section VII.ii;
- rent paid by tenants for buildings or lands occupied for the purpose of producing profits;
- foreign tax paid by a Hong Kong taxpayer where they were incurred in the production of profits;
- bad debts;
- expenditure incurred in the repair of premises, plant, machinery, implements, utensils or articles in the production of profits;
- expenditure incurred on the replacement of any implement, utensil or article, provided that no depreciation allowances are made;
- expenditure for the registration of trademarks, designs or patents used in the trade, profession or business that produced the assessable profits; and
- contributions made by individual taxpayers to mandatory provident funds in Hong Kong.
As a general rule, capital expenditures are not deductible. However, there are certain exceptions. For example, expenditure on R&D related to a taxpayer's trade, profession or business is deductible provided that the expenditure is not on land or buildings, and that the payment is to an approved research institute for R&D related to that trade, profession or business, or that the payment is to an approved research institute, the object of which is the undertaking of R&D relating to that particular class of trade, profession or business. To promote technological progress in local industries, the purchase of patent rights and rights to know-how are also deductible. In addition, payments for technical education and approved charitable donations may also be deducted from the assessable profits.
Depreciation is allowed for qualifying industrial and commercial buildings, and plant and machinery. For industrial buildings, a taxpayer who has incurred capital expenditure on the construction of an industrial building or structure is allowed a 20 per cent initial deduction of the capital expenditure. Thereafter, a 4 per cent deduction of the original capital expenditure is allowed annually.
A taxpayer with an interest in a commercial building or structure who has incurred construction costs can claim a deduction of 4 per cent annually. No depreciation deduction is available for commercial buildings that are more than 25 years old.
Capital expenditure on plant and machinery is allowed an initial deduction of 60 per cent in the year in which the expenditure is incurred. Thereafter, depending on the type of asset, depreciation is allowed on a reducing-value basis at 10, 20 or 30 per cent.
A super tax deduction scheme for R&D expenditure was introduced on 2 November 2018 and applies to expenditures incurred by enterprises on R&D activities conducted after 1 April 2018. Under this new scheme, a 300 per cent tax deduction will be offered for the first HK$2 million of qualifying R&D expenditure and, for expenditure in excess of HK$2 million, HK$6 million plus a 200 per cent tax deduction. In April 2019, the IRD issued DIPN No. 55 to provide guidance on the application of the new super tax deduction scheme. It also emphasises the need to maintain adequate documentation of R&D activities and expenditure to support any deduction claims.
Capital and income
Hong Kong does not impose tax on capital gains. However, the issue of whether income constitutes trading profits or non-taxable capital gains arises frequently in relation to the disposal of real property. Relevant factors include the frequency of the transactions, the accounting treatment adopted by the taxpayer, how long the property was held, how the property was financed and developed, and the reason for its sale. Profits obtained from properties acquired, developed and then sold are generally regarded as trading profits.
Hong Kong allows losses to be carried forward indefinitely.
The profits tax rate for companies is 8.25 per cent for the first HK$2 million of profits and 16.5 per cent for profits in excess of HK$2 million, subject to restrictions on connected entities discussed in Section II.i. If a company is a partner in a partnership, profits tax for its share of assessable profits is also charged according to the same two-tiered system of 8.25 per cent and 16.5 per cent. The rate for unincorporated businesses is 7.5 per cent for the first HK$2 million of profits and 15 per cent for profits in excess of that amount, subject to restrictions on connected entities as well.
A single tax authority – the IRD – exists in Hong Kong, and is responsible for administering the IRO.
Tax is charged on the assessable profits for the year of assessment. The assessable profits for a business that makes up annual accounts are calculated on the profits of the year of account ending in the year of assessment. Generally, profits tax returns should be filed within one month of the date of issue. However, under the IRD's Block Extension Scheme, this may be extended depending on the accounting date of the company. If a business objects to a tax assessment issued by the IRD, it has the right to file an objection within one month of the issuance of the assessment with the IRD, which will then render a determination that is subject to appeal to the IRD Board of Review as well as the Hong Kong courts.
No group loss relief is available to companies that are members of a group in Hong Kong.
ii Other relevant taxes
Hong Kong imposes stamp duty on instruments of transfer rather than the transaction itself. Instruments relating to the sale and lease of real property are subject to stamp duty, as are instruments relating to the sale of Hong Kong stock. Hong Kong stock is defined to include equity and debt instruments registered on a Hong Kong register. Therefore, if an offshore company maintains its share register in Hong Kong, any transfer of shares will be subject to stamp duty. Stock also includes units in unit trusts that maintain their registers in Hong Kong.
Hong Kong bearer instruments such as promissory notes and bills of exchange are also subject to stamp duty. However, owing to the range of exemptions applicable to these instruments, they are rarely subject to stamp duty in practice.
Tax residence and fiscal domicile
Owing to the territorial tax system of Hong Kong, whether profits tax is chargeable under domestic law depends on whether the source of profits is in Hong Kong. As part of the amendments of the IRO to introduce comprehensive transfer pricing rules passed on 13 July 2018, there are further provisions to clarify what constitutes a permanent establishment in Hong Kong, especially with regard to entities resident in jurisdictions with which Hong Kong has not concluded a double taxation agreement (DTA). However, it is important to bear in mind that the territorial principle continues to apply despite the introduction of detailed rules on the definition of permanent establishment.
Whether a person resident in a territory with which Hong Kong has concluded a DTA has a permanent establishment in Hong Kong is to be determined in accordance with the relevant provisions of the DTA concerned.
For a non-DTA territory resident person, it has a permanent establishment in Hong Kong if it has a fixed place of business in Hong Kong through which the business of the enterprise is wholly or partly carried on. Carrying out certain preparatory or auxiliary activities would not constitute having a permanent establishment in Hong Kong. However, the fact the activities carried on does not reach the threshold of a permanent establishment does not necessarily mean that it would not be chargeable to tax in Hong Kong. If the activities carried out constitute carrying on a trade, profession or business within the definition of Section 14 of the IRO, any profits derived from such activities sourced from Hong Kong would nevertheless be taxable profits.
Tax incentives, special regimes and relief that may encourage inward investment
In general, and as a matter of policy, Hong Kong does not offer tax incentives. However, this principle has been relaxed in recent years with the result that four industries currently enjoy lower statutory tax rates.
Corporate treasury centres
In addition to the general allowance for deductions discussed in Section III.i, the IRO allows the deduction of interest payable on money borrowed by a corporation carrying on an intra-group financing business in Hong Kong provided that the following conditions are satisfied:
- the deduction claimed is in respect of interest payable by a corporation (i.e., the borrower) on money borrowed from a non-Hong Kong associated corporation (i.e., the lender) in the ordinary course of an intra-group financing business;
- the lender is, in respect of the interest, subject to a similar tax (i.e., such tax has been paid or will be paid) in a territory outside Hong Kong at a rate that is not lower than Hong Kong's profits tax rate (i.e., 16.5 per cent); and
- the lender's right to use and enjoy that interest is not constrained by a contractual or legal obligation to pass that interest to any other person, unless the obligation arises as a result of a transaction between the lender and a person other than the borrower dealing with each other at arm's length.
In addition, there is a reduction in the profits tax rate to 8.25 per cent for qualifying corporate treasury centres (CTCs), which are dedicated CTCs, multifunction CTCs and CTCs by determination. A dedicated CTC is one that carries out one or more corporate treasury activities that stands alone. It would generally be prohibited from carrying out other activities. Multifunction CTCs can engage in a certain level of income-generating activities but still qualify for the profits tax concession on qualifying profits. A CTC by determination is a CTC that does not meet the conditions of either a dedicated CTC or a multifunction CTC, but may obtain a determination from the IRD stating that it is a qualifying CTC. Qualifying profits include lending transactions, corporate treasury services and corporate treasury transactions with non-Hong Kong-associated corporations.
These CTC incentives became effective on 1 April 2016.
Captive insurers enjoy a 50 per cent reduction in profits tax on their business of insuring offshore risks, thereby also reducing the effective corporate tax rate to 8.25 per cent.
Over the years, Hong Kong has rolled out numerous exemptions for different types of funds, starting with profits tax exemptions for offshore funds in 2006, for offshore private equity funds in 2015 and, most recently, for open-ended fund companies incorporated in Hong Kong in 2018.
However, starting from 1 April 2019, a new comprehensive regime was introduced that grants exemption to all privately offered onshore and offshore funds operating in Hong Kong, regardless of their size, structure or purpose, for transactions in specified assets, subject to meeting certain conditions. The exemption also applies to special purpose entities established by a qualifying fund.
The existing exemptions for offshore funds will continue to apply for any entity that does not satisfy the criteria under the new regime but the previous regime for open-ended fund companies will be repealed.
A concessionary tax regime for carried interest received by or accrued to fund managers and employees was introduced in January 2021, taking effect retroactively from 1 April 2020. This is a part of the continued effort of the Hong Kong government to promote the attractiveness of Hong Kong as a jurisdiction for private equity funds.
Under this regime, a concessionary profits tax rate of zero per cent will apply to net eligible carried interest received or accrued and such a sum will be completely excluded from employment income for salaries tax purposes.
In order for carried interest to qualify for concessionary tax treatment, the following conditions must be satisfied: (1) the fund must be certified by the Hong Kong Monetary Authority (HKMA) as a 'certified investment fund', which involves the HKMA being satisfied that the fund is focused on private equity investment strategies and fulfils the substantial activities requirements; (2) the carried interest must be profit-linked, meaning that the carried interest must be linked to the profits generated by the fund and subject to a hurdle rate; (3) the carried interest must arise from tax-exempt qualifying transactions, which are private equity transactions (i.e., transaction in shares, stocks, debentures, loan stocks, bonds and notes issued by a private company) exempt from tax under the fund tax exemption provisions of the IRO.
Aircraft lessors and managers
Through legislative amendments passed in July 2017, Hong Kong now offers a tax concession to qualifying aircraft lessors and aircraft leasing managers.
Qualifying aircraft lessors enjoy an 8.25 per cent tax rate on their assessable profits. In addition, the assessable amount of leasing income of a qualifying aircraft lessor is deemed to be 20 per cent of the gross leasing income less deductible expenditure. Effectively, the profits tax payable on the assessable profits of a qualifying aircraft lessor is reduced to 1.65 per cent of its net profit (ignoring depreciation). An 8.25 per cent profits tax rate also applies to the assessable profits of aircraft leasing managers providing management services (which also include aircraft financing activities) to qualifying aircraft lessors. These tax concessions apply to all profits derived on or after 1 April 2017.
Any aircraft lessor or manager who wishes to take advantage of the regime must make a written election with the IRD. The election is irrevocable.
To qualify for the reduced profits tax rate, the aircraft lessor or manager must satisfy the following conditions:
- the lessor or manager must have its central management and control in Hong Kong;
- the entity must not carry on any aircraft leasing or management activities from a permanent establishment outside Hong Kong;
- the aircraft lessor must not carry on any activities other than aircraft leasing activities; and
- an aircraft leasing manager must ensure that at least 75 per cent of its profits are derived from the aircraft leasing management business, and at least 75 per cent of its assets are deployed for such business.
If an aircraft lessor or manager fails to satisfy any of the conditions above, it will automatically be disqualified and cannot opt back into the regime. No grace period is allowed.
Withholding and taxation of non-local source income streams
i Withholding on outward-bound payments (domestic law)
Hong Kong has no withholding tax. However, sums paid as royalties to non-residents for the right to use intellectual property are subject to a tax similar to withholding tax. The withholding tax rate is 4.95 per cent if the recipient is a corporation and 16.5 per cent if the two parties are associates. However, even if the recipient is an associate, provided that no person carrying on a trade, profession or business in Hong Kong has at any time held an interest in the ownership of such intellectual property, the normal 4.95 per cent rate would apply. For payments to unincorporated businesses, the rates are 4.5 and 15 per cent, respectively.
There is no withholding tax on interest or dividends.
ii Domestic law exclusions or exemptions from withholding on outward-bound payments
There are no exclusions or exemptions applicable.
iii Double tax treaties
Traditionally, as Hong Kong adopts a territorial basis for taxation, Hong Kong residents generally do not suffer from double taxation. However, in recent years, Hong Kong has negotiated and entered into numerous DTAs with its trading partners, recognising that DTAs provide certainty to investors on the taxing rights of the contracting parties, helping investors to better assess their potential tax liabilities and providing an added incentive to do business in Hong Kong.16
Jurisdictions with which Hong Kong has concluded comprehensive DTAs include Austria, Belarus, Belgium, Brunei, Cambodia, Canada, the Czech Republic, Estonia, Finland, France, Georgia, Guernsey, Hungary, India, Indonesia, Ireland, Italy, Japan, Jersey, Kuwait, Latvia, Liechtenstein, Luxembourg, mainland China, Macao, Malaysia, Malta, Mexico, the Netherlands, New Zealand, Pakistan, Portugal, Qatar, Romania, Russia, Saudi Arabia, Serbia, South Africa, South Korea, Spain, Switzerland, Thailand, the United Arab Emirates, the United Kingdom and Vietnam.
iv Taxation on receipt
Dividends from a company subject to Hong Kong profits tax are not included in profits. No part of the profits or losses of a trade, profession or business carried on by a person subject to profits tax is included in ascertaining profits on which any other person is subject to profits tax.
Taxation of funding structures
i Thin capitalisation
There are no thin capitalisation rules in Hong Kong.
ii Deduction of finance costs
Interest payable upon money borrowed by a person for the purpose of producing assessable profits is deductible, subject to certain restrictions. In general, interest will be deductible if borrowed from a foreign or domestic financial institution or if borrowed from a person subject to tax in Hong Kong on the interest received. Generally (aside from the CTC rules discussed in Section V), interest paid to a corporation outside of Hong Kong will not be deductible.
In addition, legal fees, procuration fees, stamp duties and other expenses in connection with the borrowed money are also deductible.
Borrowing expenses that are of a capital nature are not deductible. In making this determination, the relevant consideration is the purpose of the loan; namely, whether money was borrowed for capital expenditure purposes. For example, where interest was paid on money borrowed for the purpose of acquiring a redevelopment site, intended ultimately to generate rental income, the interest expenses was of a capital nature and deduction should not be allowed.17
iii Restrictions on payments
A company must not make a distribution except out of profits available for the purpose, where 'distribution' is defined to include every form of distribution of a company's assets to its members.18 Profits available for distribution are the company's accumulated realised profits less accumulated realised losses.
iv Return of capital
Return of capital is permitted under the Companies Ordinance (CO) for a company limited by shares through a reduction of share capital.19 This is generally used when changes in a company's business result in excessive capital in the company. A reduction of capital is tax neutral in Hong Kong.
Acquisition structures, restructuring and exit charges
As Hong Kong does not impose tax on the sale of capital assets, capital gains on the sale of shares are not taxable. It is a question of fact as to whether shares are capital or trading assets. As discussed previously in Section III.ii, instruments of transfer of Hong Kong stock are subject to stamp duty.
The CO introduced a court-free amalgamation scheme on 3 March 2014 for intra-group mergers. Under this scheme, two or more Hong Kong-incorporated, wholly owned companies within the same group could amalgamate and continue as one. However, neither the CO nor the IRO itself currently contain provisions on the tax consequences of such amalgamation. These rules are under development.
There is no exit tax for Hong Kong.
Anti-avoidance and other relevant legislation
i General anti-avoidance
Anti-avoidance measures under the IRO include the following.
- Use of artificial or fictitious transactions under Section 61 of the IRO.20 A fictitious transaction is one that was never intended to be carried out by those who were ostensibly parties to it.21 An artificial transaction includes transactions that have been carried out but are commercially unrealistic.22 Commercially realistic transactions with incidental tax benefits could not be struck down under this provision.
- Implementation of transactions with the sole or dominant purpose of producing a tax benefit under Section 61A of the IRO. This section aims to strike down blatant or contrived tax-avoidance schemes. If a transaction is found to have the sole or dominant purpose of obtaining a tax benefit, then the transaction as a whole or a part of it will be disregarded.
- Sale of loss companies under Section 61B of the IRO. If a change in the shareholding of a company has been effected, and the sole or dominant purpose of the change in shareholding was to use a tax loss to obtain a tax benefit, then the set-off of a loss may be disallowed.
ii Controlled foreign corporations
Hong Kong has no controlled foreign corporation legislation.
iii Transfer pricing
Hong Kong introduced its first ever transfer pricing legislation in July 2018 through substantial amendments to the IRO. These amendments codify the arm's-length principle,23 which, prior to July 2018, had been applied in Hong Kong through informal practice rules rather than legislative provisions. This means that all transactions with associated parties must be conducted on arm's-length terms. In addition, the amendments introduce transfer pricing documentation requirements, namely local and master files, and country-by-country reporting. The IRD's recently issued DIPNs – namely, No. 58 on transfer pricing documentation and country-by-country reports, No. 59 on transfer pricing between associated persons and No. 60 on attribution of profits to permanent establishments in Hong Kong – further clarify provisions in the IRO relating to transfer pricing.
A Hong Kong entity entering into transactions with associated persons is required to prepare and keep on record a local file and a master file, unless such entity meets any two of these three conditions: (1) the total revenue of the entity does not exceed HK$400 million; (2) the total value of the entity's assets does not exceed HK$300 million; and (3) the average number of the entity's employees does not exceed 100.24 While the Hong Kong entity is not required to submit the master file and local file when filing its profits tax return, it must declare in the return whether it is required to prepare the master file and local file. Whether the Hong Kong entity has prepared the master file and local file in a timely and adequate manner may be subject to compliance checks by the IRD.
The master file should contain information on the group's structure, the location of all the group entities, high-level information about the group's global business operations, the group's transfer pricing policies and consolidated financial statements. The local file should describe the business of the relevant entity, record information and transfer pricing documentation on each material category of related-party transactions (even where the relevant income or profits are sourced outside of Hong Kong), and contain the entity's financial statements. However, if a certain transaction falls below the relevant monetary thresholds, then it would not be necessary to cover the transaction in the local file. Nonetheless, according to DIPN No. 58, all entities are encouraged to keep documentation on file even if they are not subject to transfer pricing documentation rules, as proper maintenance of transfer pricing documentation helps to mitigate audit and penalty exposure.
Multinational corporations are also subject to country-by-country reporting requirements that generally follow the OECD's requirements on the same. If a multinational corporation's ultimate parent entity is a tax resident in Hong Kong for each accounting period beginning on or after 1 January 2018, then the parent entity should prepare a country-by-country return in a form specified by the IRD.25 A Hong Kong entity that is not the ultimate parent entity may also be required to file a return if, for example, the ultimate parent company is not required to file a return in its tax residence jurisdiction, where there is no exchange arrangement in place between Hong Kong and the other jurisdiction, or where there has been a systemic failure to exchange a country-by-country report by the other jurisdiction.26
Advance pricing arrangements are now available in Hong Kong, allowing entities to reach a prior agreement with the IRD on the application of transfer pricing rules to material transactions during specified years of assessment.27
iv Tax clearances and rulings
Under Section 88A of the IRO, the IRD is empowered to make advance rulings upon an application made by a person. An advance ruling may relate to how any provision of the IRO applies to the applicant or to the arrangement described in the application. However, it must not relate to the imposition or remission of a penalty, the correctness of a return supplied by a person, the prosecution of a person or the recovery of any debt owing by any person.28 The IRD will not entertain applications for arrangements that are hypothetical or speculative, and a ruling will only be given for a seriously contemplated arrangement.
Where a ruling has been made, that ruling applies to the arrangement for the period specified in the ruling. Each ruling is confined to its specific terms and cannot be relied on as a precedent for similar arrangements in the future.
Advance ruling applications are subject to a charge calculated on the basis of cost recovery.
Year in review
As a part of the continued effort by the Hong Kong government to remain competitive and attractive in the asset management industry, a concessionary tax regime for carried interest received by fund managers and employees was introduced in 2021. Recognising that the tax treatment of remuneration received by fund managers and employees is a key factor influencing the choice of jurisdiction for fund domiciliation and operation, this regime hopes to attract more private equity funds to operate in Hong Kong. Other legislative initiatives in recent years for promoting the asset management industry include the 2019 unified profits tax exemption regime for funds and the introduction of the limited partnership funds regime in 2020.
Following the release of the BEPS 2.0 package by the OECD, Hong Kong has joined the OECD/G20 Inclusive Framework on BEPS, together with 140 other jurisdictions. The Hong Kong government has stated that it will actively implement the BEPS 2.0 proposal according to international consensus, while striving to maintain the key advantages of Hong Kong's tax regime in terms of simplicity, certainty and fairness; minimise the compliance burden on the affected enterprises; and continue to improve the business environment and competitiveness of Hong Kong.
To this end, the government has set up an Advisory Panel to formulate response measures to BEPS 2.0, and the recommendations from the Advisory Panel will be presented to the government after the OECD finalises the technical details of the BEPS 2.0 package. Therefore, while it is fairly clear that Hong Kong will implement both Pillar One and Pillar Two of the package, the exact measures to be adopted remain to be seen.
On 5 October 2021, the European Union announced that Hong Kong has been added to its grey-list on tax cooperation as it considered that the non-taxation of certain foreign-sourced passive income in Hong Kong may lead to situations of 'double non-taxation'. In response to this, the Hong Kong government stated that the jurisdiction will 'continue to adopt the territorial principle of taxation'.29 Noting that the European Union is concerned that corporations with no substantial economic activity in Hong Kong are not subject to tax in respect of certain offshore passive income, the government has agreed to cooperate with the European Union to amend the IRO to combat cross-border tax evasion by the end of 2022 and implement the relevant measures by 2023. The precise amendments to be made to the IRO remain to be seen.
Outlook and conclusions
Hong Kong prides itself on maintaining a simple tax system with a low effective tax rate, a principle that was enshrined in the Basic Law,30 the quasi-constitutional document governing the operation of Hong Kong. In general, the government continues to satisfy this objective, but the system's complexity has increased significantly in recent years, largely as a result of international pressure. Tax treaties, once unknown to Hong Kong, have become part of the tax landscape and, while providing some taxpayers with additional certainty, have introduced additional complications. Similarly, concepts such as transfer pricing and exchange of information were once unknown but have now become part of domestic law.
Notwithstanding such developments, Hong Kong retains an enviable competitive position with respect to taxes, as complexity has increased in most other jurisdictions at an even faster pace. Moreover, the absence of any sales taxes, significant duties, withholding taxes on dividends and interest, or tax on capital gains makes it an attractive investment location, particularly as a gateway to mainland China, with which Hong Kong enjoys a privileged relationship.
1 Steven Sieker is a partner and Wenwen Chai is an associate at Baker McKenzie.
4 Inland Revenue Ordinance (Chapter 112 of the laws of Hong Kong).
5 Section 14(2), IRO.
6 Section 14AAB, IRO.
7 Partnership Ordinance (Chapter 38 of the laws of Hong Kong).
8 Limited Partnership Ordinance (Chapter 37 of the laws of Hong Kong).
9 Section 22(1), IRO.
10 American Leaf Blending Co Sdn Bhd v. Director General of Inland Revenue (Malaysia) 1978 STC 561.
11 IRC v. Korean Syndicate Ltd (1921) 3 KB 258; South Behar Railway Co Ltd v. IRC (1925) AC 476.
12 D15/87 Inland Revenue Board of Review Decisions Vol 2, 373.
13 IRC v. Maxse (1919) 1 KB 647.
14 Section 2, IRO.
15 Commissioner of Inland Revenue v. Hang Seng Bank Limited (1990) 1 HKRC.
17 Wharf Properties Limited v. Commissioner of Inland Revenue  AC 505.
18 Sections 297(1) and 290, CO (Chapter 622).
19 Section 210, CO (Chapter 622).
20 Section 61, IRO.
21 Commissioner of Inland Revenue v. Douglas Henry Howe (1977) 1 HKTC 936.
22 Cheung Wah Keung v. Commissioner of Inland Revenue (2003) HKRC.
23 Section 50AAF, IRO.
24 Section 58C, IRO.
25 Section 58E, IRO.
26 Section 58F, IRO.
27 Section 50AAP, IRO.
28 Section 1, Part 1 of Schedule 10, IRO.
30 Article 108, Basic Law.