Hong Kong General Anti-Avoidance Rules
In Hong Kong, we are somehow in the very ‘luxurious’ position not to have only 1 General Anti-Avoidance Rule provision (“GAAR”), but even to have 2 GAAR provisions. The first GAAR provision can be found in section 61 of the Hong Kong Inland Revenue Ordinance (“IRO”), and the second GAAR provision in section 61A of the IRO. Both sections are not mutually exclusive, which means that they both can be applied by the Hong Kong Inland Revenue Department (“IRD”) simultaneously.
The main difference between the 2 GAAR provisions lies in the remedy, i.e. within section 61 IRO, the only remedy for the IRD is to ignore a taxpayer’s transaction, but within section 61A IRO, apart from ignoring a taxpayer’s transaction, the IRD may also substitute the transaction by a reasonable postulated hypothetical transaction, such as by an arm’s length price transaction.
Another difference, as also follows from below, is its application, i.e. section 61 IRO is applied to artificial or fictitious transactions whereas section 61A IRO is applied to transactions that are carried out for the sole or dominant purposes of obtaining tax benefits.
It should be noted that apart from GAAR provisions, the IRO itself also contains so-called Specific Anti-Avoidance Rule (“SAAR”) provisions, such as section 9A of the IRO, to counteract specific tax avoidance transactions / arrangements. Within section 9A IRO, the focus is on arrangements that are entered into to avoid salaries tax by the use of so-called service companies.
What are the General Anti-Avoidance Rules?
The Hong Kong GAAR provisions focus on those transactions or schemes or arrangements or dispositions that
- Either are fictitious or artificial resulting into the reduction of tax payable of a taxpayer (section 61 IRO) or
- That create a tax benefit for a taxpayer whereby 7 factors are taken into account in order to establish whether it objectively can be concluded that the transactions were carried out for the sole or dominant purpose of enabling this taxpayer such tax benefit (section 61A IRO).
The first 2 out of these 7 factors look at the manner in which the transaction was carried out and the form and substance of the transaction, i.e. basically looking at the background of the transaction. The remaining 5 factors are more money related questions and look at the result of a transaction if not stopped, the changes of the financial position of a taxpayer and/or related persons (if any), whether the transaction is at arm’s length and whether or not any offshore company has been involved.
What is GAAR Really?
To answer that question one might want to raise another question: whether GAAR is a compilation of existing tax doctrines developed by the courts such as substance-over-form, sham transaction(s) or step-transaction(s) or whether it is something / a rule that goes beyond these existing authorities?
Both the Hong Kong Board of Review (a tax tribunal) in Decision 94/04 and the IRD within its Departmental Interpretation and Practice Notes (“DIPN”) No. 15, have stated that principles such as Ramsey (applied in Furniss v Dawson,  1 All E.R. 530), which like substance-over-form and step-transaction(s) focuses on ignoring certain steps, can be applied next to the GAAR provisions.
It was said that being an interpretation approach, the Ramsey principle can co-exist/operate alongside GAAR. Therefore, it seems that all tax avoidances cases that are not accepted or not liked by the IRD can be either dealt with by GAAR provisions or through the judicial anti-abuse doctrines as at the end of the day they all tend to focus on substance-over-form.
It can therefore be argued that GAAR is a way for governments to incorporate judicial doctrines into statute and/or a way to guide the courts on how to interpret the laws when abusive anti-avoidance tax transactions supposedly take place.
What is the Purpose of GAAR?
As stated above, it is argued that because of disliked court behaviour, more and more governments like India have recently introduced GAAR provisions in order to incorporate judicial tax doctrines. It must however be said that in Hong Kong, section 61A of the IRO has already been in existence since the year 1986 and has been ‘copied’ from the Australian GAAR provisions.
As businesses have become very globally orientated nowadays, the Organisation for Economic Co-operation & Development (“OECD”) introduced global standards resulting into the introduction of various tax avoidance rules in double taxation treaties such as the ultimate beneficial ownership standard. From that point of view, it could be argued that GAAR provisions themselves are less needed.
According to DIPN No. 15, 61A of the IRO was introduced to ‘strike down blatant or contrived tax avoidance arrangements, but it should not cast unnecessary inhibitions on normal commercial actions’. The question therefore arises, what is ‘blatant’ and what is ‘contrived’? As a first impression, it comes across that it relates to arrangements that are rather aggressive / abusive. The DIPN No. 15 further states that the presence of the sole or dominant tax purpose, one of the requirements for 61A IRO, must be clearly evident.
But what is ‘clearly evident’? Again, it looks like that the focus is on aggressive or abusive anti-avoidance tax transactions. It should be noted here that in Hong Kong, GAAR provisions are also used for adjustments of transfer pricing arrangements as up till today (although this might change soon) Hong Kong still has not introduced any formal transfer pricing regulations into its legislation.
Does GAAR Bring Sensible / Responsible Tax Planning in Jeopardy?
A first question one might want to raise here is, what is tax planning? Is it a part of tax avoidance, which is considered by governments as acceptable? Or, as tax avoidance according the commentaries of the OECD Model Convention should be prevented and is therefore unacceptable, should we restrict tax planning to tax mitigation only? Obviously, it is just a name and much will depend on the substance of the transaction or arrangement or scheme or disposition itself, but for sure it is the aggressive or abuse tax planning that is being disliked by governments.
According to the Court of Final Appeal in Ngai Lik Eectronics Company Limited v CIR, CACV 22/2008, GAAR is not to attack arrangements made to secure tax benefits, which are legislatively intended to be available to the taxpayer, such as the Hong Kong offshore regime. Therefore, receiving tax advice on how to benefit from the offshore claim seems to be well accepted in Hong Kong and should not be subject to GAAR attacks.
An interesting aspect to mention here is that although GAAR provisions generally tend to focus basically on substance-over-form, when it comes down to discussions on whether or not a Hong Kong company is able to qualify for its offshore regime, the IRD seems to be more focused on form than on substance, which is rather contradictory.
Application of an Anti-avoidance Rules
One of the issues with Hong Kong GAAR is that it is often used in the alternative. For example, when a particular transaction is disliked by the IRD, such as the deduction of interest because the expense was not incurred for the production of profits as stipulated in sections 16/17 IRO, the IRD often does not only argue its non-deductibility under sections 16/17 IRO; it often also disputes alternatively under section 61 IRO and/or alternatively under section 61A of the IRO.
As the onus of proof is on the taxpayer in Hong Kong, it creates therefore a heavy burden for taxpayers to proof that the transactions, arrangements or schemes or dispositions involved cannot be subject to a GAAR claim from the IRD.
Apart from interest deduction cases, other GAAR cases have focused on management/consultancy fee deductions, interpositions of companies between sole proprietorships & clients, complicated refinancing cash round transactions and purported non-arm’s length transactions. However, a common character of all these transactions is that they all relate to internal reorganisations.
Interesting enough, when looking at the various tribunal cases / court cases since the year 2000, there seem to have been roughly only 17 GAAR cases, i.e. on average 1 GAAR case per year! When looking at those cases in more detail, it shows that 11 out of these 17 GAAR cases, are rather straightforward, i.e. they can be considered as aggressive, abusive tax anti-avoidance transactions, for which now SAAR provisions are or at least should be in place.
Further, 2 out of these 17 GAAR cases are in relation to at arm’s length pricing transactions, which in the near future will be solved through specific arm’s length pricing legislation. It is only the remaining 4 cases that really can be considered as complex or as non-straightforward, which may be solved under a GAAR provision or under a judicial tax doctrine. The above shows that GAAR applications by the IRD are therefore less severe present then one might have thought and that most GAAR claims can be solved under SAAR or under other specific tax rules.
Does GAAR Change Taxpayer’s Behaviour?
At one hand one could argue, it does not, simply because GAAR in itself is difficult to be enforced. At the other hand, as the onus of proof rests on the taxpayer, it will not be easy to discharge such burden. That being said, if a taxpayer has the feeling that certain reorganisation steps might potentially trigger any GAAR provisions, the following tips should be taken into consideration.
– One should take tax advice from a tax lawyer only. The reason for this is simply because of legal advice privilege that is attached to the advice from a lawyer, this in contrast to advice that is provided by a tax consultant or an accountant. In Decision 94/04, the potential tax ant-avoidance scheme and therefore the potential application of GAAR to the proposed reorganisation was explicitly discussed by the accountant in its tax advice to the client. The court became aware of this advice and obviously this awareness did not contribute much to a positive outcome of the case;
– Apply for an advance ruling with the IRD. Even in case the outcome is not positive, i.e. either the IRD decides not to rule on the proposed transaction (s) or decides negatively on the proposed transaction, at least one is able to find out why exactly the IRD did not like the proposed transaction(s).
– Most GAAR provisions are applied to internal reorganisations that are carried out for non-commercial reasons, mainly being a tax reason. This clearly shows that in order to avoid the application of any GAAR provisions, there must be proper commercial reasons showing why one undertook the reorganisation in the first place. It must be noted that if there are 2 commercial reasons and only one tax reason for the reorganisation, this does not automatically mean that the main reason for the reorganisation was a commercial one. As may be read from the Australian High Court Case FCT v Spotless Limited (1996) 168 CLR 404, one particular purpose/reason of a transaction might be given more or less weight to than another purpose/reason of the same transaction.
– Do not involve in the restructuring/reorganisation any offshore jurisdiction, such as the British Virgin Islands or the Republic of Seychelles, unless one has proper substance over there.
Does GAAR Conflict with International Tax Treaties?
The question is whether GAAR provisions, being of a domestic character, conflicts with international and Hong Kong tax treaties, especially with double tax treaties. According to OECD’s Base Erosion & Profit Shifting (“BEPS”) Project 6, this should not really be the case as the purpose of tax treaties is, amongst others, preventing tax avoidance, which with the introduction of the new principle purpose test is made even more clear.
Besides, as also stated in BEPS Project 6, many tax treaties do already contain many anti-avoidance rules and tax provisions such as the ultimate beneficial ownership provisions when claiming reduced withholding taxes for dividends, interests and royalties.
Other reasons for no conflict, according to the OECD, are because the GAAR provisions usually focus on determining the tax liability, which does not take place within a tax treaty and besides no country wants to have a tax treaty in place with a country that allows for abusive tax avoidance to take place.
Despite the above, there however still might be situations where certain domestic anti-avoidance rules overrule the treaty, such as in exit tax cases whereby a country still wants to levy on capital gains values that are arisen after the exit from a country has already taken place.
How should governments ensure then that a GAAR is used for appropriate cases only?
In some countries so-called review panels have been introduced before a GAAR claim is initiated, such as in Australia. According to the Australian Tax Office (“ATO”) website, these panels help them in their administration of GAARS by providing independent advice to their decision-makers. It however seems that apart from business & professional people, such panel also exists out of senior ATO people.
Besides, their advice is not binding. One could, therefore, wonder how this would contribute to independent advice and whether such panel is basically not just a way for the ATO to contract-out some work?
In general, it seems therefore to be better to have more SAAR, than GAAR, i.e. as soon as a common anti-avoidance rules scheme is somehow considered as GAAR, governments should create SAAR provisions, as GAAR provisions simple create unwanted uncertainty.
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