Tax Substance in Hong Kong
It is sometimes argued that a company incorporated under HK Law (“HK Co”) will (a) automatically be regarded as a Hong Kong tax resident for tax purpose; and (b) only be subject to profits tax in Hong Kong but not in other tax jurisdictions. However, one has to be well aware that if HK Co lacks (has insufficient) ‘tax substance’ or ‘economic substance’ in Hong Kong, HK Co might be considered as having taking up its tax residency in the jurisdiction that has ‘more’ tax substance.
As a result, HK Co becomes potentially subject and liable to Hong Kong and foreign corporate income tax at the same time, thereby incurring double taxation. In addition, HK Co might not be entitled to tax benefits (such as reduced withholding tax rates on dividend, interest and royalties) granted under Hong Kong double tax treaties (‘DTAs’).
What is Tax Substance?
There is no definition of tax substance under Hong Kong tax laws. In determining whether HK Co maintains tax substance in Hong Kong, tax authorities generally look at every relevant fact and circumstance of HK Co. The relevant factors include but are not limited to the following:
- Whether the business is managed and controlled in Hong Kong
- Whether the business is carried out in Hong Kong and if yes, what is the nature of business?
- Whether the directors and other senior management personnel reside in Hong Kong and their respective roles and responsibilities?
- Whether directors’ meetings are held in Hong Kong?
- Whether physical office(s)/warehouse(s)/other forms of establishments is maintained in Hong Kong?
- Whether any staff is employed in Hong Kong?
- Whether and how many Hong Kong bank accounts are maintained?
- Whether fixed assets(s) and cash are kept in Hong Kong?
The more of the above activities take place in Hong Kong by the HK Co, the stronger a claim for having sufficient tax substance by the HK Co in Hong Kong can be ascertained.
Adverse Effects of Insufficient Substance in Hong Kong
As mentioned above, inadequate tax substance maintained by HK companies in Hong Kong will potentially result into two major unfavourable consequences:
Exposure to corporate income tax in foreign jurisdictions
The place of management and control of a company is usually one of the critical factors in determining tax residency. Therefore, HK Co, although incorporated in Hong Kong, but managed and controlled from out a foreign tax jurisdiction, is likely to be regarded as a tax resident in that foreign tax jurisdiction whereby it then will also be exposed to foreign corporate income tax.
Failure to obtain a certificate of resident status (“the Certificate”)
In order to enjoy certain tax preferential treatments under the Hong Kong DTAs signed with 35 tax jurisdictions, HK Co has to be qualified as a Hong Kong tax resident. This assessment is made by the Hong Kong Inland Revenue Department and upon a positive assessment, results into the issuance of the Certificate.
One of the HK-IRD’s major considerations in assessing the application for the Certificate by HK Co is whether HK Co maintains sufficient tax substance in Hong Kong. It is observed that the HK-IRD has become more and more stringent in reviewing the application for the Certificate in recent years, probably due to international pressure on combating treaty shopping.
For the purpose of obtaining the Certificate, it is required to complete an application form prescribed by the HK-IRD, in which applicants have to provide, amongst others, their particulars and details regarding the tax treaty benefits to be claimed as well as answer a number of questions in connection with tax substance as mentioned in items (i) to (viii) of paragraph 2 above.
In case the information supplied in the application form is not sufficient for assessing the application for the Certificate, the HK-IRD would probably issue follow-up enquiry letter(s) to applicants requesting for further detailed information/supporting documents.
Policy & Legal Cases About Tax Substance
Landmark cases have shown the importance of having proper substance for corporate tax as well as trust tax structures. The corporate tax substance case and its appeal showed how careful tax structures should be in order to qualify to the legal requirements above mentioned.
This is not only true of a corporate tax structure but also about other structures as this tax substance case regarding a trust have shown as well.
These are not isolated cases. In fact, tax substance related disputes between the Hong Kong Inland Revenue Department (‘HK IRD’) and the taxpayer have recently become a rather common feature.
Some of those discussions might relate to tax residence certificates or the treatment of royalty income, but most discussions however can be related to either whether a gain is of a capital or of an income nature or whether the trading income and/or commission income allocated to a Hong Kong company, being the Taxpayer, can be considered as offshore or onshore.
One of the reasons why the HK IRD has become more critical when assessing an offshore claim of a Taxpayer is simply due to government policies. Although Hong Kong and thus China is not a member of the Organisation for Economic Co-operation and Development (‘OECD’), Hong Kong would still like to avoid to be considered by the OECD as a non-cooperative jurisdiction or to be put on a grey or black list by the countries from the European Union.
As a result, the HK IRD has become critical: Not only by asking the Taxpayer standard question such as whether the claimed offshore income is being taxed or is taxable somewhere else, but even by denying the Taxpayer its offshore claim when it feels that the Taxpayer has some ‘form’ of presence in Hong Kong, which makes it in general already rather hard to claim offshore.
The Taxpayer at the other hand is not required to answer questions related to whether it paid taxes in another jurisdiction in relation to its offshore income or whether taxes should have been paid the other jurisdiction in the event that the offshore income would have been allocated to that jurisdiction.
In addition, the Taxpayer usually tends to focus more on substance as that would not only be in accordance with international tax practices, but even more in accordance with Hong Kong common law, i.e. based on Hong Kong case law.
It is vital for Hong Kong companies to keep sufficient tax substance in Hong Kong with a view to mitigate its foreign tax exposures as well as obtain the Certificate from the HK-IRD smoothly and successfully for the purpose of tax treaty benefits.
One should note that further to implementation of automatic exchange of information/Common Reporting Standard in short CRS in the near future, tax information will be more and more transparent among tax authorities of various jurisdictions.
Tax substance is not an easy concept to deal with. As most of Hong Kong case law is still in favour of a substance over form approach when it comes to tax substance, the taxpayer usually tends to be in a stronger position than the HK IRD.
HKWJ Tax Law & Partners Limited (“HKWJ”) has international tax advisers who can offer assistance to fight for your rights.
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