Hong Kong’s New and Aggressive Approach to Tax Treaty Benefits

Travis Benjamin, Head, Tax Practice, Deacons

On 29 January 2015, the Inland Revenue Department announced new, hard-line procedures for obtaining a certificate of Hong Kong resident status for the purpose of Hong Kong’s comprehensive double taxation agreement network. The new rules became effective on 1 February 2015.

In a radical departure from past practice, all companies, partnerships, and trusts claiming Hong Kong tax resident status must now annually submit to an abridged tax-audit examination when making an application to the Inland Revenue Department (“IRD”) for a certificate of Hong Kong resident status (“tax residence certificate”).

All applicants are now required to provide a colossal amount of data to the IRD in support of their application. The data burden is greater still where the applicant is part of an unlisted group or is a private wealth vehicle held by one or two shareholders. The burdens created by the new rules will be most immediately felt by Hong Kong incorporated companies, which were previously, generally, not required to provide data to the IRD for this purpose. Such companies will now face one of the most compliance-heavy application procedures in the developed world.

Hong Kong does not impose profits tax on dividend and interest payments to non-resident recipients, nor does it impose tax on the sale of capital assets. It follows that entitlement to tax benefits under Hong Kong’s double taxation agreements (“DTAs”) typically involve the reduction or elimination by the DTA partner jurisdiction by virtue of the DTA of taxes on dividend, interest and royalty income beneficially owned by Hong Kong residents.

Hong Kong resident status under Hong Kong’s DTAs is a creature of the relevant DTA itself. Generally, Hong Kong’s DTAs define the following persons as Hong Kong resident:

  • companies incorporated in Hong Kong;
  • companies incorporated outside Hong Kong if normally managed or controlled in the Hong Kong; and
  • any other person (eg, a partnership, trust (or trustee of trust estate) or other body of persons) constituted under Hong Kong law or, if constituted outside Hong Kong, being centrally managed and controlled in Hong Kong.

Properly understood, the points at issue when certifying Hong Kong resident status are narrow and the relevant facts are in a relatively limited compass. The mass of information requested by the IRD appears to have tenuous relevance to the correct legal questions that the IRD should be considering in the context of tax residence.

In an unusual move, the IRD has indicated that it will use the data collected to, apparently, put itself in the shoes of its DTA partner’s tax authorities and speculate on the (Hong Kong) applicant’s entitlement to DTA benefits in the other jurisdiction. In a curious twist, this will include a determination on whether the (Hong Kong) applicant has beneficial ownership of the income arising in the other jurisdiction under the DTA. Accordingly, where the IRD is of the opinion that the applicant should not be entitled to the benefit of the relevant DTA (ie, any DTA tax benefits arising in the other jurisdiction), it will refuse to grant a tax residence certificate.

The IRD has previously indicated that it is vitally important for the IRD to uphold the terms and purpose of Hong Kong’s DTAs by not issuing tax residence certificates to those who were clearly not entitled to relief from foreign taxes since the IRD had to act in good faith according to the terms of DTAs. In doing so, however, the IRD is exceeding the usual scope of its role as a DTA partner and introducing a series of arbitrary tests, which confuse economic substance for beneficial ownership, which in turn is confused for resident status.

Implicit in the IRD’s approach is a belief in its right to deny DTA tax benefits by relying on anti-abuse provisions in the relevant DTA (if any exist) or domestic law anti-avoidance rules (if Hong Kong is reserved such a right under the DTA). This view is no doubt technically correct to the extent that the impugned tax benefits are Hong Kong tax benefits (eg, a reduction of Hong Kong profits tax on royalty payments to a non-resident). On the other hand, it is hard to find any authority for the proposition that the IRD has the right to apply anti-abuse or anti-avoidance provisions where the impugned tax benefits arise in the taxing jurisdiction of the DTA partner (eg, a reduction of foreign income tax on royalty payments to a Hong Kong resident).

It follows from the IRD’s published position that it is unlikely to grant tax residence certificates to companies, partnerships, and trusts lacking economic/operational substance in Hong Kong. As a result, thousands of Hong Kong companies will be unable to obtain a tax residence certificate even though they qualify, as a matter of law, as Hong Kong residents under the terms of the relevant Hong Kong DTA.