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Hong Kong: Effects of the international tax framework

The globalisation and development of the digital economy has fostered continuous growth of cross-border transactions. As different countries adopt different tax regimes, taxpayers may avoid taxation in their home countries by pushing activities abroad to low or no tax jurisdictions. The Organisation for Economic Co-operation and Development (OECD) and various tax authorities have tried to introduce new rules to address base erosion and profit shifting.

Hong Kong, being a low-rate and source-based tax jurisdiction, is facing challenges and pressure to improve its tax information exchange, transfer pricing, tax transparency arrangements and requirements. The following article contains a summary of the OECD’s actions against base erosion, profit shifting and recent developments of Hong Kong’s international tax framework.

OECD’s Action  Plan on Base Erosion and Profit Shifting

At the request of G20 Finance Ministers, the OECD launched an Action Plan on Base Erosion and Profit Shifting (BEPS Project). This action plan identifies 15 specific actions needed in order to equip governments with the domestic and international instruments, to address the arrangements that lead to double non-taxation or

less than single taxation (which is being referred to as “harmful tax practices”) in July 2013. These 15 actions include:

Address the tax challenges of the digital economy

  1. Neutralise the effects of hybrid mismatch arrangements
  2. Strengthen Controlled Foreign Corporation rules
  3. Limit base erosion via interest deductions and other financial payments
  4. Counter harmful tax practices more effectively, taking into account transparency and substance
  5. Prevent treaty abuse
  6. Prevent the artificial avoidance of Permanent Establishment status
  7. Develop rules to prevent BEPS by moving intangibles among group members
  8. Develop rules to prevent BEPS by transferring risks among, or allocating excessive capital to, group members
  9. Develop rules to prevent BEPS by engaging in transactions which would not, or would only very rarely, occur between third parties
  10. Establish methodologies to collect and analyse data on BEPS and the actions to address it
  11. Require taxpayers to disclose aggressive tax planning arrangements
  12. Re-examine transfer pricing documentation
  13. Make dispute resolution mechanisms more effective
  14. Analyse the tax and public international law issues related to the development of a multilateral instrument.

The BEPS Project is scheduled to be finalised in three phases and completed by December 2015.

The following deliverables are expected:

September 2014

  • An in-depth report identifying tax challenges raised by the digital economy and the necessary actions to address them (Action 1)
  • Recommendations regarding the design of domestic and tax treaty measures to neutralise the effects of hybrid mismatch arrangements, both from a domestic and treaty law perspective (Action 2)
  • Finalise the review of member country regimes in order to counter harmful tax practices more effectively (Action 5)
  • Recommendations regarding the design of domestic and tax treaty measures to prevent abuse of tax treaties (Action 6)
  • Changes to the transfer pricing rules in relation to intangibles (Action 8)
  • Changes to the transfer pricing rules in relation to documentation requirements (Action 13)
  • A report on the development of a multilateral instrument to implement the measures developed in the course of the work on BEPS (Action 15).

September 2015

  • Recommendations regarding the design of domestic rules to strengthen Controlled Foreign Companies Rules (Action 3)
  • Recommendations regarding the design of domestic rules to limit base erosion via interest deductions and other financial payments (Action 4)
  • Strategy to expand participation to non-OECD members to counter harmful tax practices more effectively (Action 5)
  • Tax treaty measures to prevent the artificial avoidance of permanent establishment status (Action 7)
  • Changes to the transfer pricing rules in relation to risks and capital, and other high-risk transactions (Actions 9 and 10)
  • Recommendations regarding data on BEPS to be collected and methodologies to analyse them (Action 11)
  • Recommendations regarding the design of domestic rules to require taxpayers to disclose their aggressive tax planning arrangements (Action 12)
  • Tax treaty measures to make dispute resolution mechanisms more effective (Action 14).

December 2015

  • Changes to the transfer pricing rules to limit base erosion via interest deductions and other financial payments (Action 4)
  • Revision of existing criteria to counter harmful tax practices more effectively (Action 5)
  • The development of a multilateral instrument (Action 15).

September 2015

  • Recommendations regarding the design of domestic rules to strengthen Controlled Foreign Companies Rules (Action 3)
  • Recommendations regarding the design of domestic rules to limit base erosion via interest deductions and other financial payments (Action 4)
  • Strategy to expand participation to non-OECD members to counter harmful tax practices more effectively (Action 5)
  • Tax treaty measures to prevent the artificial avoidance of permanent establishment status (Action 7)
  • Changes to the transfer pricing rules in relation to risks and capital, and other high-risk transactions (Actions 9 and 10)
  • Recommendations regarding data on BEPS to be collected and methodologies to analyse them (Action 11)
  • Recommendations regarding the design of domestic rules to require taxpayers to disclose their aggressive tax planning arrangements (Action 12)
  • Tax treaty measures to make dispute resolution mechanisms more effective (Action 14).

December 2015

  • Changes to the transfer pricing rules to limit base erosion via interest deductions and other financial payments (Action 4)
  • Revision of existing criteria to counter harmful tax practices more effectively (Action 5)
  • The development of a multilateral instrument (Action 15).

In response to a question raised in the Legislative Council in November 2013, the Secretary for Financial Services and the Treasury, Professor Ceajer Ka-keung Chan (Professor K C Chan) said Hong Kong has been closely monitoring the latest development in respect of the BEPS Project with a view to assessing the need for introducing corresponding measures. Professor K C Chan also advised that the Hong Kong Inland Revenue Department (IRD) has set out in its Departmental Interpretation and Practice Notes No. 46, the methodologies and practices adopted for dealing with transfer pricing issues. The IRD has no plan at this juncture to change the current practices.

Tax Information Exchange Agreement and Intergovernmental Agreement

Tax Information Exchange Agreement (TIEA)

The Global Forum on Transparency and Exchange of Information for Tax Purposes of the OECD conducted Phase 1 and Phase 2 Peer Reviews on Hong Kong in 2011 and 2013 respectively. These reviews examined Hong Kong’s legal framework for exchange of tax information. The OECD used a four-tier rating system (from non-compliant, partially compliant, largely compliant, to compliant) when reviewing and assessing the framework. The overall rating for Hong Kong is “largely compliant”. 

According to the Phase 1 review report published in October 2011, the Global Forum commented that Hong Kong has generally implemented the necessary legal framework for exchange of information. However, Hong Kong was advised to put in place a legal framework for entering into TIEAs.

In 2013, Hong Kong amended its Inland Revenue Ordinance and Inland Revenue Rules (Disclosure of Information) extending the IRD’s information gathering power and allowing the IRD to exchange information under TIEAs. On 25 March 2014, Hong Kong and the United States (US) signed a TIEA which became effective on 20 June

This is the first TIEA signed by Hong Kong. Currently, there is no double tax agreement between Hong Kong and the US. The TIEA with the US allows the exchange of tax information on request between Hong Kong and the US, which will help Hong Kong to meet the US Foreign Account Tax Compliance Act (FATCA) requirements.

FATCA Requirements

The purpose of FATCA is to combat tax evasion by US taxpayers using offshore financial accounts. In brief, under FATCA, foreign financial institutions (FFIs) are required to sign agreements with the US Internal Revenue Service (IRS) to identify and disclose detail regarding their US account holders. These FFIs will be required to withhold tax for relevant US account- holders who do not give consent to such disclosures, or to close such accounts. An FFI which does not sign or is not otherwise exempt, will face a punitive 30% withholding tax on all “withholdable payments” derived from US sources, including dividends, interest and certain derivative payments.

The TIEA with the US provides the necessary basis for Hong Kong to provide an exchange of information upon request, made in relation to the information reported by financial institutions in Hong Kong to the US, under the FATCA.

Intergovernmental Agreement (IGA)

The US Treasury announced in June

2012 its intention to sign IGAs under FATCA with other jurisdictions, in order to simplify due diligence and disclosure requirements, reduce or eliminate conflicts with local legislation, and eliminate certain withholding requirements. The US has developed two Model IGAs to simplify the implementation of FATCA:

  • Model I establishes a framework of reporting account information on US persons by FFIs to the relevant domestic authority, which in turn provides the information to the IRS. Thirtyfour jurisdictions, including Australia, Canada, France, Germany and the United Kingdom, have signed Model I IGA with the US.
  • Model II establishes a framework of enabling relevant FFIs to seek consent for disclosure from US clients, and to report relevant tax information of such clients to the IRS directly. Model II of IGA will be supplemented by the operation of a TIEA. Austria, Bermuda, Chile, Japan and Switzerland have signed Model II IGAs with the US.

Hong Kong and the US have reached consensus on the substance of a Model II IGA. Hong Kong will sign the IGA with the US when both sides complete the necessary legislative procedures. This IGA will provide additional exemptions, simplified reporting and due diligence procedures to minimise the compliance burden of financial institutions in Hong Kong. 

According to the proposed IGA with the US, financial institutions in Hong Kong, with the consent of their US clients, have to report to the IRS their US clients’ identification details (e.g. name, address, the US federal taxpayer identifying numbers etc.), the relevant account balances, gross amounts of relevant interest income, dividend income and withdrawals.

If their US clients refuse to give any consent to report their account information, the financial institution concerned should report “aggregate information” of account balances, payment amounts and number of non-consenting US accounts to the IRS. Based on such aggregate information, the IRS may request the IRD, where necessary, for exchange of information on a group basis pursuant to the Hong Kong’s TIEA with the US.

Our Comments

The BEPS Project may have a substantial effect on multinational companies using offshore structures where little or no business activities take place. More stringent transfer pricing rules in relation to intangibles, interest deductions, financial payments and documentation requirements are expected.

According to the ‘IRD’s Departmental

Interpretation and Practice Notes No. 45 - Relief from Double Taxation due to Transfer Pricing or Profit Reallocation Adjustments’, where the tax administration of another state makes a transfer pricing or profit reallocation adjustment and no relevant double tax agreement exists, the question of any relief from the resultant double taxation does not arise.

If the tax authorities of our non- treaty partners adopt a more stringent transfer pricing rule following the changes to the international tax framework that are recommended by the BEPS Project and make transfer pricing adjustments on overseas companies and charge additional overseas tax on their cross-border transactions with Hong Kong group companies, the existing Hong Kong tax laws do not allow the IRD to make a downward adjustment of tax for the Hong Kong group companies. As such, adjustments shall be made to the prevailing Hong Kong tax system to avoid the potential double taxation issues arising from this.

The change in international tax standards and the request for exchange of information between different jurisdictions are inevitable. These changes may have a significant impact on taxpayers’ cross-border transactions. Taxpayers should be alert to the development of the international tax framework and review their operating models periodically so as to be in compliance on one hand and to effectively reduce any risk of double taxation on the other.

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