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Hong Kong

Yongjun Peter Ni and Linda Ng
White & Case
Hong Kong

A proposal to align tax treaties with OECD information exchange standards and transfer pricing litigation were features of Hong Kong's year, report Yongjun Peter Ni and Linda Ng of White & Case

Hong Kong had an interesting 2009, with several substantial developments reshaping the tax landscape. The government announced initiatives in the 2009-2010 budget to make Hong Kong more competitive, including an alignment of Hong Kong's arrangements for the exchange of information with international standards to facilitate the expansion of its network of comprehensive double taxation agreements (DTAs) and an improvement of Hong Kong's regime for Islamic finance. Two new DTAs entered into force. In the transfer pricing area, the Inland Revenue Department (IRD) issued guidance about relief from double taxation because of transfer pricing or profit reallocation adjustments, and the Court of Final Appeal handed a victory to a taxpayer in a transfer pricing case.

Double taxation agreements

Exchange of information

After consulting the industry in mid-2008, the government decided to align Hong Kong's arrangements for exchange of information (EOI) with international standards. The policy change will facilitate an expansion of Hong Kong's DTA network by eliminating a major obstacle in Hong Kong's DTA negotiations.

The EOI article in Hong Kong's DTAs is based on the 1995 version of the OECD Model Tax Convention on Income and on Capital (the OECD Model), which allows the IRD to refuse to collect and supply the information requested by another jurisdiction when the IRD does not need the information for its own domestic tax purposes. However, most developed economies (particularly OECD members) have indicated to the Hong Kong government that they will not negotiate a DTA with any jurisdiction that cannot comply with the 2004 OECD version of the EOI article, which states categorically that the lack of a domestic tax interest does not constitute a valid reason for refusing to collect and supply the information requested by another contracting jurisdiction.

Hong Kong previously could not adopt the 2004 OECD version of the EOI article because the IRD could exercise its information-seeking power under the Inland Revenue Ordinance (IRO) only for domestic tax purposes. However, Hong Kong has taken steps to change its laws to allow the collection and disclosure of information concerning tax of a territory outside Hong Kong under DTAs. That will enable Hong Kong to align the EOI arrangements in its comprehensive DTAs with the OECD standard, pursuant to the government's announcement in the 2009-2010 budget.

Hong Kong-Luxembourg double taxation agreement

The Hong Kong-Luxembourg comprehensive DTA that was signed on November 2 2007, entered into force on January 20 2009.

An important benefit of the DTA is that it reduces Luxembourg's dividends withholding tax rate to zero, if the beneficial owner of the dividends is a Hong Kong resident company that directly holds 10% or more of the capital of the dividend-paying company or a participation with an acquisition cost of at least €1.2 million ($1.7 million) in the dividend-paying company. In the case of other Hong Kong residents, the DTA reduces Luxembourg's dividend withholding tax rate to 10%.

The DTA exempts from Luxembourg tax capital gains derived by a Hong Kong resident from the sale of shares in a Luxembourg company, provided that not more than 50% of the asset value of the Luxembourg company is derived, directly or indirectly, from immovable property situated in Luxembourg. Even if a company derives more than 50% of its asset value, directly or indirectly, from immovable property situated in Luxembourg, gains derived by a Hong Kong resident from the sale of the company's shares are exempt from Luxembourg tax if the shares are:

• quoted on such stock exchange as may be agreed between the parties to the DTA; or
• sold or exchanged during a reorganisation of a company, a merger, a division or a similar operation; or
• in a company deriving more than 50% of its asset value from immovable property in which it carries on its business.

A further benefit of the DTA is that it exempts from Luxembourg tax profits from international shipping and air transport earned by Hong Kong residents that arise in Luxembourg, and vice versa.

Under the DTA, Luxembourg will provide a full exemption to her residents for income derived by Luxembourg residents from Hong Kong that is subject to Hong Kong profits tax.

Hong Kong-Vietnam DTA

The Hong Kong-Vietnam comprehensive DTA that was signed on December 16 2008, entered into force on August 12 2009.

Hong Kong residents receiving royalties from Vietnam will enjoy a 7% reduced withholding tax rate under the DTA, instead of the standard 10% rate, where the payments are made for the use of any patent, design or model, plan, secret formula or process. The Vietnamese withholding tax on interest will be reduced from 10% to zero if the recipient is the Hong Kong government, the Hong Kong Monetary Authority or a financial establishment as mutually agreed.

Other benefits under the DTA include a tax exemption for profits from international shipping transport earned by Hong Kong residents that arise in Vietnam. Moreover, Hong Kong airlines operating flights to Vietnam will be taxed at the much lower corporate profits tax rate of 16.5% in Hong Kong as compared with the corporate tax rate of 28% in Vietnam.

For the purposes of the agreement, Hong Kong residents include:

• any individual who ordinarily resides in Hong Kong;
• any individual who stays in Hong Kong for more than 180 days during a year of assessment or for more than 300 days in two consecutive years of assessment one of which is the relevant year of assessment;
• a company incorporated in Hong Kong or, if incorporated outside Hong Kong, being normally managed or controlled in Hong Kong; and
• any other person constituted under the laws of Hong Kong or, if constituted outside Hong Kong, being normally managed or controlled in Hong Kong.

Transfer pricing

Relief from double taxation

Departmental Interpretation and Practice Notes (DIPN) No 45, issued in April 2009, sets out the IRD's views and practices about the granting of relief from double taxation because of transfer pricing or profit reallocation adjustments under DTAs.

Each of Hong Kong's DTAs includes an associated enterprises article modelled on article 9 of the OECD Model. It provides for primary transfer pricing adjustments by a DTA state and for relief from the resultant economic double taxation to be given by the other DTA state. If Hong Kong's commissioner of Inland Revenue agrees with a DTA state that its transfer pricing adjustment is correct both in principle and amount, the relevant assessment of the Hong Kong enterprise will be revised in accordance with the relief provision in the associated enterprises article of the DTA and section 79 of the IRO to refund the excess tax paid or to reduce the tax that would otherwise be payable on the assessable profits of the Hong Kong enterprise. A claim for an appropriate adjustment must be made under section 79 of the IRO within six years of the end of the relevant year of assessment.

Each of Hong Kong's DTAs also includes a business profits article and a methods for elimination of double taxation article modelled on articles 7 and 23, respectively, of the OECD model. They provide for both primary profit reallocation adjustments and relief from the resultant juridical double taxation. Juridical double taxation suffered by a Hong Kong enterprise arising from the application of the domestic tax law of the source DTA state can be relieved through a tax credit under section 50 of the IRO for the foreign tax paid. Any claim for allowance by way of tax credit must be made not later than two years after the end of the relevant year of assessment. A claim by a non-resident enterprise for a refund under section 79 of the IRO must be made within six years of the end of the relevant year of assessment. The commissioner will provide relief from juridical double taxation only to the extent that the commissioner agrees both in principle and in amount with the profit reallocation adjustment made by the DTA state.

The mutual agreement procedure article in each of Hong Kong's DTAs is modelled on article 25 of the OECD model. It enables the competent authorities to consult with each other with a view to resolving double taxation, but does not compel agreement. It permits a taxpayer to present a case to the relevant competent authority within three years from the first notification to the taxpayer of the actions giving rise to taxation not in accordance with the DTA.

If either the commissioner or the tax administration of another state makes a transfer pricing or profit reallocation adjustment and no applicable DTA exists, there are no bilateral procedures to provide relief from the resultant double taxation. There also are no provisions in the IRO for unilateral relief.

Court of Final Appeal decision

In Ngai Lik Electronics Company Limited v the Commissioner of Inland Revenue, FACV No 29 of 2008 (2009), the Court of Final Appeal allowed the appeal of the taxpayer in a transfer pricing case. The court annulled additional assessments made by the commissioner, but held that the general anti-avoidance provisions in section 61A of the IRO applied to three of the five years of assessment at issue, because the price-fixing arrangement between the taxpayer and its supplier had the effect of conferring on the taxpayer a tax benefit involving a reduction of its assessable profits by transferring them to other group members. That was done with the dominant purpose of obtaining a tax benefit for the taxpayer.

The court held that the commissioner must exercise her power under section 61A(2)(b) of the IRO on the basis of a reasonably postulated hypothetical transaction that produces an assessment designed rationally to counteract the tax benefit. In this case, a reasonable approach would have been to raise an assessment on the profits that would hypothetically have been earned if the taxpayer had purchased the goods at arm's-length prices from its affiliated supplier, instead of the prices the taxpayer actually paid pursuant to the price-fixing arrangement. The assessment cannot be raised in some arbitrary amount or arrived at upon some basis that is unreasonable or not rationally related to the tax benefit in question. Consequently, the court annulled the additional assessments made by the commissioner and ordered the case to be remitted with a direction that fresh additional assessments be raised for three of the five years of assessment at issue.

Islamic finance

The government plans to improve Hong Kong's regime as a platform for the growing area of Islamic finance. Under the tax rules, Islamic financial products may produce tax liabilities in Hong Kong because the structure of most Islamic financial products involves the sale and repurchase of assets. Therefore, the government aims to create a level playing field for Islamic financial products vis-à-vis conventional ones. That will include making changes to or clarifications of the arrangements for stamp duty, profits tax and property tax.

Peter Ni (yni@whitecase.com) and Linda Ng (lng@whitecase.com)