If returns on cross-border investment were taxed twice, global economic growth and expansion would be seriously impeded. Tax treaties between countries seek to prevent such double-taxation. Hong Kong has an extensive network of such treaties. These treaties have strengthened its position as an economic hub of Southeast Asia and have helped break down the tax barriers that obstruct cross-border flow of trade, investment, technical know-how and expertise between Hong Kong and the rest of the world.
This article highlights the importance of Hong Kong’s tax treaties and outlines their principal features.
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What is Double Taxation?
Double taxation occurs when the taxpayer is taxed twice on the same income by two jurisdictions – the jurisdiction where the income arises i.e. the source jurisdiction and the jurisdiction where the income is received i.e. the jurisdiction of residence. This is commonly referred to as source-residence conflict and is the most common circumstance under which double taxation arises. Most jurisdictions make provisions for some form of relief from double taxation either on a unilateral basis under their domestic tax laws or on a bilateral basis under the double taxation agreements (DTAs) they have entered into with other jurisdictions.
What is a Double Tax Agreement?
A Double Tax Agreement (DTA) is a bilateral agreement between two countries that seeks to eliminate the double taxation of income. The main purpose of a DTA is to modify the tax rights of the respective jurisdictions. DTAs generally over-ride domestic law.
Benefits of Double Tax Agreements
Double tax agreements offer the following benefits:
- DTAs clearly lay down the rules for division of revenue between two countries and how tax is to be imposed in each. In other words, DTAs define the jurisdictional authority on transnational trade.
- DTAs help taxpayers of one country know the potential limits of their tax liabilities in the other country.
- DTAs enhance the integrity of a country’s tax system and prevents tax evasion through a framework for the exchange of information between revenue authorities.
- DTAs allow taxpayers to claim for relief for taxes paid overseas.
Who benefits from DTAs?
Under the DTAs, relief from income tax is only available to Hong Kong resident individuals who are not at the same time residents of the contracting countries. In the case of corporations, only Hong Kong incorporated companies and those companies that are managed and controlled in Hong Kong are eligible for relief.
The term ‘Hong Kong resident individual’ refers to:
- An individual who ordinarily resides in Hong Kong i.e. (s)he has a permanent home or habitual abode in Hong Kong, or
- An individual who stays in Hong Kong for more than 180 days during the relevant year of assessment.
A company is considered to be a resident of Hong Kong if:
- It is incorporated in Hong Kong, or
- It is incorporated outside Hong Kong but is managed and controlled from Hong Kong
Contents of DTAs concluded by Hong Kong
Although each DTA concluded by Hong Kong is separately negotiated and has specific terms that may differ from one country to another, there are certain general aspects that a typical DTA will address, as outlined below:
- Scope of the DTA: The arrangement only applies to a resident of Hong Kong and the treaty country. Normally, certification of resident status will be required. DTAs are not applicable to non-residents of either country.
- Taxes covered by the DTA: The DTA usually applies to taxes on income and property.
- Defining the concept of Permanent Establishment (PE): Defining a PE is important as business profits attributable to a PE as defined in the domestic legislation are liable to get taxed in the jurisdiction of the PE. In other words, the existence of a PE is used as a basis for determining the source of business profits. A PE refers to a fixed place of business through which the business of an enterprise is wholly or partly carried out. This includes a place of management; a branch; an office; a factory; a workshop; a house; a warehouse; a stall; a mine, oil or gas well or quarry; a building or construction site or installation project lasting more than 12 months.
- Dividend income: Dividend income can be taxed in the country of source (i.e. the country in which the company paying the dividend is resident) according to its domestic tax laws. The income is also liable to tax in the country of residence (i.e. the country in which the recipient receives the dividend income). Normally the country of source will impose a reduced dividend withholding tax rate. However, it must be noted that the right to tax a dividend can only be exercised if the respective country’s domestic tax law imposes taxes on dividend income. Since Hong Kong does not tax dividends, no tax is imposed, irrespective of whether the DTA permits Hong Kong to impose a tax on dividend. Whether the dividend income is taxable in the treaty country would depend on the domestic tax laws of that country and what the treaty specifies.
- Interest: Interest is usually taxed at a reduced withholding tax rate in the country in which the interest income arises (source country). The reduced tax rate depends upon the negotiation between the respective jurisdictions.
- Royalties: The tax treatment of royalty income varies from DTAs signed with different countries.
- Income from employment: Employment income will be taxed in Hong Kong if the employment is exercised in Hong Kong unless: a) The employee is not present in Hong Kong for more than 180 days in a tax year, or b) His employer is a resident of the contracting country, or c) His remuneration is not borne by a permanent establishment in Hong Kong of an enterprise of a contracting country.
- Directors’ fees: Directors’ fees received by the resident of one jurisdiction in his/her capacity as a director of a company that is resident in another jurisdiction is liable to tax in the other jurisdiction i.e. the country in which the company paying the fee is resident. The full domestic tax rate would apply, as there is no exemption or reduced tax rate.
- Airline or shipping profits: Airline or shipping profits derived by an enterprise of one country from the other country are usually entitled to full tax exemption in the other country. The enterprise will be taxed only in its country of residence. For instance, profits derived by a Hong Kong air transport enterprise or shipping enterprise from its air transport or shipping business in China will be taxed in Hong Kong alone. It is exempt from tax in China.
- Business profits: The profits of an enterprise are taxable only in the country in which the enterprise is resident. If the enterprise carries out business in the contracting country through a PE situated in the contracting country, the enterprise is liable to tax in the contracting country as well. However, note that the tax liability is the contracting country is limited to the PE’s profits derived from the contracting country only.
- The right to tax gains: The right to tax gains arising from the sale of immovable property and gains from sale of shares varies with DTAs signed with different countries.
- Government payments: Any salary, wage, pension, or similar rewards for personal services paid by the government of a contracting country to persons performing services in Hong Kong on behalf of that government are exempt from tax in Hong Kong and will only be taxed in the contracting country.
- Income from immovable property: Income from immovable property is usually taxed in the country of source where the property is situated.
- Tax credit: Under the credit system a taxpayer’s foreign tax is credited against his domestic tax on the same income.
Methods of relieving double taxation in Hong Kong
The methods of relieving double taxation are either prescribed by a country’s domestic tax laws or under the specific DTA. In general, there are four methods of relieving double taxation.
- Tax credit relief: Under the credit system a taxpayer’s foreign tax is credited against his domestic tax on the same income. Under the credit method, the residence jurisdiction is required to grant a tax credit for tax payable in the source jurisdiction. In other words, the tax payable in the source jurisdiction is to be deducted from the tax payable on the same income in the residence jurisdiction. The tax credit is limited to the amount of tax payable on that income in the residence jurisdiction.
- Tax exemption: Under the exemption method, foreign income is exempt from domestic tax. The exemption may be given on the entire or part of the foreign income.
- Reduced tax rate: This form of relief taxes income at a lower rate and is usually applicable to interest, dividends and royalties.
- Relief by deduction: In this case, domestic tax is applied on the foreign income after deducting foreign tax suffered.
In most treaties concluded by Hong Kong, double taxation is eliminated by allowance of a tax credit.
Hong Kong’s Current Tax Treaties
Hong Kong has concluded 40 Double Taxation Agreements and these are categorized as follows:
- Comprehensive DTAs: A bilateral agreement that provides relief from double tax to all types of income. At present, Hong Kong has concluded comprehensive DTAs with Belgium, Mainland of China, Thailand, Vietnam and Luxembourg.
- DTAs that cover airline and shipping income. At present Hong Kong has concluded airline and shipping income treaties with Sri Lanka and Singapore.
- DTAs that cover airline income only. Hong Kong has concluded airline income treaties with Bangladesh, Belgium, Canada, Croatia, Denmark, Estonia, Ethiopia, Fiji, Finland, Germany, Iceland, Israel, Jordan, Kenya, Korea, Kuwait, Laos, Macau SAR, Mainland of China, Maldives, Mauritius, Mexico, Netherlands, New Zealand, Norway, Russian Federation, Seychelles, Sweden, Switzerland and the United Kingdom.
- DTAs that cover shipping income only. Hong Kong has concluded shipping income treaties with Denmark, Germany, Netherlands, Norway, United Kingdom and USA.
- Tax information exchange agreements: Hong Kong has concluded the agreements with Denmark, Faroes, Greenland, Iceland, Norway, Sweden and USA.
Eliminating the impediment posed by double taxation
Hong Kong’s tax treaty network seeks to eliminate the impediment posed by double taxation to overseas investment by helping to structure operations at a minimum tax cost.