Latest Changes to Hong Kong – China Tax Treaty

Hong Kong, the Special Administrative Region (SAR) of China and the Peoples Republic of China entered into an Avoidance of Double Taxation treaty (DTA) on 8 December 2006. Since then several changes have been made to the original treaty. The latest one, the fourth protocol, was made on 1 April 2015. It is expected to exalt the position of Hong Kong as a hub for aircraft and ship leasing and asset management businesses. At the same time, it increases the obligations of business entities operating in both jurisdictions by introducing anti-avoidance clauses and enhancing the scope of exchange of information. The following is an overview of the changes and its implications.

 

Withholding tax on royalty slashed to 5%


The current withholding tax on royalties is 7% in China. Hong Kong does not levy withholding tax.  Subsequently, the Chinese withholding tax rate on the royalties will be slashed to 5%.

The rentals paid towards the lease of aircrafts or ships are treated as royalty for tax purposes. When the protocol turns effective, ship and aircraft leasing companies operating from Hong Kong will benefit immensely because Hong Kong will enjoy the lowest withholding tax rate among other competing countries like Singapore.

Presently, China charges the lowest withholding tax rate on royalties- at 6%- to Singapore and Ireland resident lessors via the DTA established between the two jurisdictions. However, it should be noted that the lowered tax rate is applicable only to the rental portion of leasing arrangements and does not extend to sum paid as interest under finance-lease arrangements.This will nail the position of Hong Kong as an aircraft and ship-leasing center. More aircraft leasing businesses will be set-up in Hong Kong as they try to capitalize on the growing airline industry in China. Aircraft leasing businesses operating from Hong Kong will thus have lower Chinese tax liability and will be able to enter into more competitive leasing agreement compared to businesses operating from other jurisdiction.

Tax exemption on Capital Gains derived from transactions of China listed companies

The protocol extends the exemption of Chinese tax on capital gains to profits made by a Hong Kong resident from the sale or purchase of shares of companies listed in China stock exchange. Such gains will be subjected to tax in Hong Kong only. Hong Kong resident funds will also qualify for this tax exemption.

Criteria for Hong Kong Resident Funds

  • The fund must be established in accordance to the law of Hong Kong and registered and governed with the Securities and Futures Commission of Hong Kong.
  • A Hong Kong incorporated company must be the manager of the fund.
  • Majority of the fund, that is more than 85%, must have been raised from Hong Kong, including funds raised via the Hong Kong stock market or through private placements or sale to Hong Kong based financial institutions or capital raised from investors or through means that are mutually agreed by tax authorities of Hong Kong and China.

The recent change in the protocol, providing more clarity on tax exposure, is deemed to catalyze the fund management companies in Hong Kong. Prior to the protocol, tax on capital gains made from disposal of share in Chinese companies was exempted to Hong Kong residents only if the company is not a property holding company and the Hong Kong resident had less than 25% stake in the company whose share is being disposed.

The fourth protocol gives great clarity to Hong Kong domiciled funds trading in Chinese listed shares. Earlier, according to Notice No 79, issued by the Ministry of Finance, State Administration of Taxation and China Securities Regulatory Commission in October last year, Qualified Foreign Institutional Investors (QFII) and Renminbi Qualifies Foreign Institutional Investors (RQFII) are temporarily exempted from withholding tax in China on gains derived from trading of equity investment assets.

The China-Hong Kong Stock connect unveiled in November last year relaxed the restrictions on trading in shares in China listed companies. Prior to this relaxation, not all China listed companies shares were open to international investors. Following the relaxation, more than 800 additional companies were made accessible to international investors who earlier faced restriction. According to Notice No 89, capital gains from trading of listed shares derived through Stock Connect are also temporarily exempted from withholding tax in China.

Not being exposed to Chinese tax on gains made in transactions involving shares of China listed companies will provide impetus to the asset management industry in Hong Kong. Such gains will essentially be tax-free because in Hong Kong it will be treated as offshore profits and will be exempted from tax. The fund management industry will rev up when the protocol comes into effect. More funds will be set-up in Hong Kong.

Main Purpose Test

The protocol introduced a ‘main purpose test’ to prevent abuse of the benefits available under the treaty provisions. If the entities fail the main purpose test and if it is proven that the main purpose of the entity was to take advantage of the treaty benefits then the benefits of the treaty will not be available. This is an important step to prevent treaty abuse and to strengthen the anti abuse measures under the original DTA that allows the parties to the treaty to apply domestic laws to scrutinize tax avoidance.

This latest development is in line with the international norms and the main purpose test is also part of the treaties concluded by China with other international jurisdictions. However it must be noted that the test is applied to dividends, interests, royalties and capital gains articles only and does not include other incomes.

Scope of Information exchange extended

The Fourth Protocol also amends the Exchange of Information (EoI) article of the China-HK DTA, such that, information that can be exchanged under the DTA is now extended to include VAT, Consumption Tax, Business Tax, Land Appreciation Tax and Real Estate Tax.

This is also in line with the international call for transparency between tax jurisdictions. It is also intended to improve cooperation between tax authorities and to clamp down tax avoidance practices by multi-national corporations. Such expansion of scope of information exchange will become more common among tax administrations in the coming years.

Conclusion

The fourth protocol to the China – Hong Kong DTA enhances the tax benefits available to Hong Kong resident taxpayers in the form of lowered withholding tax on lease rentals that are treated as royalty. This is especially beneficial to the aircraft leasing businesses that are Hong Kong residents. The exemption on capital gains tax levied by China on disposal of shares in China listed companies brings clarity regarding tax exposure to Hong Kong resident funds and investors with investment interests in China. This will lead to more fund management companies being set-up in Hong Kong. The treaty abuse measures and enhanced scope of information exchange will increase the obligations of taxpayers interested in benefiting from the DTA provisions.

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