Hong Kong has an expanding international tax treaty network.
Comprehensive Double Tax Agreements (CDTAs) are bilateral agreements signed between two countries with the aim to protect against the risk of double taxation where the same income is taxable in two jurisdictions, to avoid the absence of taxation, and to facilitate cross-border trades and investments. CDTAs generally reduce the withholding tax rates on investment income (such as interest, dividends, royalties) and provide favorable tax treatment on capital gains, allowing taxpayers to reduce their tax burden.
However, in order to claim the benefits of a tax treaty, the taxpayer must be a resident of at least one of the contracting country.
Tax resident legal entities can be subject to the economic substance requirements, which have been introduced by the OECD, under the Base Erosion & Profit Shifting (BEPS) regulation, with the aim to prevent tax avoidance. The concept of substance concerns not only multinational corporate, but also Small and Medium Enterprises and generally, all businesses with international and cross-border transactions.
Economic substance, nowadays, is a tool used by the tax authorities against tax optimization schemes which are implemented with the exclusive goal to obtain a treaty benefit (the so-called treaty shopping). It is therefore intended for all legal entities considering to have an international expansion by setting up a foreign entity.
What is economic substance ?
In a global economy, businesses may decide freely the jurisdiction where to base their operations and establish their entity.
However, the choice should depend on a number of factors, reflecting an economic reality.
Indeed, the company incorporated in the jurisdiction must be necessary from an economic and commercial perspective. Tax considerations can also be taken into account provided that it is not the sole and entire motivation.
Each country has its own definition of corporate tax residence and substance, and tax authorities are paying more and more attention to the respect of these requirements.
What are the economic substance requirements in Hong Kong ?
The Hong Kong law does not provide any clear definition of tax/economic substance.
Hong Kong residents who require proof of resident status may apply for a Tax Residency Certificate (TRC).
Under CDTAs entered by Hong Kong with other treaty partners, a Hong Kong resident company is defined as “a Hong Kong incorporated company” or “a company incorporated outside Hong Kong that is managed or controlled in Hong Kong”.
Based on this definition, being a Hong Kong incorporated company should be sufficient to obtain a TRC. However, the Inland Revenue Department (IRD) generally requires to obtain information and supporting documents as proof for the applicant’s management or control normally exercised in Hong Kong. The substance test is conducted on a case-by-case basis. The tax authorities will assess the activity, and the commercial operations of the company to determine if it has substance.
General list of information/documentation requested by the IRD are as follows:
- Composition of board – whether the board members have residence in Hong Kong;
- Board meetings – where the place of board meetings are held, what is discussed and resolved, how the resolved matters are implemented or executed;
- Business operation, including the business address, management and staff numbers and details, business activities details, place of operation;
- For business address – the Hong Kong lease agreement (if any) should be provided;
- For management and staff numbers – employment visas, employment contracts and employer’s return submitted as well as their personal particulars (nationality, residential address) and responsibility/place to perform the job;
- For business activities – nature of income (any passive income or offshore income included);
- Name of bank in Hong Kong;
- Audited accounts showing the value of fixed assets/cash maintained in Hong Kong;
- If the company has establishment outside Hong Kong, details (office address, management and employees details, business activities, income, etc.) is also required.
This list should not be considered comprehensive.
It should be noted that on 1st February 2015, the Inland Revenue Department has adopted stringent rules and procedures for obtaining a certificate of Hong Kong resident status. Hong Kong authorities are now stricter in reviewing these applications.
Finally, in order to minimize the risk of a lack of substance, it is important to pay attention to the location of the human, economic and material resources needed to perform the activity. In fact, the place of effective management is determined after looking into the activity of the company. The level of substance which must be maintained in the jurisdiction of the entity will depend on its actual function.
Consequences of non-compliance and lack of substance
If the substance requirements are not met, or if the management of the company is in another jurisdiction, the risk is to be considered as tax resident not in the country of incorporation, but in the country where the management is effectively done.. Indeed, companies incorporated in Hong Kong but managed outside Hong Kong are likely to be considered as tax residents in the foreign jurisdiction and therefore may be subject to foreign corporate tax (according to the foreign tax law).
If the tax authorities are not satisfied that the company has enough substance, then the application for the tax residency certificate will be rejected.
Entrepreneurs must be aware of these requirements when considering to establish the most appropriate and efficient tax structures for cross-border activities. Others having already set up a foreign company are recommended to review their business structures to ensure that it complies the requirements of substance.
Sarah Meriguet, Manager of the French Desk of Fidinam (Hong Kong)