In October 2021, the European Union (EU) placed Hong Kong on the so-called grey list or watchlist of tax cooperation due to concerns about the tax treatment of offshore passive income.
Based on its territorial source principle of taxation, Hong Kong generally does not impose profits tax on foreign-sourced passive income. However, the EU is concerned that businesses could exploit the rules by setting up shell companies in Hong Kong without having a substantial economic presence here and, potentially, benefit from “double non-taxation.”
To strengthen Hong Kong’s status as an international financial centre, minimize reputational risk arising from non-compliance with international tax standards and protect Hong Kong businesses against potential defensive measures that the EU may implement if its concerns are not addressed, the government has made a strong commitment to refine Hong Kong’s foreign-sourced income exemption (FSIE) regime for passive income. Against this backdrop, there are various key principles that will be upheld, which includes maintaining Hong Kong’s territorial source principle of taxation and its simple and low-tax system, as well as ensuring that the compliance burden of corporates will be minimized. The issue on the upcoming tax rules on foreign-sourced passive income was one of a number of taxation challenges companies are grappling with in the digital era that was explored during a panel discussion at the Hong Kong Institute of CPAs’ Annual Taxation Conference 2022 in July.
Speakers: (from left) Irene Lee CPA, Partner, Global Transfer Pricing Services, KPMG China; Gwenda Ho CPA, Partner, Tax Services, PwC Hong Kong, and a member of the Institute’s Taxation Faculty Executive Committee (TFEC); Eugene Yeung CPA, Tax Partner, KPMG China, and Deputy Chair of the TFEC; Benjamin Chan CPA, Deputy Commissioner (Technical) (Acting) of the Inland Revenue Department; Grace Tang, Partner, Global Compliance and Reporting Services, at EY Tax Services Limited, and a member of the TFEC; and Doris Chik CPA, Partner, National Tax Technical Centre, Deloitte China.
Taxing intellectual property
To meet the EU’s requirements, the refined FSIE regime is due to come into force on 1 January 2023. The revised rules will see foreign-sourced passive income, including income from intellectual property (IP), be deemed to be sourced from Hong Kong and be subject to profits tax, if the income is “received in Hong Kong” by a taxpayer that is a constituent entity of a multinational enterprise group and that does not meet the relevant test of having substantial economic activities or nexus in the city applicable to the type of income.
Benjamin Chan CPA, Deputy Commissioner (Technical) (Acting) of the Inland Revenue Department (IRD), explained: “The very important thing is that as long as IP income is not received in Hong Kong within the meaning to be provided under the Inland Revenue Ordinance (IRO), it continues to be exempt from Hong Kong tax, as only foreign-sourced passive income received in Hong Kong by a covered taxpayer will be taxable in Hong Kong.”
For foreign-sourced IP income that is received in Hong Kong, the nexus approach adopted by the Organization for Economic Co-operation and Development (OECD) will be used to determine the granting of tax exemptions. Under this approach, income from certain IPs (i.e. patent and patent-like IPs) will have preferential tax treatment based on a nexus ratio, which is defined as the qualifying expenditures of the Hong Kong constituent entity as a proportion of the overall expenditures that have been incurred by the taxpayer to develop the IP.
Chan explained that in this context, the proportion of research and development (R&D) expenditures will be used as a proxy for substantial economic activities. This aims to ensure that there is a direct nexus between the income receiving benefits and the expenditure contributing to that income.
Doris Chik CPA, Partner, National Tax Technical Centre, Deloitte China, pointed out that the nexus approach Hong Kong proposes to take in determining the extent to which IP income can be exempted under the FSIE regime contains most of the key features set out by the OECD. With the jurisdictional approach to be adopted, qualifying R&D activities carried out by the taxpayer have to be carried out in Hong Kong to benefit from the tax exemption.
“We will continue to listen to industry views to see how best we can refine the deduction side or even the income side to encourage more R&D activities in Hong Kong.”
Chan noted that qualifying R&D expenditures, under the nexus approach, could also include expenditures incurred by the taxpayer for R&D activities outsourced to an unrelated party that are carried out either inside or outside Hong Kong, while excluding activities outsourced to a related party outside of Hong Kong. “There is no room for us to deviate from this international standard,” he says.
But Chan added that, under existing rules, as an incentive for local R&D activities, Hong Kong companies can claim enhanced deductions for qualifying R&D expenditures in Hong Kong (of 300 percent for the first HK$2 million and 200 percent for the remainder).
He said that while the government is currently focusing on the income side of the taxation of IP, on the deduction side, it has always welcomed ways to refine the tax system to promote R&D activities in Hong Kong. “We will continue to listen to industry views to see how best we can refine the deduction side or even the income side to encourage more R&D activities in Hong Kong. I would like to emphasize that it has always been the government’s policy to encourage such activities to be conducted in Hong Kong.”
However, Irene Lee CPA, Partner, Global Transfer Pricing Services, KPMG China, expressed concerns about the tax treatment of companies that have set up R&D centres outside of Hong Kong to benefit from making some of their profits in a low tax jurisdiction. “This [arrangement] would involve foreign entities participating in a cost-sharing arrangement, so the Hong Kong entity may bear R&D costs, and if they are subcontracting that function out, they will be paying tax in Hong Kong, but not having the R&D costs deducted. As a result, it may diminish the attractiveness of having a cost-sharing arrangement,” she said.
Eugene Yeung CPA, Tax Partner at KPMG China, Deputy Chair of the Institute’s Taxation Faculty Executive Committee, and Convenor of its Taxation Faculty Budget Proposals Sub-committee, who was moderating the panel discussion, pointed out: “Based on recent discussions with the government and IRD on the FSIE and various topics, I think enhancing Hong Kong’s competitiveness is definitely on top of the government’s agenda. It is also very aware of the need to protect Hong Kong’s competitiveness when rolling out the FSIE regime.”
Meanwhile, Grace Tang, Partner, Global Compliance and Reporting Services, at EY Tax Services Limited, and a member of the Institute’s Taxation Faculty Executive Committee, expressed concern that the current deduction system for R&D expenses may lead to multinational enterprises having a lower effective tax rate under the new base erosion and profit shifting 2.0 requirements. “This system may not be beneficial to multinational enterprises considering whether to set up R&D centres in Hong Kong because this may result in Hong Kong enterprises having an effective tax rate below the global minimum tax rate of 15 percent, and so having an enhanced deduction may mean they have to pay more ‘top-up’ tax.”
Instead, she suggested Hong Kong should introduce a refundable tax credit, similar to that in Australia and Ireland, to encourage more multinational entities to use Hong Kong as an R&D base. Chan appreciated the suggestion, though cautioned that under such a system, the government would not only forgo revenue but would also face a cash outlay that could have some impact on the government’s fiscal position.
“Having an enhanced deduction may mean they have to pay more ‘top-up’ tax.”
Guidance on cryptocurrency
Addressing other areas of the digital economy, panel members pointed out that there was still some uncertainty over Hong Kong’s tax treatment of cryptocurrency, with Yeung asking whether the government was considering providing more guidance or making a legislative amendment in this area.
Chan explained that, before the government considers making any changes to its rules in relation to the taxation of certain types of income, it needed to consider whether any new principles or rules were necessary; whether the existing rules could adequately address the general concerns or cater for the taxation of that income. “From our observations, we can still apply our basic tax principles based on whether the asset is a revenue asset or a capital asset, and whether the taxpayer is receiving the revenue in Hong Kong.” As a result, he said the government did not see a forthcoming need to change the law, although he added that it is contemplating to introduce some guidance on the taxation of crypto assets to reflect new developments in this area.
Gwenda Ho CPA, Partner, Tax Services, at PwC Hong Kong, and a member of the Institute’s Taxation Faculty Executive Committee, agreed: “We don’t actually need any legislative changes generally because the existing framework is sufficient for most of the issues, but I do agree that a bit more guidance would be helpful.”
But she added that, as it takes time for the IRD to update Departmental Interpretation and Practice Notes, there was a danger that by the time updates were made, they would already be outdated. Instead, she suggested that the IRD could consider issuing other forms of guidance, such as “frequently asked questions” on its website, which is something other countries have done. “That would be helpful to keep taxpayers abreast of these developments and help them to understand their tax position,” she says.
Ho also pointed out that when dealing with tax questions from clients, it is necessary to understand the details of the business model and income flow, as well as to consider the accounting treatment. But where cryptocurrencies are concerned, there is a lack of precedents from an accounting perspective. “Our accounting team needs to apply existing accounting standards on these new types of models, which is actually a very complicated process. If the IRD could provide some examples that would be helpful.”
Lee said that the challenge is further compounded by the fact that companies in the crypto space are often evolving very quickly. “We have a player that when they reached out to us, had 2,000 people in the group, who were quite scattered around the world. We were helping them with a complicated central entrepreneur business model, and how to split the profits they gained between different jurisdictions where core people were located,” she explained. “But two-to-three months into the project, they told us they now had 6,000 people, and we had to look at the functions again, and whether our transfer pricing model would still work and apply.”
“Our accounting team needs to apply existing accounting standards on these new types of models, which is actually a very complicated process.”
Lee added that another issue for accountants dealing with digital business models was how to classify some of the entities around the central company. “Under our transfer pricing model, we call them routine service providers, but sometimes the way we classify them may not accord with what the regulators think.”
She explained that some regional exchanges in the crypto space do not have many staff, as they perform an automated function, but regulators do not always agree with defining them as a routine profit entity. “We have to think about how to define them from a transfer pricing perspective to the regulators, to ensure the model still works,” Lee said.
Another problem is that crypto players may experience significant losses, which they want to split across their different jurisdictions and entities. “But tax authorities in jurisdictions, where what we define as ‘simplified routine entities’ are located, may ask why these entities are taking a loss when they don’t get any of the upside when there is a profit. There are a lot of these kinds of issues that we have to think about. It is different from the traditional business model,” Lee said.
“It puts Hong Kong at a disadvantage if income is taxable, but expenses cannot be deducted.”
A holistic review of taxation
Going forward, Chik would like to see a holistic review of Hong Kong’s tax regime to ensure that the city’s competitiveness is not impacted by the new rules under the refined FSIE regime. “Because of FSIE, I think more IP income, such as income from patents and licensing fees that used to be foreign-sourced, will be taxed in Hong Kong, and the deductions are very limited under the current tax system. It puts Hong Kong at a disadvantage if income is taxable, but expenses cannot be deducted,” she says. Instead, she suggested that Hong Kong could consider having a separate tax regime for onshore IP income to see if it would encourage more companies to base their R&D in Hong Kong.
Yeung went further and said he would like to see a holistic review of Hong Kong’s entire tax system. “It was first written in the 1940s and the recent changes have been put into the IRO in a piecemeal way. A review to ensure the new regimes do not conflict with other parts of the IRO would be useful.”
“A review to ensure the new regimes do not conflict with other parts of the IRO would be useful.”
But Chan pointed out that conducting a review of the whole tax system is a time-consuming exercise, and could lead to the rules being less responsive to developments in both the business and technology sectors. “Our reasoned approach to introduce new measures or amend our law whenever we come across new problems or developments appears to be a more appropriate approach for the time being,” he said.
One change Ho would like to see is the inclusion of crypto assets as qualifying assets for the unified fund exemption. “We hope that the government can consider extending the unified fund exemption to cover assets under crypto funds, so that more of these activities can be done with a better tax outcome,” she said.
Lee would also like to see regulations and guidelines relating to the digital world kept up to date, particularly from a transfer pricing perspective. “People say transfer pricing is an art not a science, but I would still like to have the lines drawn out so I know how we can set up everything, and how transfer pricing will work out,” she said.
“People say transfer pricing is an art not a science, but I would still like to have the lines drawn out so I know how we can set up everything, and how transfer pricing will work out.”
Concluding the panel, Yeung said: “Technology advancement is one of the key drivers for economic growth and it is also the government’s plan to develop Hong Kong into a technology centre to enable it to develop and integrate into the Greater Bay Area. We, as professional accountants, should continue to keep up to date and the Institute will continue to propose different measures and changes to the government and the IRD.”
The European Union announced in October 2021 the inclusion of Hong Kong in its watchlist on tax cooperation as it considered that the non-taxation of certain foreign-sourced passive income in Hong Kong might lead to situations of “double non-taxation.” In response, Hong Kong is refining its foreign-sourced income exemption regime for passive income to bring it in line with international standards.