Examining the new DIPN covering ship leasing and management tax concessions

Ivor Morris

A look at the implications of the Inland Revenue Department’s newly-issued DIPN 62

The Inland Revenue Department (IRD) has released Departmental Interpretation and Practice Note (DIPN) No. 62 Taxation of Ship Leasing Activities, setting out its views on the implementation of the ship leasing and ship leasing management concessions introduced in the Inland Revenue (Amendment) (Ship Leasing Tax Concessions) Ordinance 2020, enacted in June. 

Overview of the new tax concession

Under the new tax concessions, qualifying ship lessors would be chargeable to profits tax on their qualifying business operations, as defined in the relevant provisions in the Inland Revenue Ordinance (IRO) at a concessionary rate (i.e. 0 percent for the year of assessment commencing on or after 1 April 2020). In addition, qualifying ship leasing managers would be charged at half the normal profits tax on profits generated from qualifying business activities, or 0 percent where the services are intragroup.

The legislation, while providing a useful tax concession for certain businesses, also raised a number of questions for others. DIPN 62 addresses some, but not all, of these concerns.

Incidental income

In paragraph 7 of the DIPN, the IRD has stated that qualifying profits includes income incidental to profits from a ship leasing business, like interest income, exchange gains or hedging gains, as long as the transactions are ancillary to the qualifying activities. This appears to be a concession as the legislation does not contain any mention of incidental profits, leaving the risk that a small amount of bank interest could have prevented the lessor from qualifying for the reduced tax rate.

Substance requirements

It is a condition of the concession that central management and control be exercised in Hong Kong. The DIPN stresses the role of day-to-day work by the directors in Hong Kong. From a practical perspective, the IRD’s comments show the importance of ensuring that the directors are competent to perform their role, that they are provided with the relevant information to make their decisions and are seen actively to investigate whether proposals are in the best interests of the company, and that board meetings are properly held and minuted.

Anyone claiming the concession is required to have substance in Hong Kong. For ship leasing activities, this consists of at least two full-time employees with appropriate qualifications and at least HK$7.8 million of operating expenditure in Hong Kong. For ship leasing management activities, the appropriate minimums are at least one full-time employee and at least HK$1 million in operating expenditure. In addition, the number of employees and the amount of the expenditure must be adequate in the opinion of the assessor and they must undertake the business’ core income generating activities (CIGAs) in Hong Kong.

The CIGAs are defined to align with the definition of a ship leasing activity in schedule 17FA of the IRO. These are: agreeing funding terms, identifying or acquiring ships to be leased, setting the lease terms and duration, monitoring or revising any funding agreements and managing any risks associated with leases.

A wide range of expenditure will be regarded as operating expenditure including staff costs, rental and admin costs. It also includes any finance costs directly related to the acquisition of a ship for use in the leasing business. Importantly, provided the loan is taken out for the purpose of acquiring a ship for use in a Hong Kong ship leasing business, the IRD will accept that it is incurred in Hong Kong even if it is borrowed from an overseas financial institution. The DIPN does not discuss the case where the money is borrowed from someone other than a financial institution, for example a related party, although logically the same test should apply.

The DIPN states that depreciation on the vessel cannot be included as operating expenditure on the basis the ship is used for earning lease payments but not for carrying out CIGAs. It is a little hard to follow the logic here, given that they have accepted that interest payments on loans taken out to acquire the vessel can be included. Nevertheless, it is unlikely many lessors will need to rely on depreciation to meet the expenditure threshold, provided they have incurred sufficient interest expense.

The DIPN confirms that outsourcing of CIGAs to an associated person in Hong Kong is allowed provided that an arm’s length fee is charged and appropriate monitoring is undertaken by the special purpose vehicle (SPV). In this case the number of employees employed by and the service fee paid to the associated person can be taken into account in determining whether the substantial activities requirement is met. Note that the wording of the relevant section does not make it clear whether the total number of employees and expenditure is to be determined on a per-SPV basis or on a group basis.

It will typically be easy for a SPV to meet the expenditure threshold, provided the SPV is incurring interest on the acquisition of the ship. From any commercial perspective, the number of employees adequate to run a business is more closely related to the number of vessels operated than the number of SPVs that may hold them, and in the case of a long term bare-boat charter business would clearly be substantially less than two per vessel. However, concerned taxpayers may wish to consider obtaining an advance ruling.

Our observations 

What is a lease and what is a ship operator?

One of the biggest concerns that has not been fully addressed by the DIPN was that the envisaged segregation of the activities of ship owners into “pure leasing” and “ship operating” is not as clear as the IRD would have us believe. Many ship owners engage in a range of activities, seeking to maximize the return on their vessels in whatever ways they can, according to the nature of the market at different points in time. The nature of the market in recent years has tended to require greater flexibility on the part of ship owners to consider short-term charters or taking on greater operational risk.

Against this kaleidoscope of activities, the legislation sought to impose an all-or-nothing test, posing problems for more complex businesses. Unfortunately, the DIPN largely does not address these concerns. The DIPN reiterates that ship operators are not eligible for the exemption and that to be eligible a lessor must be acting as a standalone corporation engaging solely in ship leasing activities. It makes clear that the provisions can apply to leases regardless of whether the lessor provides the crew (i.e. both wet and dry leases).

Although not addressed in the DIPN, the IRD has indicated in correspondence with concerned parties that some leasing arrangements may continue to fall within section 23B of the IRO. In particular, the IRD has stated that where a ship operator generates income from leasing a ship on a voyage charter or a time charter fully equipped, crewed and supplied, this will be treated as income of the ship operator’s ship operations. They have also stated that income from bare boat charters which are an incidental or ancillary activity of the ship operator may also continue to be assessed in accordance with section 23B.

The test set out in the IRD’s correspondence is not straightforward and leaves room for interpretation. Nevertheless, it does appear that the IRD has accepted that there is a need for flexibility in the application of the two sets of rules in order to avoid the situation where a taxpayer ends up paying tax despite conducting business which is supposed to fall entirely outside the tax net. The exact application of the rules and how best to apply them is likely to vary from business to business, and ship owners should pay careful attention to this. It may be that the best way to obtain certainty is to apply for an advance ruling.

It is disappointing that the IRD’s wider comments on the distinction between operators and lessors did not make it into the DIPN. It is an important distinction for taxpayers to understand and one that the IRD is aware has caused concern. For Hong Kong to maintain its position as an international business hub, and for tax concessions designed to assist in that to be successful, it is vital that the IRD’s interpretations are made available publicly to all so that investors can have a clear understanding of their position.

The IRD also reiterates the position, which is clear in the legislation, that to be a qualifying lease, the term must exceed one year, unless it is a sublease. A ship owner engaging purely in a charter hire business would need to be careful that they did not lease ships out for periods of less than a year if they did not want to crash out of the regime. The IRD’s solution appears to be to set up subleases, although clearly there would be commercial considerations to this.

Substance requirements

The IRD does not go into detail about what qualifications it would regard as appropriate for employees of a ship leasing business, but notes they would be expected to include the leasing manager, marketing manager, legal counsel, financial controller and credit risk analyst. The test to be applied is based on average employees over a year – this should be given attention as it is possible that any enterprise operating on the minimum number of employees could crash out of the regime if it has a vacancy for any period of time after an employee leaves.

The comments on the adequacy test are concerning. The Commissioner of Inland Revenue will review each case on its facts and circumstances taking into account a range of factors and would deny any tax benefit that seems disproportionately large relative to the number of employees employed and the amount of operating expenditure incurred in Hong Kong. The DIPN gives an example in which there are two ship leasing companies engaged in a similar business. One makes a larger profit, and has lower operating expenses and fewer employees than the other. Based on this comparison, the IRD’s view is that the more profitable company has prima facie failed the adequacy test and would be denied the concession unless sufficient evidence could be produced that CIGAs were being carried out in Hong Kong.

The example as set out suggests that running an efficient business is seen by the IRD as a risk factor. We do not know why one business is more profitable than another – it may have fewer employees because it makes better use of technology or it may make more profit because it is better at adapting to customer requirements. Given the international nature of shipping, it is unlikely that many businesses can be entirely conducted within Hong Kong, especially where they involve the provision of crew or the undertaking of port agency services. A working assumption that making too much profit is in itself problematic risks making the incentive unattractive to investors.

BEPS 2.0

The potentially fleeting nature of the exemption from tax on ship leasing activities is set out plainly in paragraph 27 et seq of the DIPN. Here, the IRD notes that the introduction of a minimum tax rate under Base Erosion and Profit Shifting (BEPS)  2.0 may mean that the 0 percent tax rate is unsustainable and may rise. Investors should factor this in to their projected returns.

While a fairly detailed blueprint for the minimum tax proposals under Pillar Two of BEPS 2.0 has been produced by the Organization for Economic Cooperation and Development (OECD), there are still many details to be finalized, not least the minimum tax rate itself. Discussion is still ongoing as to whether the shipping industry may be exempted from the minimum tax rules and if so what the scope of that exemption would be. Further, not all taxpayers and holding structures would necessarily be directly affected by the new rules.

However, the legislation and the DIPN both clearly lay the groundwork for the tax rate to increase, and have set out rules for the calculation of a tax base should it become relevant. Of particular interest here is the 20 percent concession on the tax base for lessors under an operating lease. It is explained as a substitute for deprecation allowances, which lessors of ships operating outside Hong Kong are not allowed to claim under section 39E of the IRO. The minimum tax rules are likely make some adjustment to exclude some or all of the effect of accelerated capital allowances from the calculation of the effective tax rate, as this is a common adjustment in most jurisdictions. Again, the details have not yet been finalized, but there is a risk that by disallowing deprecation and instead allowing a notional deduction against income the Hong Kong rules will not fall within the scope of the accepted adjustments to effective tax rate. In this regard, the leasing regimes of other significant centres may more closely align with the BEPS model.

In the context of BEPS more widely, we also note that the DIPN spends a lot of time discussing various anti-avoidance provisions. While Hong Kong of course needs to be mindful of being seen to help profit shifting, the ship leasing rules have been reviewed by the OECD and it is important to remember that the purpose of the incentive is to encourage the ship leasing business in Hong Kong.


The IRD has provided helpful clarifications on their interpretation of the legislation, although a number of uncertainties remain. Given the complexity of the arrangements and the IRD’s form on applying concessionary rates, taxpayers should review their business models to ensure compliance and may be well advised to seek a ruling to ensure their proposals are in line with the IRD’s view.

The article is contributed by Ivor Morris, Partner, KPMG Tax Services Limited

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