The Inland Revenue (Amendment) (No. 6) Ordinance 2018 (the Amendment Ordinance) introduced three transfer pricing documentation (TPD) to Hong Kong (HK): the Master File (MF), the Local File (LF) and the Country-by-Country Report (CbCR) as prescribed in Action 13 of the OECD BEPS Project. Briefly, MF and CbCR contain group-wide information presented in narrative and numerative format respectively, whereas the LF contains detailed transfer pricing analysis of related party transactions (RPTs) to substantiate that the transactions are conducted at arm’s length.
As the preparation of the TPD requires significant resources with tight deadlines to meet, taxpayers have been waiting for the Departmental Interpretation and Practice Notes (DIPNs) on this matter. On 19 July 2019, the Inland Revenue Department (IRD) has finally issued three DIPNs on the topic, which are over 230 pages long in total. The three DIPNs are:
DIPN 58 – Transfer Pricing Documentation and Country-by-Country Reports
DIPN 59 – Transfer Pricing Between Associated Persons
DIPN 60 – Attribution of Profits to Permanent Establishments in Hong Kong
This Tax Tips will only focus on one matter covered under DIPN 58: is an entity required to prepare the contemporaneous MF and LF under HK rules. For rules relating to CbCR, please refer to “Tax Tips (20)”.
Thresholds for TPD Exemption
The Amendment Ordinance introduced two exemption tests. Taxpayers are exempt from preparing the MF and LF if they meet either one of the following two exemption tests:
A. The Size Test (ST): Exemption based on the size of the business by satisfying any two of the following three conditions below:
The total amount of the entity’s revenue of the accounting period does not exceed HK$400 million
The total value of the entity’s assets at the end of the accounting period does not exceed HK$300 million
The average number of the entity’s employees in the accounting period does not exceed 100
B. The Controlled Transaction Test (CTT): Exemption based on the amount of RPT if all of the following thresholds are satisfied:
Transfer of properties (excluding financial assets and intangibles) is not more than HK$220 million
Transactions in respect of financial assets are not more than HK$110 million
Transfer of intangible is not more than HK$110 million
Any other transactions are not more than HK$44 million
So, where to start? An entity with any transaction with associates should start by checking if an exemption is available under the ST. If ST exemption is not available, go to the CTT.
ST – What do the Numbers Mean?
DIPN 58 Para 27 provides the guidelines on how to measure the revenue, assets and the average number of employees. Taxpayers should note that the measurement is by an entity, not by group. There is no need to prepare pro-rata calculation for short accounting period.
Thresholds for revenue and assets are relatively easy to understand and apply. The threshold for the number of employees is, however, somewhat tricky.
In real life, many groups would use one entity to be the employer to streamline administration such as annual employer tax filing and handling of human resources and employee benefits. These employees will be working for different entities of the group with or without a recharge, depending on the commercial arrangement. In determining whether the entities exceed the employee threshold, it appears that the legal employment arrangement would be disregarded, and the employer-employee relationship should be considered instead.
In a large organisation with a corporate head office, the management team and functional staff (finance, legal, human resources, IT etc) would provide support to group entities regularly and sometimes on an as-needed basis. If there are 100 employees in the corporate head office and each person spends on average 2 hours every month on the business of a subsidiary, would that subsidiary be regarded as having 100 part-time employees for the ST?
It seems that the keyword is “employer-employee” relationship, which is sometimes referred to as the “master and servant” relationship. If the support services that the corporate head office provides to the subsidiaries are documented clearly to eliminate any doubts as to who is the employer of the head office staff, there should be a basis to argue against the attribution of employees to the subsidiaries in the example above. In elaborating on the ST, DIPN 58 did not provide an example on how to interpret this part, hence this can be a point of dispute between the IRD and the taxpayers.
CTT – What do the Numbers Mean?
First point to note is that the term “transaction” is widely defined to include any operation, scheme, arrangement, understanding and mutual practice. The definitions of the various categories of transactions are also very wide in order to ensure that all transactions would fall into one of the four categories.
Attention should be paid to the financial asset category. Intercompany loans, which are popular in large groups, would give rise to a loan transaction (i.e. drawdown of the loan) and an incidental transaction (i.e. payment of interest), both are “transactions in respect of financial assets”. The threshold of HK$110 million could be easily breached when a holding company lends to subsidiaries to fund their operations.
Important Points to Note on the CTT
There are several important points on the CTT that taxpayers should be aware of:
Dividend is excluded from “other transactions” (Para 34). Indeed, dividend is totally excluded from any transfer pricing analysis.
The transaction can be a revenue item or an expense item, and each transaction should be considered separately without setting off each other. (Para 46)
The threshold of each category of controlled transaction applies to the aggregate amount of transaction of the same category. (Para 46)
It is the arm’s length amount of the transaction which should be aggregated for determining whether the threshold is exceeded. (Para 46)
Specified domestic transactions and grandfathered transactions (i.e. transactions which were entered into or effected before the Amendment Ordinance came into operation on 13 July 2018) are disregarded when computing the amount of the above four categories of controlled transactions, and do not need to be documented in the LF. (Para 35)
The LF of an HK entity in respect of an accounting period is required to cover a transaction even if the income or profits from the transaction are or claimed to be sourced outside HK. (Para 36)
Amongst these points, point (4), (5) and (6) worth further discussion.
Arm’s length amount
Some taxpayers may be mistaken by thinking that as long as the amount of RPTs per book are in aggregate below the thresholds, they would pass the CTT. The DIPN has clarified that it is the arm’s length amount of the transaction that should be considered.
For example, an HK entity of a multinational enterprise (MNE) group receives various supporting services from the MNE head office (say group marketing, customer relationship, legal, finance and tax support) without charge. The financial statements of the HK entity shows the amount of RPT as nil. The HK entity should still review the arm’s length amount that she should pay for the services received to see if the HK$44 million threshold is exceeded. The same kind of analysis applies to other categories of controlled transactions.
This is why for an entity with any kind of RPT, the first step in determining if an exemption is available is to satisfy the ST. If the ST is breached, unless the management is confident that the arm’s length price of the transactions would not exceed the thresholds, it is advisable to prepare a detailed TP study on the controlled transactions (and thus preparing the LF). If the result shows that the arm’s length price of the transactions are close to or even exceeded the thresholds, the MF should also be prepared.
The below flow chart diagram which first appeared in Tax Tips 3 would be a good quick reference.
Specified domestic transaction
At the consultation stage of the Amendment Ordinance, many commentators suggested that transactions between HK related parties should be excluded from TPD requirement, on the basis that there is little or no tax impact in case the transactions are not conducted at arm’s length. The suggestion was partially considered and thus the CTT excludes “specified domestic transaction”.
DIPN 58 did not attempt to elaborate on what are “specified domestic transactions”, but simply copied the definition of the term directly from section 2 of Schedule 17I of the Amendment Ordinance, and supplement it with an example. Based on the example, the transaction between two associated HK corporations would be a specified domestic transaction on the basis that they both carry on business in HK and the profits or loss arising from the transaction were chargeable to or allowable for the purposes of HK tax.
Further elaboration on this subject can be found in DIPN 59.
Offshore transaction
If the profit of a transaction is sourced outside of HK and not subject to tax, one would expect that there would be no tax impact even if the transaction is not conducted at arm’s length and thus any transfer pricing analysis would not be necessary. The IRD does not think that way.
Consider this example: an HK entity that breached the ST lends, say, HK$110 million to an associated entity outside of HK at an interest rate of 0.1% per annum. There is no other RPT for the year. If the conditions of the Provision of Credit Test is met, the interest income would not be subject to tax in HK. However, the taxpayer would still need to prepare an LF on the loan and MF on the group, even though any potential upward adjustment on the loan interest income should have no impact on the profits tax position.
The interaction between transfer pricing and the locality of profits is briefly discussed in DIPN 59 (Para 29): after ascertaining the amount of arm’s length profits, the broad guiding principle on the locality of profits as explained in DIPN 21 would be applied to determine whether and, if so, the extent to which such profits arose in or were derived from HK. This two-step approach of first determining the arm’s length amount of the transaction and then assess the taxability/deductibility explains the position taken in DIPN 58.
Tax Tips
Preparation of the TPD can be a costly compliance exercise. The IRD listened to the comments of the practitioners during the consultation stage and lifted the thresholds for ST to a reasonably high level in order to reduce the number of HK taxpayers that need to prepare the TPD.
Notwithstanding, while taxpayers may be exempted from preparing the TPD, they are obliged to keep sufficient records to enable the assessable profits to be readily ascertained, and provide information and documents about its controlled transactions upon tax return or transfer pricing examination. It would, therefore, be wise to maintain sufficient supporting documentation for the pricing of the RPT even when the entity is exempted from preparing the MF and LF under the Amendment Ordinance.
A multilateral tax cooperation mechanism under the Belt and Road Initiative (BRI), the Belt and Road Initiative Tax Administration Mechanism (BRITACOM) which includes tax authorities from 34 countries and regions, was established on 18 April 2019. The reported aim of BRITACOM is to facilitate cross-border trade and investment along BRI routes by expanding tax dispute resolution activities, increasing transparency, streamlining compliance and digitizing filing. An office will be opened in Beijing to help facilitate these goals.
Since the BRI consists primarily of Chinese outbound investment in infrastructure projects in the participating countries, BRITACOM will likely function more in facilitating outbound Mainland Chinese entities’ local tax compliance and dispute resolution when engaged in such projects. BRITACOM will be different from the various anti-tax avoidance initiatives of the OECD and other international organisations.
International Effort in Anti-Tax Avoidance
The most well-known international effort against tax avoidance is the Base Erosion and Profit Shifting (BEPS) project. The 15 BEPS Actions issued in October 2015 challenge tax avoidance practices by large Multinational Enterprises (“L-MNEs”) by amending the global tax treaties, increasing disclosure and transparency, introducing new documentation in transfer pricing, countering harmful tax practices, lowering threshold of permanent establishment recognition, investigating into new form of taxation for digital services and toughening interest deduction rules. The primary aim of BEPS is to ensure that the international tax rules do not facilitate the shifting of corporate profits away from the real economic activity and value creation are taking place. Many of these Actions have been implemented already, the latest being the Economic Substance Law (with the BVI just issued the Draft Economic Substance Code).
In addition, the OECD has stepped up efforts in international cooperation on tax matters in recent years. Heads of tax administrations meet regularly at the Forum of Tax Administration (FTA). Cross-border tax avoidance intelligence is shared among tax offices under the Joint International Taskforce on Shared Intelligence and Collaboration (JITSIC). The International Compliance Assurance Programme (ICAP) invites large MNEs to engage voluntarily with tax administrations from 17 jurisdictions (expanded from 8 when the pilot began in January 2018). Tax Inspectors Without Borders sends experience tax officials to train those in developing countries to perform tax audits on MNEs.
The United Nation, the World Bank, the International Monetary Fund, and the European Unions are also very active in introducing new initiatives in combating tax avoidance.
Large MNEs have Acted
Many L-MNEs have already started restructuring back in around 2013/14 in view of the disclosure requirements especially the Country-by-Country Reporting (CbCR). In the past, many L-MNEs housed the intellectual properties (“IP”) in tax haven jurisdictions earning untaxed royalties or have captive insurance companies there to provide insurance coverage to group companies in order to receive untaxed income while the group companies could take a tax deduction. Smart L-MNEs would have restructured early so that no tax office would have the opportunity to ask the sensitive questions. Their most immediate challenge to the L-MNEs would likely be dealing with the economic substance law in the tax haven countries, especially those that have been acting as funding vehicles.
Smaller MNEs – Act Now
L-MNEs have internal tax resources to help them manage tax risks in this rapidly changing tax environment. What about the Small and Medium Size MNEs (S-MNEs) that do not have in-house tax people? They obviously have to rely on external tax consultants. The key is to identify the right consultants to do the following two things:
1. Review the existing structure, operations and arrangements
The objective of such review is to identify tax risks and opportunities currently embedded in the group structure and operations. The author had seen a group missing out the 50/50 offshore claim in the Hong Kong profits tax filing on a contract manufacturing arrangement. In another case, a Hong Kong-based listed group devoted resources in Hong Kong to help the overseas affiliates in high tax countries to become highly profitable but they do not realise that they should recoup the costs incurred in Hong Kong via transfer pricing in order to align with the commercial reality and reduce the group’s effective tax rate. These can be dug out and properly addressed in order to create legitimate tax saving.
Some groups have not paid attention to documentation of decision making and thereby creating risks of being regarded as tax resident in jurisdictions unexpectedly. The old model of cost-plus remuneration of agents may now be exposed to permanent establishment risks. Some have ignored the documentation of substance. The impact of the Economic Substance Law introduced by the tax havens such as the British Virgin Islands (BVI) must be properly analysed with a set of action determined to address the issue.
To be a good manager, issues should be addressed and resolved upfront so that the expectation of shareholders and directors of the group/company is well-managed. The review should be conducted by professionals with solid technical and business experience. There are well-qualified tax advisors in the market to do the work at competitive rates and high efficiency to deliver substantial value to the groups.
Often the finance managers of the groups/companies prefer to stick their heads into the sand instead of dealing with the problems because they don’t want to take the blame for issues uncovered by the seasoned tax advisors. It is thus important for the directors or even the shareholders to realise what the current tax environment is like and take initiative in carrying out the review. At the end of the day, if the hidden tax exposures are not cleared before they crystalise, the group/company, the directors and shareholders would be badly hurt.
2. Seek on-going tax support especially on documentation
Having identified and dealt with past issues, it is important that no such issue will arise again in the future. This can be achieved by retaining the tax advisor to review transactions or documentation as and when required, just a family doctor caring for the health of the family. For example, sometimes the auditors, being unaware of the tax exposure created, may make disclosures in the audited financial statements that are unnecessary and sometimes even harmful to the tax arrangement of the company. For listed companies, they should be very careful in the disclosures in the annual reports.
Board papers are crucial. It is direct evidence of management and control which is one of the key factors in determining substance and tax residency. Tax advisors play an important role in advising who should be on the board of each company, location of board meetings and review the board papers.
Also, management should be made aware of tax law changes and new cases that affect their business. Questions they should ask, or proactively addressed by the tax advisor, include:
What are the benefits of the new tax incentives introduced in Hong Kong such as the two-tier tax system to the group?
Should something be done about intellectual property in view of the new Section 15F of the Inland Revenue Ordinance?
What should the group do in view of the Beneficial Ownership rules in Mainland China to ensure that the benefits can be obtained?
It is time for the smaller groups to gear up the tax risk monitoring and compliance, and ensure that structures are sustainable in the medium term. The BEPS Project is at the implementation stage and it will not be long before OECD reviews the achievement and point to the next target: the S-MNE groups. The time to act is NOW.
The article “The Mysterious 183 Days” (10 September 2018 – Tax Tips 15) addressed the question “Is it true that there is no IIT liability if one stays in the Mainland for not more than 183 days?”. The Ministry of Finance and the State Taxation Administration of Mainland China issued two important notices on Individual Income Tax (“IIT”) on 14 March 2019, namely 《Determination of the Duration of Residence of Non-China-domiciled Individuals – Public Notice 2019 No.34》 (“PN34”) and the very complex 《Policies Regarding the Tax Treatment of Non-Residents and Non-China-domiciled Resident Individuals – Public Notice 2019 No.35》 (“PN35”), which set out a new way of calculating the days of residence in China and details of IIT computation for non-residents and non-domiciled resident individuals under different scenarios. Both Public Notices are effective on 1 January 2019. This article focuses on the implications of the new definition of days of presence in China.
The Relevant Articles on the Days of Residence
To help Readers’ better understanding of the issue, the Articles in the IIT Law and Detailed Implementation Rules relating to the days of residence are set out below.
Article 1 of the IIT Law
Individuals who are domiciled in China, or non-domiciled but resided in China for 183 days in aggregate in a tax year, are resident individuals. Resident individuals are subject to IIT on income from sources within and outside China.
Individuals who are neither domiciled nor resident in China, or who are not domiciled and reside in China for less than 183 days in aggregate in a tax year, are non-resident individuals. Non-resident individuals shall pay IIT in accordance with this Law on income derived from sources within China.
Article 4 of the Detailed Implementation Rules of the IIT Law (“DIR”)
Individuals who are not domiciled in China and resided in China for 183 days in a year for a consecutive period of not more than 6 years, upon completion of filing procedures with the in-charge tax office, the foreign sourced income that is paid by foreign entities or individuals is exempt from IIT; whenever a single trip of more than 30 days is made in the year that the days of residence reached 183 days in aggregate, the accumulation of consecutive years would start afresh.
Article 5 of the DIR
Individuals who are not domiciled in China and resided in China for not more than 90 days in aggregate in a tax year, China sourced income that is paid by the foreign employer and is not borne by a place or establishment of the foreign employer located in China would be exempt from IIT.
PN34 – Days of Residence
Article 1 of PN34 clarifies what is meant by “resided in China for 183 days in a year for a consecutive period of not more than 6 years” as per Article 4 of the DIR of the IIT Law. The provisions are in line with the general expectation.
Article 2 is more impactful. The article states that: “the length of residence of a non-domiciled individual in China in a tax year shall be calculated based on the days of presence in China. A full 24 hours-day of presence would be counted as one day of residence. Where the presence is less than 24 hours in a day, that day is not counted as a day of presence”.
Based on PN34, only a full 24-hours day of presence would be counted as a day of residence in China. This day of residence is relevant to the determination of “resided in China for 183 days” or “more than/not more than 90 days” under Article 1 of the IIT Law and Articles 4 and 5 of the DIR. The implication of this change is that it will be harder for individuals to be subject to IIT or become a Chinese tax resident, and easier to meet the conditions set forth in Article 4 of the DIR such that IIT liabilities would be reduced or even totally exempted. This is good news to non-China-domiciled Hong Kong individuals.
PN35 – Days of Work
Article 1 Para 1 of PN35 is about the determination of the source of wages and salaries. Para 1 stated that “The wages and salaries earned by an individual attributable to the working period in China are regarded as China-sourced wages and salaries. The working period in China shall be calculated according to days worked by the individual in China, which includes the actual working days in China and days spent inside or outside China for public holidays, personal vacations and training.
If the individual holds employment positions in both foreign and Chinese entities or is solely working for foreign entities, time spent in China that is less than 24 hours in a day would be counted as 0.5 days for the purposes of determining the number of days worked in China.
Why is this method of counting so different from that prescribed in PN34? Since non-China sourced income that is paid by foreign entities or individuals outside of China would be exempt from IIT, the determination of China and foreign sourced income is very important.
If a Hong Kong individual is only working for an entity in China, the days that are spent outside of China for vacation or training are all related to China employment and it is reasonable to include days spent outside of China as a working period in China, such that no days would be deducted from his China working period. On the other hand, if an individual is working for both China and foreign entities, it is reasonable that part of a day spent in China is counted for only 0.5 days as China working period.
The foreign working period is determined by deducting China working period from the calendar days of the month. The number of days worked in China and outside China would be inserted into the formulae prescribed in PN35 in determining the wages and salaries from sources in and outside China.
Double Tax Arrangement – Days of Presence
“The Mysterious 183 Days” mentioned that the exemption from IIT for individuals who visit China for not more than 183 days is an effective extension of Article 7 of the old Detailed Implementation Rules of the IIT Law. Article 5 of the new DIR has basically retained the same provision. Under Article 14 <Income from Employment> of the Mainland-Hong Kong Double Taxation Arrangement (“CN-HK DTA”), the period of stay is “extended” from 90 days to 183 days. A Hong Kong resident would be exempt from IIT if the three conditions in Para 2 of Article 14 are all satisfied. The three conditions are:
1. the recipient is present in the Other Side for a period or periods not exceeding in the aggregate 183 days in any 12-month period commencing or ending in the taxable period concerned;
2. the remuneration is paid by, or on behalf of, an employer who is not a resident of the Other Side;
3. the remuneration is not borne by a permanent establishment which the employer has in the Other Side.
“The Mysterious 183 Days” also mentioned that in counting the actual number of days for condition 1, one should include all days spent in China, including days that are not the full day such as the day of arrival and day of departure, as well as weekends, holidays, and vacation etc spent in China before, during and after the employment. Does the relaxation of counting the days under PN34 cover the 183 days in the DTA?
Unfortunately, there is no relaxation for the purposes of the DTA (notwithstanding, relaxation can be attained under Article 5 of the DIR, as to be explained further below). The days referred to by PN34 is the “days of residence”, the days referred to in the DTA is the “days of presence”. The new definition applies to “days of residence” only. Thus the counting of 183 days under the DTA has not changed.
According to the OECD Model Tax Convention on Income and on Capital: Condensed Version 2017, there is only one method of counting 183 days: the “days of physical presence” method, which aligns with what was mentioned in “The Mysterious 183 Days”.
PN35 listed out a number of old IIT circulars that are abolished with effect from 1 January 2019, which included the “State Taxation Administration Notice on Certain Issues in Relation to the Implementation of DTA and IIT Law for Non-China-Domiciled Individuals – GuoShuiFa (2004) No.97”. Article 1 of the circular stated that “for individuals who do not have a domicile in China, for the purposes of calculating the days of residence in China for the determination of IIT liabilities under the law or DTA, the actual physical presence days would be counted. The day of arrival, the day of departure, round-trip and multiple round-trips to and from China would each be counted as one day of presence”. The new definition of days under PN34 and the abolition of GuoShuiFa (2004) No.97 could lead some people to wonder if the method of calculating the days of presence under the DTA has also been amended.
Readers should also pay attention to the fact that Article 15 Para 2(1) of the circular “Interpretation of the DTA between China and Singapore and the Protocols – GuoShuiFa (2010) No.75” applies the same OECD method in computing the days of presence, and the article in this circular has not been abolished by PN35.
The IIT Law is More Favorable than Tax Treaty Provisions?
Assuming a Hong Kong resident who is not domiciled in China and only has employment in Hong Kong. His salary is paid by the Hong Kong employer in Hong Kong and is not borne a place or establishment of the employer in China (fulfilled the 3 conditions set forth in Article 14 Para 2 of the CN-HK DTA and Article 5 of the DIR). Starting in 2019, the individual visits China every week, Monday to Friday, and his weekly travel pattern is as follows:
Monday Hong Kong to Guangzhou
Tuesday Guangzhou to Hong Kong
Wednesday Day trip to Shenzhen
Thursday Hong Kong to Zhuhai
Friday Zhuhai to Hong Kong
Saturday Hong Kong
Sunday Hong Kong
According to CN-HK DTA, the individual stayed 5 days in a week in China, and he will reach 183 days in week 37 such that he will have to report and pay IIT for his China-sourced income for the past 37 weeks. However, the individual’s day of residence in China is zero. Is he subject to IIT?
The point to note here is that zero-day of residence does not mean zero-workday in China. Therefore, the individual is still required to apply the formulae in PN35 to determine the IIT calculation in this case.
Tax Tips
Whenever an employee is seconded to work in China or an individual chooses to be employed by a Mainland Chinese enterprise or even taking up positions inside and outside China, the IIT implications should be carefully assessed. The individual’s domicile, residency, employment inside or outside of China, the bearer of wages and salaries, the days of residence, work and presence would all affect the reporting and calculation of IIT.
Although under the new IIT law the tax rates have been reduced, more deductions are allowed and the grace period of avoiding taxation on global income has been extended, the complexity of the new IIT law has made it more difficult to comply, easier to make filing mistakes and result in increased tax risk.
On the other hand, the more relaxed days of residence calculation would encourage more people to stay in China for a longer period of time, which would make it easier for foreign enterprises to create a Permanent Establishment in China (discussed in details in “The Mysterious 183 Days”). The matter has to be handled carefully by both employers and individuals.
(This is an English translation of the Chinese article published in the Hong Kong Economic Journal Forum on 29 March 2019: https://manageyourtax.com/HKEJ Forum 21 )
If you work in a Hong Kong subsidiary of a large Multinational Enterprise (MNE) Group and you think Country-by-Country Reporting (CbCR) has nothing to do with you, think again.
Your employer could be facing a penalty of HK$50,000 (US$6,400) on each Hong Kong entity for failing to file CbCR notification with the Hong Kong Inland Revenue Department (“IRD”), the first deadline falls on 31 March 2019 (the IRD announced on 21 March 2019 that the notification deadline for qualifying entities is extended by 45 days to 15 May 2019). Failing to file the CbCR will also attract the same level of penalties. In addition, you may be under a statutory obligation to keep the underlying records of the CbCR, which includes detailed information of the global operations of the Group, for 6 years or you may once again get hit with the HK$50,000 penalty. What is more, the Hong Kong CbCR Rules could impact your Group’s relationship with business partners and potential investors.
The CbCR rules are contained in Part 9A Division 3 of the Inland Revenue Ordinance (“IRO”) introduced under Inland Revenue (Amendment) (No 6) Ordinance 2018, which also included the other transfer pricing documentation requirements, namely the master file and local file. This Tax Tips focuses on the CbCR, which many in the community are not aware of the statutory requirements, the additional hurdles introduced for compliance, the practical issues of preparing the CbCR, and the importance of project management. The Hong Kong CbCR rules are, unfortunately, very tough.
Worried? Read on.
The Basics about CbCR
The CbCR was introduced under the Final Report on Action 13 of the OECD Base Erosion and Profit Shifting (“BEPS”) Project (“Action 13”) as a tool for high-level transfer pricing risk assessment. It may be used by tax administrations in evaluating other BEPS related risks and where appropriate for economic and statistical analysis.
Action 13 – Who needs to prepare CbCR and where to file
Normally it should be relatively easy to determine if an entity is required to file a tax return or not. Not the case for CbCR. The general rule under Action 13 is that if an MNE Group’s annual consolidated group revenue in the immediately preceding fiscal year (for example, for the year ended 31 December 2017) exceeds EUR750 million, then Ultimate Parent Entity (“UPE”) of the group will need to prepare CbCR for the following year (the year ended 31 December 2018 in the example), and file it with the UPE’s tax office which is due within 12 months after the year-end date (31 December 2019 in the example).
The CbCR submitted will then be automatically exchanged with other jurisdictions (based on an international agreement – the Multilateral Competent Authority Agreement on the Exchange of CbC Reports (the “CbC MCAA”)) that the MNE Group operates in (as indicated on the CbCR) so that there is no need for the UPE to file the report multiple times in different tax jurisdictions. However, there are a variety of situations for CbCR exchanges. The United States, for example, did not sign the document but instead arrange bilateral exchange agreements with other jurisdictions. Some jurisdictions, such as the Cayman Islands and Bermuda, are only doing one-way exchange: sending the CbCR collected to other jurisdictions but is not accepting CbCR (likely because there is no tax there).
The CbCR
The CbCR consists of three tables. Table One requires aggregate tax jurisdiction-wide information relating to the global allocation of the income, the taxes paid, and certain indicators of the location of economic activity among tax jurisdictions in which the MNE Group operates. Below is Table One.
Table 1
Table Two requires a listing of all the Constituent Entities (“CE”) of the MNE Group for which financial information is reported, including the tax jurisdiction of incorporation, where different from tax jurisdiction of residence, as well as the nature of the main business activities carried out by that CE.
Table 2
MNE Groups may use Table Three to provide additional information or explanation that is considered necessary or that would facilitate the understanding of the compulsory information provided in Table One and Two.
Table 3
Simple in Design, Difficult to Comply
After Action 13 was published in 2015, tax jurisdictions around the world have to pass the filing requirements into the local laws before CbCR can be collected. Naturally, some tax jurisdictions (mostly OECD countries) managed to swiftly implement the rules (the first year of filing would be for the year 2016, meaning the financial year that began within the calendar year 2016) but many were late. Hong Kong passed the law in July 2018 and the first year of filing is for the year 2018.
What would happen if the jurisdiction where the UPE is located has not introduced the CbCR laws but in some jurisdictions that the MNE Group operates the CbCR laws have been implemented?
This is where the “fun” is.
Local Filing, Parent Surrogate Filing, Surrogate Parent Filing
The MNE Group has to find out at each location that it operates, what is the status of CbCR implementation, and whether there is a “Local Filing” requirement. Local Filing, in simple terms, refers to the filing requirement imposed on the CE located in the tax jurisdiction to file the Group CbCR when the tax office is not able to obtain the CbCR from the UPE’s tax jurisdiction. In some jurisdictions, Local Filing is needed only upon request (for example, during a tax investigation).
If the UPE is required to file CbCR, it will need to check all the locations where the group operates whether the tax jurisdiction of the local CE is able to obtain the CbCR via an exchange mechanism with the UPE’s tax jurisdiction. If not, the local CE needs to perform Local Filing. In which case, the UPE needs to provide the CbCR to the local CE for filing. Multiple Local Filings may be needed.
If the UPE is not required to file CbCR, the Group is more likely to face multiple filings in different jurisdictions. To help reduce the compliance burden, Action 13 introduced two solutions: Parent Surrogate Filing and Surrogate Parent Filing (there is no typo here, these are two different terms), but it is up to each tax jurisdiction to determine if they allow such filing.
Parent Surrogate Filing refers to a voluntary CbCR filing by the UPE at the UPE’s tax jurisdiction before statutory filing is introduced into law. The tax office will exchange the CbCR obtained with other jurisdictions via automatic exchange or bilateral agreement. Hong Kong is a jurisdiction that accepted Parent Surrogate Filing for years 2016 and 2017 but it is unlikely that this offer has ever been taken up as the exchange network was very limited (thus incapable to avoid multiple Local Filing in other jurisdictions).
Surrogate Parent Filing allows the UPE to appoint a CE in another jurisdiction to be the parent entity for CbCR purposes and file the group’s CbCR with that other jurisdiction as if the CE is the UPE of the Group. This is a more popular solution for avoiding multiple Local Filing because the group can choose a CE in a jurisdiction with the widest automatic-exchange network (for example, the United Kingdom) as the Surrogate Parent Entity (“SPE”). Many Hong Kong groups selected this filing method for the years 2016 and 2017.
The OECD has been keeping track of the CbCR implementation status of different jurisdictions as well as their acceptance of Parent Surrogate and Surrogate Parent Filing. Below is the status as at 10 January 2019 extracted from the OECD website:
Anyone who had the experience of managing the CbCR filing for a reportable MNE Group for years 2016 and 2017 would know how much headache it is to ensure compliance.
Are You Ready for Preparing the CbCR Correctly?
Test your knowledge by answering the following true or false statements:
TRUE or FALSE:
CEs refer to entities that the UPE owns 50% or more.
Representative Offices or Branches with separate accounts are themselves CEs.
“Revenue” includes capital gains.
Related parties transactions can be eliminated for reporting.
Income tax paid does not include foreign taxes.
A CE that left the group during the year (e.g. disposed of) can be excluded from the CbCR for that year.
The number of employees includes independent contractors.
The Tax Identification Numbers (taxpayer file number) and addresses of CEs are not required for CbCR filing.
Answers are at the end of this article.
The OECD Action 13, the Guidance on the Implementation of CbCR (the “CbCR Guidelines”, issued by the OECD and last updated in September 2018) and the CbCR: Handbook on Effective Implementation (the “CbCR Handbook” issued by the OECD in 2017) provide some guidance on the definition of various terms and how to deal with different situations. However, it is far from comprehensive. Groups need to decide in situations specific to them the position to take in the CbCR and ensure that all CEs take the same position. It is thus important that the MNE Group studies the OECD documents and guidance issued by tax offices and prepare a set of CbCR Instructions for internal use to align the basis of preparation.
For larger groups, especially those with different business lines and frequent M&A activities, a set of Frequently Asked Questions would be helpful as the first point of contact when the people in different jurisdictions involved in the data input face questions, as some of them may raise the same questions. Where applicable, part of the CbCR Instructions and FAQ can be disclosed in Table 3 of the CbCR. For example, the Instructions and FAQ may cover items such as:
How to report newly set-up CEs that have not closed their books as at the year-end date of the UPE
Source of data
Which entities are “related entities” for CbCR purposes
How to account for withholding taxes paid if the tax is calculated on a gross-up basis
How to report the tax paid in the case of a tax grouping
How to check the “main business activity(ies)” boxes for the different businesses of the group
Who is to determine if a CE is dormant
Approach to prepare the CbCR – Top-Down or Bottom-Up?
Obviously, if the group prepares the CbCR centrally at one location (say at the headquarters) based on financial data on CEs around the world that it possesses, it can achieve the best level of consistency. This Top-Down approach can avoid worldwide training for data input. However, the central location will inevitably need to obtain information from local CEs, and they may provide incorrect information if they do not understand CbCR. In addition, when the CbCR submitted is exchanged to the jurisdictions of the local CEs, the local CEs may be approached by the local tax office for explanations on the data. In such a situation, the headquarters will need to answer the questions from afar. The situation will become unmanageable if many tax offices ask questions at the same time.
Automation or manual input?
Another question that all MNE Groups would go through is: how to avoid the manual data collection process? There is no right or wrong answer to that and it is more a cost-benefit analysis. There are two important factors to consider: (i) whether the same accounting system is adopted across the group and (ii) whether the adjustments required (for example, identifying the related party transactions with CEs) can be dealt with by the system. Further, if the Group makes acquisitions, which often happen in the corporate world, substantial efforts may be required to change the legacy accounting system of the newly acquired entities. In real life, several different accounting systems may be deployed within an MNE Group.
How to manage the CbCR preparation
If an MNE Group is required to prepare CbCR and the bottom-up, manual input approach is adopted, the steps would include the following:
Assign a Project Manager – a person who is knowledgeable about CbCR or has access to technical resources;
Manage notifications across the group;
Compile the list of CE for the reporting year and determine the tax jurisdiction of each entity including the tax haven entities;
Assign a staff person from the finance or accounts department to each CE as the first level data input;
Assign a “CbCR Champion” to each group of entities which can be based on jurisdiction and/or business lines. The CbCR Champions would need to ensure consistency in the data compilation and address questions, and review data input by staff. More difficult questions can be forwarded to the Project Manager for resolution;
Prepare a detailed Instructions and FAQ and everyone involved in the process should study them before commencing work;
Training for all involved in the process, timeline and the position taken on different aspects;
Prepare an Excel format data input worksheet for data input;
Staff perform data input and submit to CbCR champion for review with supporting documents (financial statements etc);
Final review by the Project Manager and combine all input to prepare tables;
Sign off by senior management;
Convert the file into XML format (as requested by the tax office);
Submission.
The above is not rocket science. However, each step requires careful planning and execution in order to meet the filing deadline. Needless to say, the more CEs spreading across different jurisdictions, the more difficult it will be to manage the process and the risk of error will increase. Training and project management will become most important.
In addition, although MNE Groups are given 12 months to prepare the CbCR, when they can actually commence data input depends on how long it takes post-year-end to finalise the local financial statements. The longer it takes to finalise the accounts, the less time there is to prepare for the CbCR. Realistically, the time available would likely be less than 9 months.
The Hong Kong Rules are Making Life Even Harder
The Hong Kong rules on CbCR fully incorporated the Action 13, CbCR Guidelines and CbCR Handbook. As long as MNE Groups follow these documents and adequately disclose some of the position taken, there should be relatively little concern of incorrect filing. However, on the administration side, MNE Groups with CEs in Hong Kong must pay special attention to the Hong Kong rules.
Notification – Section 58H
Section 58H under Division 3, Part 9A of the IRO sets out the requirement for notification: each Hong Kong CE of a reportable group must file a notification informing the IRD, effectively, which entity in Hong Kong will file the CbC Return* or, if the CbC Report* is to be filed in another jurisdiction, various information about such filing. One Hong Kong entity of the MNE Group can represent other group entities to file the notification. Notification deadline is within 3 months after the end of the year-end of the MNE Group.
* This article used the term “CbCR” in a broad sense to describe both the CbC Report (the three tables) that is filed with the tax office and the act of preparing the CbC Report. The Hong Kong rules distinguish between the “CbC Return” and the “CbC Report”. The CbC Report is the report containing the three tables discussed above. Under Section 58K(1), the CbC Return is the CbC Report and “any other information specified by the Board of Inland Revenue”.
In many jurisdictions (for example, the UK, Malaysia and South Korea), notification can be done by writing a letter or filling in a prescribed form. In Hong Kong, one needs to file notification via the CbC Reporting Portal (“Portal”). The Portal is developed by the IRD to facilitate the Hong Kong entities to:
submit notifications of obligations to file CbC Returns;
submit notifications of change of address;
file CbC Returns; and
receive or send messages in relation to CbC reporting.
IRD CbC Portal
Just like any online system, a registration procedure is required to access the Portal. A Hong Kong Entity should register a CbC Reporting Account under the Portal. The person authorized to register a CbC Reporting Account for the entity has to possess an e-Cert (Organisational) with AEOI Functions (“e-Cert”) for authentication purposes. The person has to apply for the e-Cert at the Hong Kong Post.
Manage Your Tax’s e-Cert (Organisation) with AEOI function
Filing – Section 58E and 58F
The deadline for the filing of a CbC Return is within 12 months after the end of the accounting period, which obviously shall be filed via the Portal. Similar to most jurisdictions, a CbC Report must be made in the form of an XML document for submission to the IRD. The reason for this is that XML documents can be validated and provide a common medium for exchange between the jurisdictions that have introduced CbCR requirements. In this regard, the IRD has developed a data schema in XML which is based on the CbC XML Schema v1.0.1 issued by the OECD. The data schema specifies the data structure and format for filing CbC Report to the IRD. The current version of the data schema and related user guide is available on the IRD website for download.
It is important to note that other than the information required in Table 1, 2 and 3 of the CbC Report, the XML Schema User Guide issued by the Hong Kong IRD mandatorily requires that the Tax Identification Number (“TIN”) of each CE, where issued by the tax administration of the tax jurisdiction of the CE, be provided. If the CE does not have a TIN, the value “NOTIN” shall be entered. In addition, the XML Schema User Guide “strongly recommended” that the address of each CE shall be provided. Finally, if the CE is a Permanent Establishment, the name of the CE should be followed by “(P.E.)”.
To the unwary, these additional information and formatting requirements may create an issue if only discovered upon XML conversion, potentially causing late filing.
Automatic Exchange of the CbCR
After filing the CbCR with the IRD as the UPE or SPE, can the MNE Group rely on the IRD to send the CbCR out to other tax jurisdictions such that the filing obligations there would be satisfied? It depends. Although Hong Kong has signed the CbC MCAA, the automatic exchange with applies for accounting period starting on or after 1 January 2019. Therefore, for a Hong Kong UPE or SPE who is filing a CbCR with the IRD for the accounting period for the year ended 31 December 2018, the IRD would only exchange it with the following 11 jurisdictions (as at 31 January 2019) based on bilateral exchange arrangement in place:
France
Guernsey
Ireland
Japan
Jersey
Korea
Malta
Netherlands
New Zealand
South Africa
United Kingdom
If the Hong Kong UPE has CEs in a jurisdiction not listed above which requires Local Filing (e.g. Germany), the Germany CEs may need to file the CbCR locally. If the Hong Kong UPE is also considered a resident in another jurisdiction and that jurisdiction has an exchange agreement with Germany, then it may file in a second CbCR with that jurisdiction to cover the German filing and elsewhere.
Record keeping – Section 58L
Section 58L requires that a Reporting Entity must (a) keep sufficient records to enable the accuracy and completeness of the CbC Return filed under this Division (i.e. Division 3, Part 9A of the IRO) to be readily ascertained; and (b) retain the records for a period of 6 years beginning on the date on which the return is filed. The burden on the Reporting Entity is indeed substantial and thus it is important to know which entity is the Reporting Entity.
Under Section 58J, a Reporting Entity includes (a) a Hong Kong UPE required to file a CbC Return (Section 58E(1)), (b) a Hong Kong entity that is required to file a CbC Return by Section 58F (i.e. either under Local Filing or the entity is appointed the SPE), and (c) a Hong Kong entity that is required to provide a notice by Section 58H.
If a Hong Kong UPE or SPE is required to file the CbC Return it is fair to expect that entity to possess information that satisfies Section 58L. It is debatable whether it is fair to demand the same level of record keeping for an entity that performs Local Filing. It is, however, unreasonable and unnecessary to impose statutory obligations for the entity that files only a notification under Section 58H to maintain sufficient records for 6 years to enable the accuracy and completeness of the Group’s CbC Return be ascertained.
To illustrate, assume a Korean conglomerate engaged in shipbuilding, mobile phone manufacturing, financial services and health care is filing the CbCR in Korea, and only the mobile phone division has subsidiaries in Hong Kong and are required to file CbCR notification to the IRD. The Hong Kong subsidiaries will need to maintain the CbCR information of the entire global group to the extent required under Section 58L. The IRD should not impose such record-keeping requirement on the Hong Kong subsidiary. If the IRD requires information, they should approach the Korean tax office to collect it. Hong Kong subsidiaries of foreign MNE groups are now faced with this unreasonable statutory requirement.
Penalties – Section 80G
Division 6 of Part 9A contains the penalty provisions for CbCR. The new Section 80G provides that a Reporting Entity commits an offence if the entity, without reasonable excuse: (a) fails to file the CbC Return (Section 58E(1) or 58F); (b) fails to file notification under Section 58H; or (c) fails to keep records as required under Section 58L. That Reporting Entity would be liable on conviction to a fine at level 5 (HK$50,000/US$6,400), and the court may order the entity to do, within the time specified in the order, the act that the entity has failed to do. The Reporting Entity is liable to a further fine of HK$500 for every day or part of a day during which the failure to file the CbC Return or notification continues after conviction.
Obviously, there are further penalty provisions for more serious offences.
The penalty provisions are quite harsh especially on MNE Groups filing CbCR outside of Hong Kong. Their Hong Kong operations may be small and with little internal tax support. If the Hong Kong CE, being a Reportable Entity, is not wholly owned by the UPE (i.e. there is a minority shareholder), for information protection reason the MNE Group may not want to provide the detailed records to the CE as required under Section 58L. Is such information protection a “reasonable excuse” for not fulfilling Section 58L? If not, the minority shareholder may demand compensation from the MNE Group for any penalties suffered.
Service Providers
A service provider may be engaged to perform the filing and notification. However, the Reporting Entity’s obligations are not relieved. In addition, the service provider is also subject to the same level of penalties as the Reporting Entity for failure to file the CbC Return or notify the IRD.
Concluding Comments
CbCR is a very unique tax return: there is no tax to be calculated and no money to be paid, the “taxpayer” can in some cases choose where to file it but need to comply with all the CbCR rules and regulations in all jurisdictions that the taxpayer operates in, and corporate restructuring or M&A could bring chaos to the filing. In an acquisition, the buyer will need to obtain warranties or indemnities from the seller for exposures relating to CbCR.
With all the complexities, jurisdictions should implement the CbCR rules in a lenient manner, thereby reducing the pain felt by businesses. For instance, Singapore only accepts UPE filing (i.e. the MNE Group whose UPE is a Singapore tax resident, and no Surrogate Parent or Local Filing is accepted) and the local tax office (IRAS) would inform the UPE that they need to file the CbCR. Why would Singapore give up such power to collect information?
For a relatively small tax jurisdiction like Singapore where many foreign MNE Groups have set up subsidiaries, as long as Singapore has wide AEOI network, she is going to obtain the CbCR filed by the MNE Group elsewhere without imposing undue filing burden on the local taxpayers. According to the OECD website, at present (February 2019), Singapore can obtain CbCR from 63 jurisdictions, mostly from 2016 onwards. Hong Kong can obtain the CbCR from 56 jurisdictions but mostly only from 2019 onwards (before 2019, Hong Kong can only exchange with the 11 jurisdictions mentioned earlier).
Even if Singapore is not collecting all CbCR now, over time, when all jurisdictions around the world have introduced CbCR rules (Action 13 is one of the minimum standards that over 125 jurisdictions, by joining the OECD Inclusive Framework, have agreed to implement), Singapore will collect all CbCR from MNE Groups that operate in Singapore. Comparing with Singapore, subsidiaries of foreign MNE Groups in Hong Kong face the Local Filing burden, notification requirement (and need to obtain the e-Cert), the record-keeping obligations, and face potentially very heavy penalties. Which jurisdiction is wiser: Singapore or Hong Kong?
In case one is not convinced, Singapore’s CbCR filing would be done by sending the CbCR in XML format to the IRAS simply by email.
Tax-imposing jurisdictions would care more about CbCR because they may be able to detect BEPS risks. Tax Havens, however, are introducing CbCR regulations mainly to satisfy the demands of the international community through their participation in the OECD Inclusive Framework. One would expect that Tax Havens would make the process simple and just do the collection and exchange of the CbCR. Not so. The British Virgin Islands (BVI) issued the CbCR Guidance Notes on 19 February 2019 which requires the MNE Groups to provide details of each BVI CE, including those being tax residents elsewhere, on an Excel template.
BVI CbCR Registration
It is probable that the designers of CbCR did not foresee the difficulties and trouble faced by MNE Groups for trying to meet the CbCR notification and filing requirements. Maybe they do not care because in their minds, the MNE Groups have been avoiding taxes and it is time to pay off. It can be foreseen that the tax offices, especially in the OECD countries, will soon announce that the CbCR is leading to successful tax audits recovering millions in taxes. If that is not happening, the scope of CbCR may be extended upon review in 2020, requiring MNE Groups to disclose more information, and lowering the revenue thresholds so that more MNE Groups will need to comply. More resources will have to be deployed by tax offices and MNE Groups to deal with CbCR.
Tax Tips
Readers should by now have an idea of how CbCR is going to hit like a tsunami, except that there is nowhere to hide if the revenue threshold is breached. The best advice is to start preparation early, especially for those MNE Groups that are about to breach the EUR750 million threshold soon. Pick the right Project Manager (we can help!) and do a Dry Run would be the best tips for handling CbCR compliance.
Readers should note that the objective of this article is to highlight the key provisions in the CbCR Rules. For completeness, Readers are advised to seek professional assistance to enhance their understanding of the rules, their obligations and the penalty provisions.
Lastly, answers to the true or false questions:
CEs refer to entities that the UPE owns 50% or more. FALSE
Representative Offices or Branches with separate accounts are themselves CEs. TRUE
“Revenue” includes capital gains. TRUE
Related parties transactions can be eliminated for reporting. FALSE
Income tax paid does not include foreign taxes. FALSE
A CE that left the group during the year (e.g. disposed of) can be excluded from the CbCR for that year. FALSE
The number of employees includes independent contractors. TRUE
The Tax Identification Numbers (taxpayer file number) and addresses of CEs are not required for CbCR filing. FALSE
(This is an English translation of the Chinese article published in the Hong Kong Economic Journal Forum on 26 February 2019: https://manageyourtax.com/HKEJ Forum 20 )
The last issue of Tax Tips (The Final Days of Tax Havens – 10 December 2018) discussed the paper “Resumption of Application of Substantial Activities Factor to No or Only Nominal Tax Jurisdictions” (the “Paper”) issued by the OECD Inclusive Framework on BEPS Action 5, and forewarned the changes ahead: tax haven companies will be required by law to hire an adequate number of full-time qualified employees and incur an adequate amount of operating expenditure to carry out the activities that they claim to be engaged in.
Tax Havens including the well-known Cayman Islands and the British Virgin Islands (BVI) have swiftly introduced economic substance legislation. Cayman Islands passed The International Tax Co-operation (Economic Substance) Law, 2018 on 17 December and the BVI’s Economic Substance (Companies and Limited Partnerships) Act, 2018 was passed into law on 19 December 2018. These laws have become effective on 1 January 2019.
The rush to pass these laws before the end of 2018 was due to the commitment made to the European Union (EU). The Cayman Islands and BVI, together with countries such as Bermuda, Guernsey, Jersey and Isle of Man were included in a list of countries whose tax policies and economic substance caused concern for the EU Code of Conduct Group (Business Taxation). These countries were given the deadline of 31 December 2018 to introduce laws (the “Economic Substance Law” hereinafter) to avoid blacklisting by the EU.
Economic Substance Law
The economic substance required by the EU is basically identical to those set out in the Paper. Although the Economic Substance Laws have been passed, the Tax Havens still need to wait for the EU to confirm that the EU requirements have been met. However, from the reports on the visit by the OECD representatives (including the Director of the Centre for Tax Policy and Administration Mr. Pascal Saint-Aman) to the Cayman Islands in early January 2019, it seems that things are on the right track. Although the legislation introduced by different countries are broadly similar, details are different and Readers using Tax Haven vehicles should study the specific legislation to analyse the impact.
Impact Assessment
Not all Tax Haven entities will be affected. Here are the general steps one could take to assess if a company shall comply.
Step 1: Is the company a “Relevant Entity”
The Economic Substance Laws generally apply only to entities that are not tax residents outside of the Tax Haven country (the Relevant Entities). For example, if a BVI company is registered to carry on business in Hong Kong, it will likely be regarded a tax resident in Hong Kong and thus out of scope for the BVI Economic Substance Law.
Step 2: Is the Relevant Entity conducting the “Relevant Activities” Corporates and individuals use Tax Haven entities for various activities but only the “Relevant Activities” are subject to the substance requirements. Generally, the geographically mobile activities such as the provision of intangibles (i.e., intellectual property (“IP”) related activities) and the below Non-IP activities would be considered the Relevant Activities:
Headquarters
Distribution centres
Service centres
Financing
Leasing
Fund management
Banking
Insurance
Shipping
Equity holding
Relevant Entities will likely be required to file notices to inform the authorities whether they are conducting Relevant Activities or not. Those conducting Relevant Activities will then need to provide information covering items such as income, expenses, assets, premises, management, employees and physical presence. If the economic substance of the Relevant Entity falls short of the requirements, it will be asked to make an improvement. Persistent failure to fulfil the substance requirement may be subject to fines and even result in being struck-off.
Step 3: Meeting the Economic Substance Requirement
In general, a Relevant Entity conducting any of the above Relevant Activities complies with the economic substance requirements if: (a)the Relevant Activity is directed and managed locally (i.e. in the Tax Haven);
(b)having regard to the nature and scale of the relevant activity:
there are an adequate number of suitably qualified employees in relation to that activity who are physically present locally;
there is adequate expenditure incurred locally;
there are physical offices or premises as may be appropriate for the core income-generating activities; and
where the Relevant Activity is IP business and requires the use of specific equipment, that equipment is located locally; and
(c)the Relevant Entity conducts core income-generating activity. A pure equity holding entity, which carries on no Relevant Activity other than holding equity participations in other entities and earning dividends and capital gains, are subject to the reduced requirement and would be considered to have adequate substance if it:
(a)complies with its statutory obligations under the relevant company laws; and (b)has adequate employees and premises for holding equitable interests or shares and, where it manages those equitable interests or shares, has adequate employees and premises for carrying out that management.
On the other hand, more stringent rules apply to high-risk intellectual property holding companies.
As to what is “adequate”, one has to wait for the details to be announced by each country. The Mauritius example mentioned in Tax Tips (18) would give some indications of what is to come.
Outsourcing of Core Income Generating Activities
The economic substance requirements generally allow for outsourcing of the core income generating activities to third-party within the jurisdiction. The Relevant Entity must, however, be able to prove that it is able to monitor and control the core income generating activities being carried out are conducted locally.
The below flowchart downloaded from the Jersey Government website is a good reference on how the laws work in general.
No-where Income
The Common Reporting Standard (CRS) and Economic Substance Laws are bringing tax residencies of companies and individuals into the limelight. Hong Kong businesses are faced with questions from their bankers that ask them to identify the tax residency of their Tax Haven companies which have bank accounts in Hong Kong. Thanks to creative tax planning advice Hong Kong businesses acted on in the past, many of them use the bank accounts in the following situations:
There is a group company in Mainland China manufacturing goods for domestic sales. Orders of overseas customers are accepted in China and are shipped out without export declaration. The overseas customers pay to the Hong Kong bank account of the group BVI company, and some of the cash received would be used to pay Hong Kong suppliers who provide the raw materials in China. These sales and purchases would not be booked by the manufacturer in China.
Services are provided in Hong Kong or China to overseas clients and they are asked to pay to the Hong Kong bank account of a BVI company. Income is booked in the BVI company while the costs of services are incurred in Hong Kong or China with tax deduction allowed unchallenged.
IPs such as brands, trademarks, designs, rights etc are owned by BVI companies and earning hefty royalty income from group companies or unrelated parties, while the work related to the development, exploitation, maintenance, protection and enhancement of the IPs are carried out in Hong Kong, and the costs of such activities have been fully tax-deducted.
In the above examples, there would be under-reporting of income as profits have been shifted to entities that do not carry out value-creation activities. Once the tax offices in Hong Kong or China have become aware of the situations (which has become more likely these days with all the reporting and information exchange arrangements), they may, for example, treat the BVI companies as carrying on business in Hong Kong or managed and controlled in China, as the case may be, and assess tax on the under-reported amount and impose heavy penalties. On the other hand, from now on the groups in question also need to maintain substance of these BVI companies in the BVI or they risk the companies being struck-off. Things will become more complicated if the shareholders of the companies become Chinese tax residents by spending 183 days or more in China in a calendar year.
Tax Tips
As mentioned in Tax Tips (1), “Base Erosion and Profit Shifting” (BEPS) refers to the tax planning strategy of multinational groups (big or small) making use of differences and mismatches of tax rules across different countries and artificially transferring profits to low or no-tax jurisdictions with little or no economic activity. The pressure now felt by taxpayers is indeed the intended effect of OECD’s project against BEPS. At the same time, the compliance costs of Tax Haven entities are rising. Taxpayers should take action to restructure their operations and shift profits back to where the activities are. There will be an increase in tax burden, but a managed transition would help minimise the tax costs and avoid heavy penalties: tax offices like to punish aggressive taxpayers with the highest penalties.
(This is an English translation of the Chinese article published in the Hong Kong Economic Journal Forum on 24 January 2019: https://manageyourtax.com/HKEJ Forum 19)
What would you do if every tax haven (e.g. BVI) company under your control is required by law to hire full-time qualified employees there and incur an adequate amount of operating expenditure to carry out the activities that they claim to be engaged in?
BEPS Action in action
In Tax Tips (13), the issue of tax residency of tax haven companies was discussed. Smart corporates will be able to ensure that the tax residencies of their tax haven entities are properly managed and thus would not create tax exposures. That does not necessarily mean that these companies can continue to book un-taxed profits with no substance. The BEPS machine is not stopping.
Last month, the OECD Inclusive Framework on BEPS: Action 5 issued a paper called “Resumption of Application of Substantial Activities Factor to No or Only Nominal Tax Jurisdictions” (the “Paper”), which sets out the substance requirements for tax havens. To the tax havens around the world, this Paper could be the last straw on the camel’s back (incidentally, tax havens such as the BVI, Cayman Islands etc are members of the Inclusive Framework).
Background
The OECD issued the report “Harmful Tax Competition: An Emerging Global Issue” in 1998 (“the 1998 Report”) setting out a framework for approaching the perceived problem that certain no or only nominal tax jurisdictions (i.e., tax havens) and harmful preferential tax regimes “affect the location of financial and other service activities, erode the tax bases of other countries, distort trade and investment patterns and undermine the fairness, neutrality and broad social acceptance of tax systems”. The 1998 Report called this “harmful tax practices,” and built a framework to assess these practices. The aim was to deliver a level playing field between jurisdictions in a context where taxpayers can easily relocate their mobile activities in response to tax considerations.
The framework for assessing whether a jurisdiction is a tax haven is based on four criteria:
(a) whether a jurisdiction imposes no or only nominal taxes;
(b) lack of effective exchange of information;
(c) lack of transparency and
(d) the absence of a requirement that the activity be substantial.
Notwithstanding, in 2001 the Forum on Harmful Tax Practice decided to only determine whether or not a jurisdiction was considered uncooperative on the basis of the first three criteria, and focused on making them cooperative and transparent.
With the implementation of BEPS Action 5 and the peer review process to ensure tax breaks are only offered to substantive activities and only if they do not pose risks of harmful competition to others, the focus is now shifted to ensure that business activity does not simply relocate to tax haven in order to avoid the substance requirements. Against this background, the Inclusive Framework has decided to apply the Substantial Activities Requirements for tax havens.
The Scope of the Substantial Activities Requirements
The types of activities that are within the scope of the Substantial Activities Requirements are geographically mobile activities such as the provision of intangibles (i.e., intellectual property (“IP”) related activities) and Non-IP activities which includes headquarters, distribution centres, service centres, financing, leasing, fund management, banking, insurance, shipping and holding companies.
What are the Substantial Activities Requirements
Non-IP-Related
For income from income not related to IP (“Non-IP Income), tax havens would be required to introduce laws to:
(i)define the core income generating activities for each relevant business sector;
(ii)ensure that the activities are undertaken by the entity (or are undertaken in the jurisdiction);
(iii)require the entity to have an adequate number of full-time employees with necessary qualifications and incurring an adequate amount of operating expenditures to undertake such activities; and
(iv)have a transparent mechanism to ensure compliance and provide an effective enforcement mechanism of the laws.
IP-Related
For income related to IP (“IP Income) derived from patents or similar assets, the core income generating activities would be the conducting of research and development activities with an adequate number of qualified full-time employees and adequate amount of operating expenditures. A similar requirement would apply where an entity is exploiting marketing IP assets such as trademarks, where the core income generating activities are branding, marketing, and distribution.
In other cases of IP Income, the entity would need to demonstrate that it is conducting strategic decision making, managing and bearing the principal risks relating to the development and subsequent exploitation of the IP asset, or carrying on the underlying trading activities through which the asset is exploited, with the adequate number of qualified full-time employees and an adequate amount of operating expenditures.
IP Income – Higher risk scenarios
Higher risk scenarios would be cases that involve related parties outside of the tax haven where (i) the entity has acquired the IP asset from related parties or through the entity funding research and development activities which took place outside the tax haven; and (ii) the IP asset is licensed or sold to related parties, or the exploitation is conducted by related parties outside the tax haven (e.g. foreign related parties are paid to develop and sell a product in which the intangible asset is embedded).
An entity in a higher risk scenario could meet the substantial activities requirements by providing evidence that there was, and historically has been, a high degree of control over the development, exploitation, maintenance, enhancement and protection (the DEMPE functions) of the intangible asset, exercised by an adequate number of full-time employees with the necessary qualifications that permanently reside and perform their activities in the tax haven. This would need to be demonstrated by providing additional information including:
detailed business plans which demonstrate the commercial rationale for holding the IP assets in the jurisdiction;
employee information, including the level of experience, type of contracts, qualifications, and duration of employment; and
evidence that decision making is taking place within the jurisdiction, rather than periodic decisions of non-resident board members.
Ensuring Compliance
To ensure compliance, tax havens would need to:
Set up a mechanism to collect various information from entities including details of the core income generating activities, the amount and type of gross income and expenses, the assets and premises held in the course of carrying out the business, and the number of full-time, qualified employees.
Set up a sanction mechanism that is rigorous, effective and dissuasive to take action in the event an entity failed to meet the substantial activities requirements. Sanction mechanism could include striking an entity off the register. The tax havens would also need to continue enforcement efforts and remedy any shortcomings in the enforcement process.
For any entities that do not comply with the substantial activities requirements, tax havens would be required to spontaneously exchange all relevant information with the jurisdictions of residence of the immediate parent, ultimate parent, and ultimate beneficial owner.
The effectiveness of the information collection and exchange mechanism is to be reviewed in 2022.
What about Holding Companies?
As discussed in Tax Tips (13), tax haven company is the ideal type of vehicle for investment holding, i.e. holding equity participations and earn only dividends and capital gains. Such companies are recognised in BEPS Action 5 that they may not require much substance in order to exercise their main activity of holding and managing equity participations, and therefore is less of a concern from BEPS’ perspective. The Substantial Activities Requirements on investment holding companies are that they respect all applicable corporate law filing requirements and have the substance necessary to engage in holding and managing equity participation (for example, by showing that they have both people and the premises necessary for these activities).
The Mauritius Example
Mauritius imposes nominal tax on companies with Category 1 Global Business Licence (“Cat 1 GBL”, commonly used as holding companies with access to the Mauritius tax treaty network). In the recent months, the Mauritius authorities issued new rules to bring about changes with effect from 1 January 2019. Under the new rules, Cat 1 GBL will be replaced by a new licence called Global Business Corporation (“GBC”) and the licensing conditions for GBC include, inter alia, carrying out of its core income generating activities at all times in, or from, Mauritius by:
Employing, either directly or indirectly, a reasonable number of suitably qualified persons to carry out the core activities; and
Having a minimum level of expenditure, which is proportionate to its level of activities.
In addition, the regulations provided the indicative core income generating activities and the minimum annual expenditure and employees (direct or indirect). For an investment holding GBC, the indicative minimum annual expenditure is USD12,000 and there is no minimum employee specified.
The Mauritius rules could be an example of what is forthcoming in other tax havens.
Tax Tips
Subject to the actual regulations to be introduced by the tax havens, the requirement that the entities in tax havens should maintain “an adequate number of qualified full-time employees and adequate amount of operating expenditures” and the threat of information exchange is likely sufficient to kill most tax haven entities earning IP or Non-IP Income (except for investment holding companies). Corporates that have not already restructured the activities to “normal tax jurisdictions” should speed up their review process and take action.
As to investment holding, which probably is a major business activity of most tax havens, corporates should follow the development closely and react to that accordingly. It is foreseeable that the OECD may accept more lenient substance requirements in order not to hurt the economies of the tax havens too significantly. The introduction of requirements on annual minimum expenditure even full-time employees will reduce the attractiveness of tax haven. As these are real additional costs of setting up investment holding companies, corporates should consider consolidating the group holding structures to eliminate duplicated costs, if not pulling out completely. The days of letterbox and brass plate companies appear to be limited.
(This is an English translation of the Chinese article published in the Hong Kong Economic Journal Forum on 10 December 2018: https://manageyourtax.com/HKEJ-Forum-18)
With the extensive media coverage in Hong Kong and elsewhere, Readers should already be well aware that the revised draft Detailed Implementation Rules of the Individual Income Tax (“IIT”) Law of China (“Draft DIR”) released by the Chinese Ministry of Finance and the State Administration of Taxation on 20 October 2018 for public consultation has provided a generous relaxation on the IIT for non-domicile tax resident (please refer our Tax Tips (14) for background).
According to Article 4 of the Draft DIR, IIT would be imposed on China-sourced income only, provided that the non-domicile resident individual does not stay in China for 183 Days for 5 consecutive years, or, in case the individual has spent 5 consecutive years, he has made a single trip outside of China for more than 30 days during the said 5 years. In other words, the “5 Year Rule” of the existing DIR has been retained with a large degree of relaxation in the Draft DIR, such that the fear that foreign individuals (including Hong Kong individuals) would be subject to IIT on worldwide income for spending 183 days in China has been swept away.
However, when one looks closer at the provisions, there is an important issue that foreign individuals should pay serious attention to.
You Become A Chinese Tax Resident by Spending 183 Days in China!
Under Article 1 of the new IIT Law effective 1 January 2019, a tax resident is defined to include a non-domiciled individual who resides in China for 183 days in a fiscal year (there is no tax resident concept in the existing IIT Law). Article 4 of the Draft DIR mentioned above applies to such an individual. Therefore, a foreign individual who does not have a domicile in China but resides in China for 183 days would still be regarded as a Chinese tax resident under the IIT Law, and, upon meeting the requirements under Article 4 of the Draft DIR, he can be exempt from IIT on foreign-sourced income. [Update] The Public Notice 2019 No.34 issued on 14 March 2019 has an impact here. Please refer toTax Tips (21) – No Tax Even if Stay in China for Over 183 Days?for details.
Accordingly, while the concern of IIT on worldwide income for foreign individuals has been eliminated, as they are regarded as Chinese tax residents, they will likely be considered tax resident of both their home jurisdiction and China. This dual-residency status creates two important issues:
1. Foreign Tax Credit Claim
The foreigner, as tax resident at his home jurisdiction, may be subject to home tax on the China-sourced income. In order to eliminate double taxation, the foreigner has to lodge a tax credit claim. However, unless domestic rules allow for other tax credit claim mechanisms, the tax credit shall be claimed on the basis of the relevant Double Tax Arrangement (“DTA”) signed with the Other Side for which the tax is suffered, which in this case is China.
For Hong Kong individuals, in the past, most would rely on the salaries tax income exclusion claim under Section 8(1A)(c) of the Hong Kong Inland Revenue Ordinance (“IRO”) to eliminate double taxation, instead of filing a tax credit claim. Unfortunately, the rule has just been changed. Claims under Section 8(1A)(c) of the IRO would no longer be accepted from 1 April 2018 (Year of Assessment 2018/19) onwards for Hong Kong taxpayers who have paid foreign tax of similar nature in other jurisdictions that have signed DTA with HK, which includes Mainland China. Instead, they have to claim relief of double taxation by tax credit under Section 50 of the IRO. Please note that Section 8(1A)(c) is still available in respect of tax suffered in jurisdictions that have not signed DTA with Hong Kong.
Technically, to claim a foreign tax credit under a DTA the individual shall be a tax resident of Hong Kong. If the individual is also a tax resident of Mainland China, the place of tax residency should first be established before a tax credit claim can be lodged in Hong Kong. How to determine the place of tax residency? According to Article 4(2) of the DTA between Hong Kong and Mainland China, when an individual is a resident of both Sides, his status shall be determined by the tie-breaker rules with reference to his “Permanent Home”, “Centre of Vital Interests” and “Habitual Abode”.
Details of the above tie-breaker rules have been discussed extensively in Tax Tips (14) so they will not be repeated here.
On the other hand, if a US tax resident is sent by his US employer to work in China for a period of time which exceeded 183 days in a year so that he has become a dual-resident for both the US and China, regardless of the dual-residency status, he would still be able to claim the foreign tax credit under the US domestic rules. The impact of dual-residency on double taxation for individuals from different home jurisdictions would therefore have to be determined on a case-by-case basis.
2. CRS Automatic Exchange of Information
If a foreign individual becomes a Chinese tax resident, he needs to be very careful in declaring his tax residency for anything related to the Common Reporting Standard (“CRS”). Under CRS, financial information of individuals will be automatically exchanged to the jurisdiction of the individual’s tax residency. As it may take time to confirm oneself as non-resident of China under the tie-breaker rules in the relevant DTA, individuals who do not want their information to be made available to Chinese tax authorities may want to avoid becoming Chinese tax residents, which could happen on 2 July 2019 the earliest, by leaving China, thereby potentially creating a talent drain.
What Can You Do?
Make your voice heard
Ideally, the Draft DIR should be amended such that individuals meeting the conditions under Article 4 of the Draft DIR would not be regarded as Chinese tax residents. They should file IIT as non-residents under Article 6(2) of the new IIT Law without the various new deductions available to resident individuals and at the same time, be entitled to the various IIT exemption on allowances currently available to foreigners for child education, language training, housing, meals, laundry, home visits, removal and deduction on Mainland social security contributions. This way, the transition to the new IIT Law would be stable and the stated policy objective of attracting foreign talents would be achieved.
If Article 4 of Draft DIR remains unchanged in the final version, in order to avoid the foreign tax credit and CRS issues mentioned above, many foreign individuals working in China will need to prepare for the determination of tax resident status as soon as reaching 183 days of stay. As mentioned in Tax Tips (14), it is likely that the Chinese tax offices have handled very few cases of resident determination in the past and when such cases begin to surface next year, the volume and technicality of the cases could be very challenging for the Chinese tax officers. The competent authorities may need to be involved too. One possible way of reducing the magnitude of the problem is to amend the DTA between Hong Kong and China to make it easier for Hong Kong individuals to be recognised as Hong Kong tax residents.
The other option is, of course, avoid residing in China for 183 days each year.
[Update on 23 Dec 2018] The new IIT DIR has been released. There is no change to the rules regarding tax residency so the concerns expressed above have, unfortunately, become real.
Tax Tips
Companies and individuals are recommended to closely follow the development of the Draft DIR in order to ensure that human resources issues are managed well and the employees’ concerns are addressed. For Hong Kong individuals who ordinarily reside in Hong Kong, they should consider applying for the Certificate of Resident Status with the Hong Kong Inland Revenue Department as supporting of tax resident status. Affected individual and companies should talk to knowledgeable tax consultants as soon as possible for advice on managing tax exposure.
The Author would like to thank US Individual Tax expert Ms. Virginia La Torre Jeker J.D. for her comments on the US tax implications in the example mentioned in this article. Please visit https://us-tax.org/ for more information about Virginia.
(This is an English translation of the Chinese article published in the Hong Kong Economic Journal Forum on 5 November 2018: https://manageyourtax.com/HKEJ Forum 17)
Many people may have forgotten about the “Summit on New Directions for Taxation” held in October last year. In his speech for the event, the Financial Secretary Mr. Paul Chan said that “the most important aspect of today’s Summit is the discussion on how taxation (policy) can play a role in the economic development (of Hong Kong) in multiple directions”, and praised that “our tax system is simple, provides certainty, and it is implemented consistently”. The Financial Secretary also mentioned that the Tax Policy Unit set up in April 2017 is working at full speed, demonstrating the determination of the Government to actively pursue economic growth and development of industries through tax policies.
The Government has indeed done a lot of work on taxation in the past year. Some are for the implementation of the BEPS Minimum Standard (such as the transfer pricing regulations), and some relate to the expansion of industries, such as the super-deduction on research and development expenditure. This issue of Tax Tips discusses Section 15F Sums derived from intellectual property by non-Hong Kong resident associates (“15F”) of the Inland Revenue Ordinance (“IRO”) hidden in the transfer pricing regulations under Inland Revenue (Amendment) (No. 6) Ordinance 2018. 15F was passed by the Legislative Council and is effective from 1 April 2019 onwards.
What Does 15F Say
In simple terms, when a person (say a Hong Kong company, “HK Co”) performs any of the development, enhancement, maintenance, protection or exploitation (collectively as “DEMPE”) activities in Hong Kong for any intellectual property (“IP”), that person would be regarded as having contributed to the value creation of the IP. If a non-Hong Kong associated person (say “X Co”) receives a sum for the exhibition, use or imparting of the IP or the rights of the IP inside or outside Hong Kong, a sum associated with value contributed by HK Co (the “relevant sum”), if not already subject to Hong Kong profits tax, would be deemed as Hong Kong sourced income of HK Co and subject to profits tax.
The original text of 15F* can be found here for Reader’s easy reference.
According to 15F, no matter HK Co is the owner of the IP or not, provided that HK Co has performed any of the DEMPE activities for an IP to contribute value to it, including carrying out the relevant functions, providing assets, or taking up the relevant risks, and the offshore associate (X Co) receives “a sum” from the IP and has not paid any Hong Kong profits tax on any part of the sum, 15F empowers the Hong Kong Inland Revenue Department (“IRD”) to deem the relevant sum as income of HK Co and taxed accordingly.
Readers may already have questions in mind about 15F, some of which may be covered below:
What is the meaning of “a sum”? Is it restricted to mean an identifiable sum received by X Co for the use of the IP? If the IP is a brand, and X Co uses the brand to sell goods, is the sales revenue “a sum”?
Would DEMPE activities performed by HK Co before 1 April 2019 be included in the analysis?
How would the IRD determine the “relevant sum” if the IP is used by various subsidiaries or joint ventures of X Co in different countries, and HK Co is unable to obtain the detailed information of the income of these companies? Even if HK Co is able to provide the information, how would the IRD assess the value contributed by these companies in order to accurately calculate the “relevant sum”?
Under the IRO, is HK Co legally bound to provide information of X Co and the various subsidiaries or joint ventures in different countries to prove whether these companies have each received “a sum” and the amounts?
If HK Co is the owner of the IP and transferred the IP to X Co at an arm’s length price, why would HK Co not be exempt from 15F?
Income of X Co and the various subsidiaries or joint ventures in different countries derived from the IP may have been subject to tax in the relevant countries; if part or all of the income is deemed to be taxable income of HK Co and subject to Hong Kong profits tax, the issue of double taxation would arise. As the double taxation is not arising from a transaction between two jurisdictions but it stems only from the deeming provisions of the IRO, the issue cannot be resolved on a bilateral basis even if Hong Kong and the other side(s) has a Double Tax Arrangement (“DTA”) signed. How would the IRD deal with this issue? Would HK Co be required to provide evidence of tax payment by the various offshore companies in order to avoid an assessment under 15F?
How would the statutory auditors ascertain the tax provision of the X Co Group (including HK Co, all together referred to as “X Group”)? If there is a multinational group interested to acquire X Group, how would the buyer assess the tax exposure of X Group under 15F?
The above may only be some of the questions created by 15F.
Facebook’s Data Centre
Last month, Facebook announced that it will invest US$1 billion to build its 15th data centre, the first in Asia, in Singapore. Tax consideration is not mentioned in the media reports covering this news. It can be imagined that some kind of DEMPE activities must be carried out in the data centre, creating certain IP to be used in different parts of the world. If Facebook were to select Hong Kong as the location for the data centre, would they be worried about the threat of 15F?
Would multinational groups or other tech giants be scared away from Hong Kong because of 15F when they select the location to invest in Asia to carry out DEMPE activities related to IP? It is entirely possible that multinational groups, in any industry, may choose to avoid Hong Kong because of tax risks and uncertainties created by 15F!
Voice Against 15F
When the Inland Revenue (Amendment) (No. 6) Bill 2017 (“the Bill”) was gazetted last year, many professional organisations made submissions to the Bills Committee voicing out concerns on 15F, some even requested that 15F be removed. The Government responded that there are companies that transfer legal ownership of IPs to associates in low-tax jurisdictions where no DEMPE activities are performed but earn the IP income. In order to align taxation with value-creation, which is the objective of BEPS, the Government is introducing 15F to combat such profits shifting activities. The Government claimed that DTA partners are adopting a similar approach to transfer pricing, and genuine commercial transactions would not be affected.
Lastly, in order to pass the Bill (and 15F), the Government has said that various issues will be clarified in a Departmental Interpretation and Practice Notes (“DIPN”) to be issued, and deferred the commencement date of 15F to 1 April 2019 to allow more lead time to taxpayers.
Tax Tips
The scope of 15F is very wide and it is not a specific anti-avoidance provision. 15F would apply even if the taxpayer is not engaged in any tax avoidance. Under the shadow of 15F, the statement that “our tax system is simple, provides certainty, and it is implemented consistently” would no longer be true. 15F discourages companies to conduct IP-related activities in Hong Kong, which is in direct contradiction to the Government policy of encouraging research and development activities in Hong Kong.
If the law is flawed, DIPN would not make it flawless. Therefore, the best approach to 15F is to ask the Government to repeal it or amend it substantially such that it only applies in limited circumstances. The Author would raise the demand through the appropriate professional organisation. In the meantime, Readers may also raise the issue via appropriate means.
If the Government refuses to amend 15F, the only way to eliminate tax risk is not to carry out any DEMPE activities in Hong Kong, which is basically an impossible task. Companies should thus wait for the DIPN before deciding the action to take.
(This is an English translation of the Chinese article published in the Hong Kong Economic Journal Forum on 9 October 2018: https://manageyourtax.com/HKEJ Forum 16)
The Amendments to the Individual Income Tax Law of the People’s Republic of China (“the Amendments”) discussed in the last issue of Tax Tips was promulgated by the National People’s Congress on 31 August. Included in the Amendment, as expected, is the adaptation of the tax resident person concept into Article 1 of the law.
Around one week before the Amendments were passed, the topic of Hong Kong people who enters the Mainland for more than 183 days will be subject to Individual Income Tax (“IIT”) liabilities of up to 45% on income earned outside of the Mainland started to heat up in the Hong Kong media.
On 31 August, according to Hong Kong media reports, Mr. Tam Yiu-Chung, member of the Standing Committee of the National People’s Congress, claimed that Hong Kong and Macau residents would have a five-year grace period, such that they would only need to pay IIT on income earned outside of the Mainland after the year 2024.
The introduction of tax residency concept would indeed have a huge impact on Hong Kong and Macau residents due to their close ties with Mainland China. It can be imagined that for residents from countries such as Japan, the United Kingdom and the United States who visit China for 183 days or more, as they would unlikely buy properties in China, they would likely maintain their home and economic ties in their home countries, and their home tax authorities would have much experience in tax residency determination, their tax residency status should be relatively clear-cut. If what Mr. Tam said is implemented, Hong Kong people can put the issue aside for the next five years.
A potential big loser to the Amendments is Taiwanese individuals. The Mainland and Taiwan signed the Cross-Strait Agreement for the Avoidance of Double Taxation and Strengthening of Tax Cooperation in 2015 (contents are similar to a standard double taxation agreement) but the Agreement is not yet in effect. In 2019 when Taiwan individuals become Mainland tax residents by staying in the Mainland for 183 days, they may need to pay IIT on income derived from inside and outside of the Mainland. If the individuals are also subject to Taiwan income tax on the same income, a double taxation situation will arise which cannot be resolved through a double taxation agreement (the tie-breaker discussed in the last Tax Tips). Nevertheless, as tax policies are designed to serve the economic and political needs, it is possible that the five-year grace period may include Taiwan individuals. At this moment, the only thing that can be done is wait-and-see.
Originally, this issue of Tax Tips would discuss how should Hong Kong companies manage the upcoming challenge in IIT. However, as the issue may be put to bed for 5 years, Hong Kong companies may not be interested in it anymore. Readers should watch the development closely in the coming months. This issue would instead discuss the so-called “183 Days Rule”, which has been given a new meaning by the Amendments: Is it true that there is no IIT liability if one stays in the Mainland for not more than 183 days?
The 183 Days Rule
Many Hong Kong people who frequently travel to the Mainland would have heard that IIT would be imposed if one stays in the Mainland for more than 183 days. Is it true? When one reads Article 1 of the IIT Law, whether the existing one or the amended version, it is clear that a non-domicile person who resides in China for less than 183 days are required to pay IIT on income derived from sources within China:
Current version: “Individuals who are neither domiciled nor resident in China, or who are not domiciled and reside for less than one year in China, shall pay individual income tax in accordance with this Law on income derived from sources within China.”
Amended version: “Individuals who are neither domiciled nor resident in China, or who are not domiciled and reside in China for less than 183 days in a tax year, are non-resident individuals. Non-resident individuals shall pay individual income tax in accordance with this Law on income derived from sources within China”.
So, is one liable to IIT if one stays in China for not more than 183 days?
The exemption from IIT for individuals who visit China for not more than 183 days is an effective extension of Article 7 of the Detailed Implementation Rules of the IIT Law (“DIR”, which is also subject to corresponding amendments to be announced). Under Article 7 of the DIR, “Individuals who are not domiciled in China, but stay in China continuously or in aggregate for not more than 90 days in a tax year, would be exemption from IIT on income derived from sources within China that is paid by the foreign employer and is not borne by a place or establishment of the foreign employer located in China”. In principle, when an employee enters China and performs services, the income would be regarded as derived from sources within China. Provided that the employee does not stay in China for more than 90 days in a tax year (continuously or in aggregate), and the income is paid by the foreign employer which is not borne by any place or establishment of the foreign employer, no IIT would be imposed. Under Article 14 <Income from Employment> of the Mainland-Hong Kong Double Taxation Arrangement (“CN-HK DTA”), the period of stay is extended from 90 days to 183 days; the relevant provisions in Para 1 and 2 are as follows:
“1. Subject to the provisions of Articles 15 [Director’s Fees], 17 [Pensions], 18 [Government Service], 19 [Students] and 20 [Other Income], salaries, wages and other similar remuneration derived by a resident of One Side in respect of an employment shall be taxable only in that Side unless the employment is exercised in the Other Side. If the employment is exercised in the Other Side, such remuneration as is derived therefrom may be taxed in that Other Side.
2. Notwithstanding the provisions of paragraph 1 of this Article, remuneration derived by a resident of One Side in respect of an employment exercised in the Other Side shall be taxable only in that One Side if all the following 3 conditions are satisfied: (1) the recipient is present in the Other Side for a period or periods not exceeding in the aggregate 183 days in any 12-month period commencing or ending in the taxable period concerned; (2) the remuneration is paid by, or on behalf of, an employer who is not a resident of the Other Side; (3) the remuneration is not borne by a permanent establishment which the employer has in the Other Side.”
The most important point is that all 3 conditions in Para 2 shall be satisfied in order to enjoy the 183 days exemption, otherwise the individual may fall into Article 1 of the IIT Law and liable to IIT on income derived from sources in China. Although the rules have been in existence for a long time, many people are still unaware of Condition 2 and 3, and they believe that simply avoid staying in China for over 183 days would be good enough to get away from IIT (and they may not even know how the days are counted).
How to Count 183 Days
The first important point is how to calculate 183 days. “Any 12-month period commencing or ending in the taxable period concerned” denotes two concepts, namely, that the number of days of presence may straddle over 2 years, i.e. the days of presence can be calculated continuously or in the aggregate irrespective of the year; and that a floating calculation method may be adopted. The 12-month period can commence or end at any day within the taxable period concerned. In counting the actual number of days, one should include all days spent in the Mainland, including days that are not the full day such as the day of arrival and day of departure, as well as weekends, holidays, and vacation etc spent in the Mainland before, during and after the employment.
Some may think that Condition 2 “the remuneration is paid by, or on behalf of, an employer who is not a resident of the Other Side” is easy to satisfy, by simply having the Hong Kong employer bears all the employment costs without charge-back to the Mainland entity that the employee works in. It is not that simple. The “employer” is the party who owns the work product of, is responsible for, bears the risk of, and assess the performance of the individual. If the Mainland entity owns the work product of the individual, is responsible for his well-being, bears the risk of his acts, and assess his performance, the tax authority would regard the Mainland entity to be the real employer, and the income of the individual would be subject to IIT on the part performed in the Mainland.
The tax authority would consider the following factors in assessing the employer-in-substance:
(1) Does the Mainland entity direct the work of the individual;
(2) Does the Mainland entity determine and is it responsible for the working location of the individual;
(3) Does the Mainland entity provide the tools and materials to the individual in performing his duties;
(4) Does the Mainland entity determine the quantity and requirement of the position?
The above are common factors considered in determining if the master-servant relationship exists. Hong Kong entities sending employees to the Mainland should pay attention to such details and ensure there is documentary evidence to support the master-servant relationship. Mainland tax authorities will take the substance-over-form approach in assessing the identity of the real employer.
Permanent Establishment
Condition 3 is related to Permanent Establishment (“PE”) which is a relatively complex area. Some basic understanding of what constitutes a PE is required.
When an employee is sent to work in China at a place or establishment that is relatively fixed and lasting, that place or establishment could be regarded as a PE. Conceptually it is like an unregistered branch of a foreign entity. If the employer is a Hong Kong entity, the CN-HK DTA shall be referred to in determining whether a PE exists.
According to Article 5 of the CN-HK DTA, the term “PE” means a fixed place of business through which the business of an enterprise is wholly or partly carried on, including a place of management, a branch, an office, a factory, a workshop, a mine, an oil or gas well, a quarry or any other place of extraction of natural resources, as well as:
(1) a building site, a construction, assembly or installation project or supervisory activities in connection therewith, but only if such site, project or activities last more than 6 months;
(2) the furnishing of services, including consultancy services, by an enterprise of One Side in the Other Side, directly or through employees or other personnel engaged by the enterprise, but only if such activities continue (for the same or a connected project) for a period or periods aggregating more than 183 days [NB] within any 12-month period.
Many people can understand sub-paragraph (1) above but not sub-paragraph (2).
When a Hong Kong entity sends employees to a fixed location in the Mainland to work in a project or connected project within any 12-month period, and from the first day of arrival to the project completion day the period of stay (continuously or in aggregate) exceeds 183 days, the fixed location is a PE of the Hong Kong entity unless exemption under CN-HK DTA applies. The number of days is counted based on all employees of the entity who work in the Mainland at different times for the same project, and each day is only counted once when more than one employee is present at the same time. For example, if a Hong Kong entity (Company A) sends 10 employees to work for the same project at the same time for 3 days, the aggregate days in China is 3 days and not 30 days. However, if another Hong Kong entity (Company B) sends 1 employee to work for a project in the Mainland for 100 consecutive days, and then sends another employee to the Mainland for the same project soon afterwards, PE would be created when the second employee stays more than 83 days, creating Corporate Income Tax liability for Company B.
Condition 3 of Article 14 Para 2 requires that the employee remuneration is not borne by a PE or fixed place of the employer located in the Mainland. If a Hong Kong individual is sent to perform services at a PE of the employer in the Mainland, or the employees themselves have created a PE of the employer through the carrying out of a project or contracted work, their remuneration is deemed to be borne by the PE no matter the length of time of their services and where the remuneration is actually paid. This rule, however, does not apply to individuals who visit the PE for inspection, review or provide temporary assistance for the head office.
In the above example, the two employees of Company B are both liable to IIT even though each of them stays in the Mainland for not more than 183 days.
Lastly, if one of the employees of Company B stayed in the Mainland for more than 183 days, would he be considered a Mainland tax resident and subject to IIT on his worldwide income (assuming that there is no five-year grace period)? What information is needed to make the determination? The answer is for the Readers to work out.
Tax Tips
183 days can be the difference between paying or not paying IIT, or the triggering point from paying IIT on China sourced income to worldwide income, and each situation has to be studied on a case-by-case basis to determine how should the rules be applied. The different ways of counting 183 days (less than or not more than 183 days, and over which period) for different purposes can often create confusion. From experience, many Hong Kong enterprises are not aware of the issue, and some of them even print the Mainland address on the name cards of the Hong Kong employees, which becomes a useful clue to the tax authority and create tax risks. Enterprises facing such issues should review the operating structure and staff secondment arrangement to manage their tax exposure.
(This is an English translation of the Chinese article published in the Hong Kong Economic Journal Forum on 10 September 2018: https://manageyourtax.com/HKEJ Forum 15)
The month-long public consultation of the Draft Amendments to the Individual Income Tax Law of the People’s Republic of China ended on 28 July 2018. According to the website of the National People’s Congress (“NPC”, www.npc.gov.cn), more than 67,000 people have submitted over 130,000 comments on the Draft Amendments. Through the increase of standard deduction, widening the lower tax bands and introducing specific deductible items, the Individual Income Tax (“IIT”) burden on individuals is expected to reduce. The NPC website reported that the IIT payable by an individual making RMB10,000 a month drop by 74%.
However, if the Draft Amendments are passed as they are, starting next year, when a foreign individual resides in China for 183 days or more in a year, his foreign earnings may be subject to IIT. This is particularly worrying for Hong Kong individuals, many of them work for Multinational Enterprises based in Hong Kong, who travel to the Mainland frequently to carry out their employment duties.
The last issue of Tax Tips was about tax residency of companies. Thanks to the timely introduction of tax residency into the IIT Law, this issue of Tax Tips discusses tax residency of individuals, which will have a profound impact on Hong Kong businesses and individuals.
The Current Rules
Article 1 of the current IIT Law reads as follows:
“Individual income tax shall be levied in accordance with the provisions of this Law by individuals who have a domicile in China, or though without domicile but have resided for one year in China on their income derived from sources within and outside China.
Individuals who are neither domiciled nor resident in China, or who are not domiciled and reside for less than one year in China, shall pay individual income tax in accordance with this Law on income derived from sources within China.”
What is domicile, not domicile, reside for one year or less than one year? According to the Detailed Implementation Rules of the IIT Law (“DIR”, which is also subject to corresponding amendments to be announced), the term “individuals who have domicile in China” means individuals who by reason of their permanent registered address (HuJi), family or economic interests, habitually reside in China. The DIR did not define what is “not domiciled in China” but generally it refers to individuals who do not fall into the definition of domicile in China. In practice, as long as the individual does not possess HuJi in China, that person would be a Foreigner and regarded as not domiciled in China.
The term “resided for one year in China” means to have resided within China for 365 days in a tax year. That does not mean that only those who live in China every day in a tax year would become what is commonly referred to as “One Year Taxpayer”. According to the DIR, no deduction of days would be considered for “temporary departure”, which is defined as absence from China for not more than 30 days in a single trip, or not more than a cumulative total of 90 days over a number of trips, within the same tax year. In other words, in order to avoid being considered a One Year Taxpayer and pay IIT on income sourced in and outside China (i.e. worldwide income), the individual shall either travel outside of China for more than 30 days in a single trip, or more than 90 days cumulatively, in a tax year. As long as the individual is not domiciled in China and is not a One Year Taxpayer, only income sourced in China is subject to IIT.
Having said the above, many Foreigners who station in China with temporary departures are not paying IIT on their worldwide income. This is because Article 6 of the DIR provides that: for individual not domiciled in China and resides in China for more than one year and less than five years, subject to the approval of the tax authorities-in-charge, IIT may be paid on only that part of income which was paid by companies, enterprises or other economic organisations or individuals in China. Individuals who reside for more than five years shall, commencing from the sixth year, pay IIT on the whole amount of income derived from sources outside China.
The effect of this Article is that Foreigners would only be subject to IIT on worldwide income on the sixth year if they become One Year Taxpayer for five consecutive years. Therefore, many Foreigners who have stationed in China for four years would, on the fifth year, make a single trip out of China for more than 30 days, or spend more than 90 days cumulatively outside of China, in order to restart the five-year-count. As such, it should be very rare that any Foreigners would be paying IIT on their worldwide income.
The Draft Amendments
The concept of tax resident has been introduced by the Draft Amendments to replace One Year Taxpayer. Article 1 of the IIT Law will be replaced by:
“Individuals who have a domicile in China, or though without domicile but have resided in China for 183 days or more in a tax year, shall be a resident individual and subject to individual income tax in accordance with the provisions of this Law on their income derived from sources within and outside China.
Individuals who are neither domiciled nor resident in China, or who are not domiciled and reside in China for less than 183 days in a tax year, shall be regarded as a non-resident person, and pay individual income tax in accordance with this Law on income derived from sources within China.”
If the above is passed into law, assuming that the definition of “domicile in China” is unchanged, Foreigners (including Hong Kong individuals) would be regarded as Chinese tax residents by residing in China for 183 days in a tax year, and their worldwide income would be subject to IIT. As a result, Foreigners may easily become dual-residents – resident of both their home jurisdiction and China. Unless the to-be-amended DIR contains provisions relaxing the requirements (similar to the provision in Article 6 discussed above), the period of stay required for IIT to be imposed on worldwide income shall be reduced from five years to 183 days!
It is understood that the Draft Amendments will be passed in August this year, and the revised IIT Law will be effective 1 January 2019. From 1 October 2018 to 31 December 2018, IIT on salaries and wages may be calculated by applying the new monthly standard deduction of RMB5,000 and the new tax rates (for consolidated income), without deducting the additional deduction (previously available to Foreigners).
What kind of Foreign Income is subject to IIT?
All income items covered under the IIT Law shall be subject to IIT at the applicable new rates, as follow:
Consolidated income (salaries and wages, labour services, author’s remuneration, royalties) at progressive rates from 3% to 45%;
Business income at progressive rates from 5% to 35%;
Interest, dividend, gains, property leasing income, property transfer income, occasional income and other income at a rate of 20%.
That is to say, if a Hong Kong individual becomes a Mainland tax resident, the above kinds of income earned in Hong Kong, including the potentially substantial amount of income from property transfer, could be subject to IIT. The Mainland tax authorities would have the taxing right even on income that is subject to Hong Kong tax, such as property rental income.
OMG, what should I do?
Before knowing how the DIR is to be amended, taking action now would seem immature. Notwithstanding, there is no harm in thinking possible solutions.
The simplest solution is to avoid staying in China for 183 days or more. That would not be easy for Hong Kong people who need to daily commute to nearby Chinese cities, and it may be harder in the future under the Greater Bay Area Initiative being promoted by the Hong Kong and Mainland governments.
A more complex and troublesome way is to re-allocate foreign assets and earnings so that the income generated would not be considered the income of the Foreigner. This is a somewhat palliative measure that should be considered only as the last resort.
A better solution is to dig deeper into the tax rules to find the way out.
Definition of “Resident” in Double Tax Agreement
Whenever tax issues between two tax jurisdictions arise, the Double Tax Agreement/Arrangement (“DTA”), if available, should be consulted. For Hong Kong individuals, the DTA between Hong Kong and the Mainland (“HK-CN DTA”) would be relevant. According to Article 4 – Resident of the HK-CN DTA, the term “resident of One Side” (for the part relating to individuals) means:
“(1) in the case of the Mainland of China, any person who, under the laws of the Mainland of China, is liable to tax therein by reason of his domicile, residence … or any other criterion of a similar nature. This term, however, does not include any person who is liable to tax in the Mainland of China in respect only of income from sources in the Mainland of China;
(2) in the case of the Hong Kong Special Administrative Region:
(i)an individual who ordinarily resides in the Hong Kong Special Administrative Region; (ii)an individual who stays in the Hong Kong Special Administrative Region for more than 180 days during a year of assessment or for more than 300 days in 2 consecutive years of assessment one of which is the relevant year of assessment…”
In case an individual who ordinarily resides in Hong Kong becomes a Mainland tax resident under the new IIT Law, he would be regarded as a resident by both Sides. Not a situation that anyone would like to be in.
How to Decide Which Side the Individual a Resident of
It is not uncommon for a tax jurisdiction to treat a Foreigner a tax resident if he resides 183 days or more in that jurisdiction. The proposed amendment to Article 1 of the IIT Law is an alignment with the international norm. From the perspective of China, such an amendment is reasonable and perhaps long overdue. Since such a change practically has no impact to local Chinese nationals, it is likely that very few of the 130,000+ comments on the Draft Amendments would argue against the change. Therefore, it is expected that Article 1 will be amended as proposed.
As it is the international norm, it should be common for two Sides to dispute on the tax residency of an individual from one Side residing in the other Side. One of the main purposes of the DTA is to prevent double taxation and thus such disputes can be resolved by the DTA. Most, if not all, of the DTAs would contain rules to settle residency issue, which can be a direct negotiation between the competent authorities of the two Sides, or they go through the tie-breaker rules contained in the DTA first and only resolve by mutual agreement when the case goes into a deadlock. According to Article 4(2) of the HK-CN DTA, when an individual is a resident of both Sides, his status shall be determined by these tie-breaker rules:
(1) he shall be deemed to be a resident only of the Side in which he has a permanent home available to him; if he has a permanent home available to him in both Sides, he shall be deemed to be a resident only of the Side with which his personal and economic relations are closer (“centre of vital interests”);
(2) if the Side in which he has his centre of vital interests cannot be determined, or if he does not have a permanent home available to him in either Side, he shall be deemed to be a resident only of the Side in which he has an habitual abode;
(3) if he has an habitual abode in both Sides or in neither of them, the competent authorities of both Sides shall resolve by mutual agreement.
There are three technical terms here: “Permanent Home”, “Centre of Vital Interests” and “Habitual Abode”. Returning readers of Tax Tips would know that elaboration of these terms may be found in the Commentaries to the OECD Model Tax Convention on Income and on Capital: Condensed Version 2017 (“the 2017 Model Tax Convention”), as extracted below:
Permanent Home
The residence is that place where the individual owns or possesses a permanent home, meaning that the individual must have arranged and retained it for his permanent use as opposed to staying at a particular place that is intended to be of short duration (travel for pleasure, business travel etc).
Home can be a house or apartment belonging to or rented by the individual, but the permanence of the home is essential; this means the individual has arranged to have the dwelling available to him at all times continuously. A house owned by an individual cannot be considered to be available to that individual during a period when the house has been rented out and effectively handed over to an unrelated party so that the individual no longer has the possession of the house and the possibility to stay there.
Centre of Vital Interests
If the individual has a permanent home in both Sides, it is necessary to look at the facts in order to ascertain with which of the two Sides his personal and economic relations are closer. Regards will be had to his family and social relations, his occupations, his political, cultural or other activities, his place of business, the place from which he administers his property etc. The circumstances must be examined as a whole, but it is nevertheless obvious that considerations based on the person acts of the individual must receive special attention. If a person who has a home in one Side sets up a second in the other Side while retaining the first, the fact that he retains the first in the environment where he has always lived, where he has worked, and where he has his family and possessions, can, together with other elements, go to demonstrate that he has retained his centre of vital interests in the first Side.
Habitual Abode
It requires a determination of whether the individual lived habitually, in the sense of being customarily or usually present, in one of the two Sides but not in the other during a given period. It is a notion that refers to the frequency, duration and regularity of stays that are part of the settled routine of an individual’s life and are therefore more than transient. The length of time to look at in determining where an individual habitually abodes should be sufficiently long, and the relevant period of time will not always correspond to the period of dual-residence.
Other than the 2017 Model Tax Convention Commentaries, readers may also refer to the “Interpretation of the DTA between the People’s Republic of China and Singapore and the Protocol” issued by the State Administration of Taxation of China under Circular GuoShuiHan (2010) 75. The interpretation contained therein would also be applicable to other DTAs signed by China and other jurisdictions where the provisions are identical. The interpretations adopted are basically a simplified version of the 2017 Model Tax Convention Commentaries.
The Practice
It is good to have rules set out in the DTA to help determine which Side the tax residency of an individual belongs to. However, what happens in practice? This is the key problem. The current IIT Law does not determine the chargeability to IIT based on residency, and a Foreigner would only be subject to IIT on worldwide income when he resides in China for five consecutive years which is a position that can be easily avoided. Therefore, it is likely that the Chinese tax offices have handled very few cases of resident determination. When such cases begin to surface next year, numerous Foreigners would face a substantial increase in IIT if the tax officers do not have a good understanding of how to determine tax residency. As employers are unlikely willing to bear the additional IIT exposure, many employees especially Hong Kong people may refuse to work in the Mainland.
Tax Tips
IIT affects the well-being of every individual and deserves high attention. The above discussions should be helpful to readers in planning ahead of the changes. Companies are recommended to closely follow the development of the Draft Amendments and the upcoming changes to the DIR in order to ensure that human resources issues are managed well and the employees’ concerns are addressed. For Hong Kong individuals who ordinarily reside in Hong Kong, they should consider applying for the Certificate of Resident Status with the Hong Kong Inland Revenue Department as supporting of tax residency. Affected individual and companies should talk to knowledgeable tax consultants, such as us, as soon as possible for advice on managing the tax exposure.
(This is an English translation of the Chinese article published in the Hong Kong Economic Journal Forum on 8 August 2018: https://manageyourtax.com/HKEJ Forum 14)
Anyone who had the experience of managing the CbCR filing for a reportable MNE Group for years 2016 and 2017 would know how much headache it is to ensure compliance.
