Hong Kong was recently added to the EU’s gray list of non-cooperative tax jurisdictions over concerns the city allows “double non-taxation”.‘ passive income. In response, the Hong Kong government reiterated its commitment to make the necessary changes to its tax laws to comply with EU standards, a move that may have limited impact on some foreign companies in Hong Kong.
Hong Kong was added to the so-called “gray list” of non-cooperative tax jurisdictions in the EU in the latest edition of its regularly updated watchlist, published on October 5, 2021.
The document entitled Council conclusions on the revised EU list of non-cooperative countries and territories for tax purposes lists Hong Kong in Annex II, which lists “jurisdictions that do not yet comply with all international tax standards but have committed to reform”.
Hong Kong was included due to “the existence of harmful tax regimes” in the city. The document also states that Hong Kong, as well as the other countries and regions on the gray list, is “committed to modify or abolish [its] detrimental foreign-source income exemption regimes ”. Countries and regions on the gray list have until December 31, 2022 to update their legislation.
Hong Kong was previously on the watch list in 2017 and 2018, but was subsequently deleted in 2019 after making the necessary changes to its laws to improve its tax environment and increase financial transparency.
Hong Kong will have the option of being removed in future amendments to the list – the next amendment is expected to be released in February 2022 – by updating its legislation to meet EU standards.
If Hong Kong does not update its legislation by the deadline of December 31, 2022, it will be moved to the blacklist or Annex I. Blacklisted countries and regions are subject to a number of defensive measures. from the EU. This could lead to denial of outgoing payment deductions, being subject to Controlled Foreign Company (CFC) rules (which prevent companies from shifting profits to offshore structures), increased withholding taxes and increased audits. of taxpayers in the blacklisted region.
Why was Hong Kong added to the list?
Hong Kong currently does not levy any taxes on capital gains, interest or dividends, which are considered “passive income”. This rule is part of what makes the city an attractive base for foreign companies wishing to expand into regional markets, as it allows them to reduce their corporate tax (CIT) obligations by channeling profits and income generated from sources such as royalties or interest. in other markets via Hong Kong.
Hong Kong also does not levy tax on profits or income generated abroad. This is called the “principle of territorial source of taxation”. While this activity is not technically illegal, it runs counter to international efforts to curb the “race to the bottom” in which different regions and countries of the world compete to attract business by lowering tax obligations.
However, the inclusion of Hong Kong on the gray list this time does not take into account the exemption from corporate tax of active income generated abroad. Instead, it focuses on the issue of the taxation of passive income.
The EU included Hong Kong in the latest list over fears that the city would allow “double non-taxation” of passive income, with companies being exempt from tax on income from passive offshore sources both in the country or region where it is generated and Hong Kong, where the company is registered and reports profits.
How will Hong Kong’s tax laws change?
In a press release issued the same day the list was published, the Hong Kong government said it “agrees to cooperate with the EU and has made a commitment to it to amend the Inland Revenue Ordinance (chapter 112 of the laws of Hong Kong) by the end. 2022 and implement the relevant measures in 2023 ”. The Inland Revenue Ordinance is Hong Kong’s primary tax law.
According to Guidance on foreign source income exemption regimes published by the EU in 2019, which explains the tax law changes required for a country or region to be removed from the list, jurisdictions must either:
a) introduce the taxation of passive income; Where
b) if they exclude certain types of passive income from tax:
- implement adequate substantive requirements for the entities concerned, in accordance with the EU Code of Conduct (Business Taxation);
- have strong anti-abuse rules in place; and
- remove any administrative discretion in determining the income to be excluded from tax.
The changes to the tax law will therefore focus on those aspects that allow companies with no significant economic activity in Hong Kong to avoid paying tax on passive income by diverting it through Hong Kong, in accordance with the requirements. above.
Impact on foreign companies
The Hong Kong government has made it clear that changes to the Inland Revenue Ordinance will be limited to businesses that have little or no economic activity in Hong Kong, but report passive income in the city. The government also stressed that the changes will not affect individuals or businesses in Hong Kong.
Changes to passive income tax clauses may cause some companies with little or no economic activity in Hong Kong to lose their tax-exempt status, require them to undergo more audits or modify their structure in order to recover tax-exempt status.
Companies that use an entity in Hong Kong to report profits from royalties, interest, or other passive income generated outside Hong Kong will be most affected by the changes. However, until the government releases the details of the scope of the changes, it is unclear exactly which companies will be affected and how they will need to adapt.
The Hong Kong government has stressed that it does not intend to change the “territorial source of taxation principle” and aims to maintain a low tax and business-friendly environment in Hong Kong. These changes will therefore not in themselves have an impact on companies that use structures in Hong Kong to report active income generated in offshore markets.
Impact of BEPS 2.0 on foreign companies based in Hong Kong
While legislative changes in response to EU demands may not have a significant impact on Hong Kong’s business environment, this development is not the only imminent change in the city’s tax regime.
Hong Kong is one of 140 countries and jurisdictions (as of August 2021) to have signed the OECD / G20 Inclusive Framework on Base Erosion and Profit Shifting (BEPS 2.0), which aims to ensure a more equitable distribution of tax rights on the profits of large multinational enterprises (MNEs) and to set an overall minimum tax rate.
Under the second pillar of BEPS 2.0, large multinationals – those with annual turnover exceeding 750 million euros (US $ 866.6 million) – will be subject to a minimum corporate tax rate. by 15%. This global corporate tax floor has already been accepted by 136 of BEPS members, including Hong Kong, and will come into effect in 2023.
The 15 percent tax floor is slightly lower than Hong Kong’s overall tax rate, which currently stands at 16.5 percent. However, thanks to various preferential tax regimes, many companies are currently eligible to pay CIT rates below this threshold and therefore may be required to pay the difference to reach the minimum rate of 15%.
Changes stemming from EU requirements and tax reforms initiated by BEPS 2.0 could have a significant impact on some large foreign companies operating in Hong Kong. Foreign companies whose annual turnover exceeds 750 million euros and whose income is passive abroad are advised to consult tax specialists to assess the effect that the changes will have on their activity and the measures that will be taken. ‘they can take to mitigate the potential impact.
However, it is clear that Hong Kong is keen to maintain its competitiveness by cultivating a favorable business environment and keeping taxes low. Despite the evolution of its tax system, it still benefits from relatively low corporate tax rates and a simplified tax system. Small businesses, in particular, will continue to benefit from Hong Kong’s preferential tax policies, and the city is likely to remain an attractive destination for foreign companies expanding into Asia.
Foreign investors wishing to better understand how Hong Kong tax changes will affect their local business can submit requests by email [email protected].
China Briefing is written and produced by Dezan Shira & Associates. The practice assists foreign investors in China and has done so since 1992 through offices in Beijing, Tianjin, Dalian, Qingdao, Shanghai, Hangzhou, Ningbo, Suzhou, Guangzhou, Dongguan, Zhongshan, Shenzhen, and Hong Kong. Please contact the company for assistance in China at [email protected]
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