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Changes to Hong Kong's government might placate the EU but harm tax appeal

The new regime for foreign income exemptions in Hong Kong SAR may take the city off the EU tax watchlist, but it will give Singapore the top spot in APAC.

A complex tax change being finalized in Hong Kong SAR is intended to keep the territory off an EU watchlist, but it may cost the region its coveted spot as one of the most alluring locations for investors in Asia.

The complexity of the regime, according to James Maylam, head of tax at Singapore-based asset management company Schroders APAC, may prompt more market players to relocate their operations and particular transactions outside of Hong Kong Special Administrative Region.

"Changes on Hong Kong’s perceived competitiveness will be important, especially given the competition from Singapore," according to Maylam. "It is preferable to adopt simpler measures based on those of Singapore, but the regime’s priority is to stave off going from the EU’s grey list to the blacklist, which is far more harmful."

The EU Code of Conduct Group keeps an eye on nations on the grey list for potentially harmful components in their tax structures. If the detrimental aspects do not change by the next round of reviews in October, Hong Kong SAR and other jurisdictions might be added to Annex I of the EU list of non-cooperative tax jurisdictions, also known as the blacklist.

Because Hong Kong SAR offers exemptions for offshore income without conducting substance checks, a procedure that increases the risk of double non-taxation, the EU kept Hong Kong SAR on the grey list in its most recent review, which was conducted on February 24.

Denial of deductions on payments, higher withholding taxes, stricter application of the laws governing controlled foreign corporations, higher dividend taxation, and additional administrative measures are examples of the sanctions against the jurisdictions listed.

A participation exemption for financial services and equity investments is also being proposed, along with an expansion of the taxation of offshore passive income and the introduction of substance requirements for tax exemptions on offshore passive income.

The government of Hong Kong SAR improved its regime for income exemption by introducing enhanced substance requirements in response to the EU's worries about its offshore regime for passive income. The anticipated implementation date is January 1st, 2023. Prior to that date, neither ownership interests nor agreements were grandfathered.

The proposed amendments' final legal text will be introduced by lawmakers in Q4 2022.

New guidelines for the taxation of offshore passive income, such as dividends, interest, capital gains, and royalty income, are included in the income exemption. Foreign income that is remitted to Hong Kong SAR is not currently taxed, but offshore passive income that is received in Hong Kong SAR will be subject to tax unless it complies with the most recent substance requirements.

The proposal for an income exemption, according to Darren Bowdern, partner and head of asset management tax, ASPAC at KPMG in Hong Kong SAR, is likely the most significant change to Hong Kong's tax code with regard to passive income.

"We have had a series of discussions with key stakeholders on how the proposals will affect typical holding structures and operating models in Hong Kong and wider Asia," according to Bowdern. "All groups need to review these rules to see what impact they could have on business models given the significance of these changes to Hong Kong’s treatment of passive income."

The territorial source principle of taxation will still be followed by Hong Kong SAR under the proposed legislation. The income exemption regime will change, regardless of the assets and income of the multinational group's local entities.

The relevant income will continue to be exempt from taxation in Hong Kong regardless of the substance requirements due to the introduction of a participation exemption for offshore dividends and disposal gains on equity.

However, there are some important requirements for the participation exemption, including a minimum equity ownership of 5%, a passive income threshold of 50%, and a minimum headline tax rate of 15%.

If the entity in question complies with the substance requirements, passive income will continue to be exempt from profits tax. Reduced requirements will apply to pure equity holding companies.

For foreign taxes paid on offshore passive income received from nations without a double taxation agreement with Hong Kong SAR, a unilateral tax credit will also be introduced. Under the regime, the credit may reduce the group entity's local tax obligations.

The proposed framework would significantly alter Hong Kong Special Administrative Region's tax laws. Investors must be certain that the country's overall competitiveness will not be impacted by the changes to the tax treatment of capital gains, dividends, and interest, particularly when compared to Singapore, its main regional rival.

According to Bowdern, "the proposed changes to its tax treatment of passive income are creating a lot of noise and giving rise to some uncertainty over how businesses will be impacted."

Many investments may be exempted from the new regulations because financial services companies will continue to be protected by the current exemption rules for funds.

However, businesses will need to take into account the wider market impact as the rules are likely to have an impact on their investment portfolio as well as how they manage their funds.

However, businesses will need to take into account the wider market impact as the rules are likely to have an impact on their investment portfolio as well as how they manage their funds.

According to Kher Sheng Lee, managing director, co-head of APAC, and deputy global head of government affairs at the Alternative Investment Management Association (AIMA) in Hong Kong SAR, "there remains some uncertainty over the proposed framework to many investment holding structures."

"We have yet to review the final legislation," Lee continues, "but remain hopeful that the guidance will clarify the questions raised during the consultation and the uncertainty over its implementation."

Another thing to think about is whether Hong Kong Special Administrative Region's (HKSAR) gradual tax harmonization with China is hurting its capacity to compete against Singapore for foreign investment and a top spot in Asia for funds management.

The harmonisation is probably going to happen soon, according to Bank of Singapore executive director and head of tax Chang Yew Kwan.

"From a tax-technical position, you probably could expect that there would be an eventual harmonisation of the Hong Kong tax rules with the mainland China tax rules."

"“It may be in five years, 10 years – we don’t know when – but at some point we will see that one country, two systems will have to harmonise," he continues

The next question is whether Singapore will overtake Hong Kong SAR as the preferred fund location. One advisor claims that it is not entirely clear.

Contrary to popular belief, Alice Leung, a corporate tax partner at KPMG based in China, claims that "being close to China gives an edge to Hong Kong, especially for those overseas enterprises wanting to invest into China and for those Chinese enterprises wanting to invest overseas."

"Hong Kong is closer to China than Singapore, and it does become an advantage in choosing Hong Kong to set up a holding company for Chinese outbound investment," Leung continues.

The majority of businesses operating in the jurisdiction should be able to comply with the incoming substance rules, which are comparable to Singapore's, according to AIMA and other industry bodies. These include special purpose investment vehicles with lowered substance requirements or with a source of substance obtained through an outsourcing arrangement.

The devil, however, is in the details, and the complexity of the pending legislation could prevent certain groups from taking advantage of tax treaty benefits if it becomes challenging to demonstrate corporate substance to local tax authorities.

According to Lee, "the logic behind that is in order to have access to the relevant tax treaty, the holding company would have to have substance, such as management and people"

"We believe that the measures identified in the proposal may be seen by some investors as more complex and, in certain situations, in the absence of clear legislation and guidance, provide less certainty for businesses in comparison to equivalent measures in Hong Kong’s competitor jurisdictions," the official continues.

The creation of contemporary tax regimes has been crucial to Hong Kong SAR's success as a financial center, despite the fact that it undoubtedly faces some of its greatest policy challenges to date.

Even if appeasing the EU runs the risk of strengthening Singapore's position, the country is likely to remain a significant centre for alternative asset management as a gateway to China with a strong legal, tax, and regulatory environment, deep talent pool, and stable capital markets.



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