Cheng & Cheng Taxation Reveals How Hong Kong Can Help Avoid Double Taxation in Cross-Border Business

HONG KONG SAR – Media
OutReach – 19 October 2021 – Transfer pricing and foreign withholding
tax are generally the two most important tax considerations when making
outbound investments and engaging in cross-border business. While the new Hong
Kong transfer pricing law has been covered in August 2020 (https://henrykwongtax.com/article/hong-kong-codification-of-transfer-pricing-law/), Cheng & Cheng Taxation
Services Limited (“Cheng & Cheng’s Taxation”) will further reveal how a
Hong Kong company can help multinational corporations (MNCs) reduce their
double taxation risk and thus the overall effective tax rate, with the below
discussion areas:

• Special
  features of the Hong Kong taxation system,
• inbound
  investment into Mainland China and other Asian countries,
• three
  examples of how Hong Kong can reduce foreign withholding tax and double
  taxation risk when doing business in Asia and
• how
  to apply for a Hong Kong Tax Residency Certificate

A three-minute
video relating to each discussion area have been prepared for the better
understanding of the issues. Please refer to this link (https://henrykwongtax.com/home/trc-videos/) to access to the videos.

 

Special features of the Hong Kong taxation system

 

Hong Kong
is a popular jurisdiction for investment holding companies and intra-group
trading companies.

 

Most MNCs
have set up companies and maintain small-scale operations in Hong Kong even
though Hong Kong is not their major market in Asia. Here the explanation of the
rationale.

 

Local tax
law

• Dividend
  income and capital gains are taxed at a 0% tax rate in Hong Kong;
• No
  withholding tax on dividends, interest, service income or trading profits are
  imposed in Hong Kong. Only royalties are subject to withholding tax and a low
  tax rate of 2.475% to 4.95% will usually apply;
• Hong
  Kong profits tax (corporation) and salaries tax (individual) are among the
  lowest rates globally, with maximum tax rates set at 16.5% and 15%,
  respectively. For the first HK$2 million of profits, a half tax rate of 8.25%
  applies to a Hong Kong corporation.

Hong Kong adopts the territorial concept, rather than the worldwide taxation
system. Generally, only Hong Kong–sourced profits are subject to tax in Hong
Kong. This is one of the most effective ways of avoiding double taxation if the
operations of the Hong Kong based company are principally performed outside
Hong Kong and foreign tax has been paid.

 

International
presence

Hong Kong
has an extensive Comprehensive Double Taxation Agreement (DTA) network with
Asian countries. A total of 45 jurisdictions have already entered into DTAs
with Hong Kong. A full list of DTA partners can be found on our website: (https://henrykwongtax.com/home/hong-kong-tax-treaty-network/)

 

Unlike
offshore jurisdictions, such as the British Virgin Islands, Hong Kong is located in the heart of Asia and offers an abundance of
finance and trade support professionals. Setting up substance in Hong Kong to
fulfil the latest international tax requirements is relatively simple and
convenient.

 

For these
reasons, Hong Kong is the first place to consider when an MNC expands into
Asia, in particular into Mainland China.  

 

Inbound investment into Mainland China and
other Asian countries

 

Hong
Kong is a good platform for an MNC to invest in Mainland China.

 

As a
general rule, an MNC would either set up a subsidiary, namely a wholly foreign-
owned enterprise (WFOE), or a representative office (RO) in Mainland China. Here
Cheng & Cheng’s Taxation will explain how a Hong Kong entity can help
reduce overall tax liabilities.

 

Subsidiary:
Wholly foreign-owned enterprise

When an MNC
plans to establish production bases or trade with customers in Mainland China, it
would normally set up a WFOE there because of that country’s VAT tax system.

 

Typically,
a Hong Kong intermediate holding company will be set up to invest in the WFOE
in Mainland China, for the following reasons:

• Dividends,
  interest and royalties paid to non-residents of Mainland China are generally
  subject to 10% withholding tax in that country. If the recipient is a Hong Kong
  tax resident, the withholding tax can be reduced to between 5% and 7% under the
  Double Taxation Agreement (DTA) between Mainland China and Hong Kong;
• Mainland
  China offers preferential treatment to Hong Kong taxpayers under the DTA
  benefits;
• As
  Hong Kong is part of the Greater Bay Area, it is relatively easy to set up
  substance in Hong Kong to support operations in Mainland China;
• As
  mentioned above, Hong Kong does not impose tax on dividend income or capital
  gains. There is also no withholding tax on dividends.

Representative
office

When an MNC
wants to set up a client liaison or back office in Mainland China, they could
invest in the form of a representative office (RO). An RO is not expected to
derive any income and is not a separate legal entity. Using a Hong Kong headquarters
to install an RO in Mainland China is a reasonable option.

 

Despite the
fact that it is a cost centre, an RO in Mainland China is still required to pay
corporate income tax based on a deemed profits ratio. As such, double taxation
issues may arise.

 

As Hong
Kong and Mainland China are DTA partners, Both a tax deduction on RO expenses and
a tax credit can be claimed to offset Hong Kong profits tax liabilities,
provided that the Mainland China RO assists in the operations of the Hong Kong
entity. This is an effective way to avoid double taxation in Hong Kong and
Mainland China.

 

Doing business in Asia: Reduction of foreign withholding
tax

 

Hong
Kong is in a good position to reduce foreign withholding tax in Asia as Hong
Kong has entered into DTAs with most Asian countries.

 

Apart from Mainland
China, other developing countries in Asia such as India and Indonesia are also attracting
MNCs due to their rapid economic growth. However, the problem is that, without
a Double Taxation Agreement (DTA), withholding tax on income repatriated from
these countries is generally very high.

 

With years
of experience, Cheng & Cheng’s Taxation identified three common scenarios
in which a Hong Kong tax resident can help reduce foreign tax liabilities.

 

Scenario 1: Service fee arrangements

Take a
service provider in Hong Kong, maintaining several clients in Indonesia as an
example. Many Hong Kong companies are unaware that they have paid withholding
tax in Indonesia on their service income, since their foreign clients typically
settle the tax liabilities on their behalf.

 

A Hong Kong
company can help reduce their Indonesian withholding tax on service income if
it can present a Tax Residency Certificate (TRC) to the Indonesian Government.
Normally, the withholding tax of 20% can be reduced to between 5% and 10%.

 

Further, a
tax credit is available against the Indonesian withholding tax paid to offset
Hong Kong profits tax liabilities. As such, with proper tax planning, the double
taxation issue should not arise.

 

Last but
not least, similar arrangements can also be applied to other Asian countries,
including India and Malaysia.

 

Scenario 2: Loan financing arrangements

This scenario
uses a company making interest-bearing loans to its group company in Japan as
an example. In Japan, interest paid by a Japanese company to non-residents of
Japan is generally subject to 20% withholding tax. Under the DTA between Hong
Kong and Japan, the withholding tax rate can be reduced from 20% to 10%.

 

As well as
the tax credit method mentioned above, double taxation issues may also be
resolved by pursuing an offshore claim on interest income in Hong Kong. Under the
provision of credit test, interest income on loans first made available to the
borrower outside Hong Kong could be offshore sourced and non-taxable under Hong
Kong profits tax.

 

As most
countries in Asia charge withholding tax on interest paid to non-residents, a
TRC can generally help in most of the loan arrangements.

 

Scenario 3: Royalty arrangements

Royalty
arrangements are common among Western brand owners when they cooperate with
Asian business partners to expand into the Asian market. This can involve
franchise arrangements, sales of branded products, and game licensing
arrangements.

 

More
importantly, MNCs appear more eager to enter into royalty arrangements with
Hong Kong entities of their Asian partners, especially when dealing with countries
that have a foreign exchange control system such as in Mainland China. An MNC
may request that their Asian partner establishes a Hong Kong entity to pay their
royalties, which can lead to a significant income and expense mismatch as
the income is earned by Mainland China or other Asian entity, while the royalty
expenses are borne by the Hong Kong entity.
Income and expense mismatches without thorough group recharge
arrangements will lead to significant tax inefficiencies and risk. 

 

Similar to
interest income, royalties are subject to withholding tax in most Asian
countries. Hong Kong also imposes a royalty withholding tax but, based on our
experience, the withholding tax can be used to offset the corporate income tax
of the recipients in their respective Western countries. However, it is
important to examine the relevant tax administrative procedures in Hong Kong.

 

As royalty
arrangements are generally very complex, it is important to look for a tax
partner with international tax experience in order to plan ahead effectively.

 

How to apply for a Hong Kong Tax
Residency Certificate

 

In above
discussion, becoming a Hong Kong tax resident and obtaining a Tax Residency
Certificate (TRC) is an important part of international tax planning. Having
said that, not every Hong Kong company is a Hong Kong tax resident.

 

In order to
obtain a TRC, a company has to exercise its management and control in Hong
Kong. There are no specific requirements set out by the Hong Kong Inland
Revenue Department (IRD), but in general, the IRD expects a Hong Kong tax
resident to maintain a Hong Kong–based director and staff, as well as an office
located in Hong Kong.

 

As the IRD
is getting more stringent about issuing TRCs, it is important to seek
professional advice from tax advisor before making application.

 

For more
details of the TRC application process, please visit our website at (https://henrykwongtax.com/home/our-services/hong-kong-tax-residency-certificate/).