Sea change

Tax was never much of a selling point for Hong Kong as a mainland investment platform. In fact, its natural operational advantages offset the burden of a tax regime that couldn’t compete with the opacity and efficiency of those in offshore havens.

That changed last year with the introduction of China’s Enterprise Income Tax (EIT) Law and the clarification off the double-taxation agreement (DTA) between Hong Kong and the mainland.

The EIT legislation ended the separate tax regimes for foreign and domestic firms and proposed to tax China-sourced corporate income globally, effectively eliminating the longstanding tax advantage of many offshore platforms. Not only was this evidence of how Beijing’s thirst for foreign direct investment (FDI) was becoming more particular, it also offered a means of increasing the government’s take of profits flowing out of the country.

Now investors are looking for offshore platforms that are able to override the EIT Law through favorable double-taxation treaties (DTTs) with China. These treaties frequently – but not always – offer lower withholding tax rates on dividend payments.

“There’s a sea change going on,” said Andrew McGinty, head of corporate and commercial practice at Lovells in Shanghai. “From a tax perspective, investing from a tax haven is no longer a good deal. Literally overnight, Hong Kong and Singapore, which both have DTTs, have become popular because firms can halve their dividend withholding tax.”

Treaty shopping

The new regime gave rise to a new phenomenon: treaty shopping. Not all of China’s DTTs were written equally; its DTT with the US, for example, offers no advantages over domestic tax rates. Barbados, on the other hand, struck a deal that allowed Barbadian companies to remit capital gains profits tax-free, including investment in real estate.

Hong Kong’s double-taxation agreement (DTA) was inked in 2006 and revised in 2008. At first glance, it is quite competitive. The Hong Kong DTA has a low 7% rate on royalties (although Singapore enjoys an advantage in royalties on equipment rental). A 7% rate is also levied on interest profits, with an exemption made for loans to certain state-owned entities.

The withholding rate on capital gains from China is higher than some other DTTs – the standard 10% unless the firm in question owns less than 25% in the Chinese interest, in which case the rate is halved. McGinty notes this is irrelevant to many investors because they aren’t looking to exit on the mainland. Instead, they exit from the Hong Kong holding company, where capital gains are exempted by Hong Kong domestic tax law.

According to Florence Yip, tax partner at PricewaterhouseCoopers (PwC), a critical change in the Hong Kong DTA’s language is its redefinition of what constitutes a permanent establishment (PE) in China. Previously, if a Hong Kong CEO spent one day per month on site at his Chinese interest over a seven-month period, his firm would cross the six-month threshold required for PE and therefore be subject to Chinese tax. But the revision allows a Hong Kong businessperson to spend up to 183 days per year at the same mainland project – at any given time – without crossing the line. Many other DTTs retain the old definition. 

Anti-avoidance approach

However, Hong Kong’s greatest advantage stems not the DTA smallprint, but rather from a new “anti-avoidance” taxation ideology adopted by many governments worldwide in the wake of the financial crisis. Business substance now takes priority over legal formality – and if the authorities suspect a corporate structure has been designed solely to exploit tax treaty benefits, they may choose not to grant them. A post office box under a coconut tree (or in Zurich) will no longer pass muster – unless accompanied by a stack of convincing paperwork.

Yip said that while in the past China was not inclined to discourage foreign investors in the name of tax revenue, now it is able to drive a better bargain. China has already renegotiated its DTT with Mauritius to eliminate its capital gains exemption, and there are rumors that the Barbados DTT is next.

First casualties

Anti-avoidance language also appears in the EIT Law – and a few foreign companies have already been bitten by it. In one recent case, a Singaporean firm created another Singaporean subsidiary, through which it sold shares to a Chinese subsidiary in Chongqing. The Chongqing tax authorities decided that the Singaporean subsidiary’s sole purpose was tax avoidance, and applied Chinese withholding tax to the share sale.

“This is the first time the Chinese government has looked to tax a purely offshore transfer,” said McGinty. “That’s pretty scary.”

John Gu, partner for China tax at KPMG, notes that the anti-avoidance language had not yet been included in the EIT legislation at the time Chongqing made its decision, but the logic was applied anyway. Indeed, many analysts are concerned by the wide interpretive leeway the “anti-avoidance” approach grants China’s tax bureaus, and its potential for discrimination and abuse.

Regardless, all of these changes play to Hong Kong’s natural advantages. Gu and PwC’s Yip believe it is far easier for firms to prove business substance in Hong Kong, and that the Chinese authorities are less likely to be skeptical when it comes to Hong Kong holding companies. If they do investigate, mainland tax officials can easily check the ownership and status of a Hong Kong firm investing in China – in English or Mandarin.

However, Patrice Marceau, a partner at DLA Piper  who specializes in Hong Kong and regional taxation, argues that this does not imply credulity on the State Administration of Taxation’s (SAT) part. “They will be looking at Hong Kong a little more strongly than expected,” he said, noting that a recent SAT circular on establishing business substance does mention Hong Kong

Robson Lee of Shook Lin & Bok, a Singapore law firm that consults on offshore investments, sees the DTA primarily as a political play: Beijing is protecting Hong Kong’s position as an entry point through tax policy. While Marceau agrees with this view, Lovells’ McGinty prefers to phrase it in milder terms, describing the move as “leveling the playing field.”

On a flat field, though, Hong Kong’s business and cultural links to the mainland make it the best player.

Horses for courses

It is by no means inevitable that Hong Kong will monopolize the mainland FDI market. For example, private equity firms taking minority stakes in countries around the world may prefer to headquarter in offshore jurisdictions with the best overall blend of international DTTs. Corporate investors also exhibit varying degrees of aggressiveness when it comes to minimizing tax.

“Tax is important, but from a business, common-sense perspective, do you want to have the tax tail wagging the business dog?” said Andy Mok, president of Red Pagoda Concepts, a Seattle-based investment consultancy specializing in China. Furthermore, he notes that shareholders’ preference for the privacy offered by offshore jurisdictions is not implicitly criminal. The fewer disclosures a company has to make, the less information falls into the hands of its competitors.

For others, Hong Kong’s proximity to Beijing may be a double-edged sword. “Many investors may also welcome some ‘distance’ between the location of their intermediary holding vehicle and China,” said Seychelles attorney Simon Mitchell. “Hong Kong is, after all, part of China.”