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.
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.
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/).
About Cheng & Cheng Taxation Services Limited
Cheng & Cheng is one of the top 20 accounting firms in Hong Kong, with over 300 staff in Hong Kong and Mainland China. We are the principal auditor for 20 listed corporations in Hong Kong and the tax advisor for over 80. We specialise in providing Hong Kong, Mainland China and international tax advisory services, as well as transfer pricing services to international clients. If you would like to know more about applying for a Tax Residency Certificate in Hong Kong, or seek tax advice from our tax experts, please do not hesitate to contact us by email (firstname.lastname@example.org) or phone (+ 852 3962 0114).