Hong Kong Tax Alert: 31 October 2013

Source of income

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Brokerage commission from overseas customers served by an overseas branch in respect transactions executed electronically on the Hong Kong Stock Exchange

The scenario posed by the HKICPA was that a Hong Kong broker had established an overseas branch to solicit customers. Most business functions including sales and settlement in respect of orders from the overseas customers were performed by the overseas branch.

The overseas customers would be able, through the broker’s electronic link with the Hong Kong Stock Exchange, to input their orders whilst outside Hong Kong to buy or sell securities listed on the Hong Kong Stock Exchange. The orders from the overseas customers would be executed electronically without any human intervention by the broker in Hong Kong, provided that the customer’s orders were within the pre-determined terms agreed beforehand between the broker and the customer.

The question put to the IRD was how the source of such commission income would be determined.

In reply, the IRD advised that based on the ING Baring case decided by the Court of Final Appeal in 2007, the place of execution of securities transactions was an important factor to take into account in determining the source of the relevant brokerage commission. The IRD then noted that in the scenario posed, the execution of the transactions only took place when there was a successful matching of the buy/sell orders and that matching was done at the Hong Kong Stock Exchange where the securities were listed, albeit perhaps electronically. As such, the IRD considered that the transactions were executed in Hong Kong and hence the source of the commission income was in Hong Kong. 

Interest earned by insurance companies from overseas listed bonds

The scenario posed by the HKICPA involved an insurance company which was not a financial institution as defined in the Inland Revenue Ordinance (IRO). The insurance company, whilst not actively trading in bonds, acquired overseas listed bonds to earn interest income. The acquisition of the bonds did not involve the insurance company borrowing monies to fund the acquisition. As such, the HKICPA considered that the bonds could be regarded as a simple loan of monies by the insurance company.

The HKICPA then noted that DIPN 13 indicates that where interest is earned by a non-financial institution from a simple loan of monies, the applicable rule for determining the source of such interest income is the “provision of credit” test. Under the “provision of credit” test, such interest would be treated as non-taxable offshore income where the loan monies are first made available to the bond issuer by way of being credited to a bank account of the bond issuer maintained outside Hong Kong.

The HKICPA however noted that, inconsistent with DIPN 13, it was apparently the IRD’s assessing practice to adopt the “operations” instead of the “provision of credit” test to determine the source of such interest income. Under the “operations” test, where the relevant operations of such insurance company were undertaken in Hong Kong, such interest would be treated as taxable onshore income, regardless that the relevant monies were first credited to a bank account of the bond issuer maintained outside Hong Kong. The HKICPA asked the IRD to clarify this apparent inconsistency.

In reply, the IRD advised that the business of an insurance company included not only insurance but also the investment of its funds. As such, it was an integral part of the business of an insurance company to invest its funds held in reserve and to turn over those funds to maximize its profits or meet its liabilities when they arose.

The return from such bond investments, whether by way of interest or profits on sale, formed an integral part of the profits of the insurance business. These investments were therefore considered by the IRD to be current assets of the insurance company even though some bonds might be held for the long term and not for speculative purposes. The IRD cited CIR v Sincere Insurance and Investment Company Limited [1973] 1 HKTC 602 in support of its view.

The IRD added that the bond investment activities of an insurance company clearly went beyond making simple loans of monies. As such, the IRD did not consider that the application of “operations” test in the scenario posed was inconsistent with DIPN 13.