Global Tax Alert | 1 November 2013

Hong Kong's Tax Authority provides interpretations on certain tax positions

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Executive summary

This Alert summarizes some of the views recently expressed by Hong Kong’s Inland Revenue Department (IRD) in its 2013 annual meeting with the Hong Kong Institute of Certified Public Accountants held earlier this year.

The topics include: (i) the IRD’s change in approach to determining the tax residency of an overseas bank with a Hong Kong branch; (ii) sourcing rules applicable to brokerage commissions on electronically executed transactions and to interest earned by insurance companies from overseas listed bonds; and (iii) whether a discount on a note was in the nature of interest.

Detailed discussion

Residency of an overseas bank with a Hong Kong branch

Under the Hong Kong-mainland China (China) income tax treaty (Treaty), a bank incorporated overseas will be considered as a resident of Hong Kong if it is “normally managed or controlled in Hong Kong.” This position has provided an overseas bank an opportunity to enjoy Treaty benefits such as a reduced 7% withholding tax on interest income from China, if the bank is deemed to be a Hong Kong resident.

Generally, such an overseas bank as a whole will be managed or controlled outside of Hong Kong. However, the IRD, through its issuance of Departmental Interpretation and Practice Notes No. 44 (DIPN 44) in August 2008, has taken a contrary position by stating that, if the Hong Kong branch of an overseas bank is managed in Hong Kong, the bank would be regarded as a resident of Hong Kong. This includes a branch managing its own daily business operations in Hong Kong, including the implementation in Hong Kong of decisions made for it by top management overseas.

China’s State Administration of Taxation (SAT) has disagreed this position, creating inconsistent approaches taken by the two tax authorities.

In its 2013 annual meeting, the IRD announced a change in its position to agree with that of the SAT.

As a result of this change in the position, the IRD would decline to issue a Hong Kong residency certificate to an overseas bank with a Hong Kong branch on a going forward basis, where only the management or control of the Hong Kong branch is exercised in Hong Kong.

Source of brokerage commission from overseas customers on electronically executed transactions

If a Hong Kong broker has established an overseas branch to solicit customers and the branch would generally perform most business functions, including sales and settlement in respect of orders from the overseas customers, the overseas customers would be able, through the broker’s electronic link with the Hong Kong Stock Exchange, to input their orders 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 are within the pre-determined terms agreed in advance between the broker and the customer.

The IRD considered that the commission income was Hong Kong source since the transactions were executed in Hong Kong. This is because 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, citing the ING Baring case1 decided by the Court of Final Appeal in 2007, in which source of income was determined where the execution of trades in securities took place.

Source of interest income earned by insurance companies from overseas listed bonds

If an insurance company which was not a financial institution acquired overseas listed bonds, interest income on the bonds are taxable in Hong Kong under the “operations” test since the bond investment activities went beyond making simple loans of monies.

The position is based on the fact 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.

Nature of a discount on a note

The IRD views a discount portion of an original issue discount note (OID) is interest, not a deductible compensation, since the note is a debt and the issue price was the sum of money to which the payment is ascertainable. The IRD also notes that to be tax deductible for Hong Kong tax purposes, the note proceeds must be employed to generate taxable profits in Hong Kong. In addition, the note issuer would need to meet the restrictive conditions for deduction of interest to claim the deduction for the discount.

Implications

The IRD’s change in a Hong Kong’s residency determination would require overseas banks to re-assess their current positions and take appropriate steps to reduce future exposure. Similarly, the IRD’s stated applicable source rules for brokerage commission on transactions executed electronically and for interest earned on overseas listed bonds may affect proper sourcing of such income earned in the current year as well as a characterization of OID discounts.

For additional information with respect to this Alert, please contact the following:

Ernst & Young Tax Services Limited, Hong Kong
  • Tracy Ho
    +852 2846 9065
    tracy.ho@hk.ey.com
Ernst & Young LLP, Hong Kong Desk, New York
  • Connie Chan
    +1 212 773 2661
    conniehf.chan@ey.com
Ernst & Young LLP, Asia Pacific Business Group, New York
  • Chris Finnerty
    +1 212 773 7479
    chris.finnerty@ey.com
  • Jeff Hongo
    +1 212 773 6143
    jeff.hongo@ey.com
  • Kaz Parsch
    +1 212 773 7201
    kazuyo.parsch@ey.com
  • Bee-Khun Yap
    +1 212 773 1816
    bee-khun.yap@ey.com

EYG no. CM3934