The tax challenges of the digital economy were identified as one of the areas of focus of the OECD/G20 Base Erosion and Profit Shifting (BEPS) Project, leading to the BEPS Action 1 – 2015 Final Report. Since then, further work has been done by the Inclusive Framework (IF) on BEPS to identify possible solutions to address the concerns around the tax implications of a rapidly digitalizing economy.
Further to the Policy Note Addressing the Tax Challenges of the Digitalisation of the Economy and the public consultation document issued in early 2019, on 31 May, the BEPS IF issued the Programme of Work (the Programme) to explore the technical issues to be resolved through the two main pillars and to lay out a process for reaching a new global agreement for taxing multinational enterprises (MNEs), with the aim of delivering a long-term and consensus-based solution in 2020. Over the last few weeks, the OECD has issued a Secretariat proposal for Pillar 1 and Pillar 2 respectively for public consultation:
- Unified Approach under Pillar 1 addresses the allocation of taxing rights between jurisdictions and considers various proposals for new profit allocation and nexus rules.
- Global Anti-Base Erosion (GloBE) proposal under Pillar 2 calls for the development of a coordinated set of rules to address ongoing risks from structures that allow MNEs to shift profit to jurisdictions where they are subject to no or very low taxation.
It is important to note that the proposals currently put forth do not represent the consensus views of the IF, the Committee on Fiscal Affairs or their subsidiary bodies, they have been prepared by the OECD Secretariat.
The two proposals are complex and go beyond the taxation of highly digitalized business models, affecting a much wider group of enterprises with cross-border business operations.
The combined effect of Pillars 1 and 2 should lead to the redrafting of the international tax law; and investment hubs (like Hong Kong) could experience significant losses in tax base. This article focuses on the GloBE proposal under Pillar 2 and how it could affect the financial services industry in Hong Kong.
What is GloBE?
The GloBE proposal comprises a set of inter-related rules that would effectively operate as a global minimum tax to ensure all internationally operating businesses pay a minimum level of tax, irrespective of the locations where they carry on their operations. A description of the GloBE’s main components is included in the table below:
| GloBE’s primary rules | Sub-components |
| Income inclusion rule | - Income inclusion rule – Requires a shareholder in a foreign entity (foreign branch or controlled entity) to bring into account a proportionate share of that foreign entity’s income if that income was subject to tax at an effective rate that is below a minimum rate.
- Switch-over rule – Requires the application of the credit method instead of the exemption method under a tax treaty where the profits attributable to a permanent establishment (PE) or derived from immovable property (which is not part of a PE) are subject to tax at an effective rate below the minimum rate.
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| Tax on base eroding payments | - Undertaxed payments rule – Operates by way of a denial of a deduction or imposition of source-based taxation (including withholding tax) for a payment to a related party if that payment was not subject to tax at or above a minimum rate.
- Subject to tax rule – Complements the undertaxed payment rule by subjecting a payment to withholding tax or other taxes at source and adjusting eligibility for treaty benefits on certain items of income where the payment is not subject to tax at a minimum rate.
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In broad terms, the income inclusion rule seeks to protect the parent jurisdiction by allowing it to impose tax on income which was subject to no or low taxation in the subsidiary jurisdiction, while the tax on base eroding payments aims to provide protection to the source jurisdiction against low taxation in the residence jurisdiction by denying deduction or imposing taxation in the source jurisdiction. In each case, the effective rate of tax (ETR) is proposed to be used as an indicator of the level of taxation.
How the GloBE proposal may impact Financial Services in Hong Kong?
Though many of the important design aspects of the GloBE proposal remain to be determined, given the aggressive timeline in arriving at a consensus solution by end of 2020, it is important that financial services taxpayers, whether headquartered in Hong Kong or operate as branch/subsidiary in Hong Kong, understand how GloBE could impact Hong Kong, from both a policy and technical perspective.
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The territorial concept has always been fundamental to the taxation of profits in Hong Kong. Only those profits which arise in or are derived from Hong Kong are liable to tax here. In a financial services context, various types of income could typically be claimed as offshore sourced and therefore not chargeable to Hong Kong profits tax. Types of income frequently claimed as offshore sourced income can include interest earned on loans initiated/funded outside Hong Kong, overseas stock exchange brokerage fees, fees attributable to services rendered, or the assumption of risk, outside Hong Kong, and profits from the purchase and sale of securities effected outside Hong Kong.
In the above situations, the taxpayer’s income should not be subject to profits tax in Hong Kong. Under the current GloBE proposal, such untaxed income will be required to be brought into account by the taxpayer’s shareholder and subject to tax in the parent jurisdiction under the income inclusion rule. Furthermore, depending on the proposed mechanism to avoid double taxation, the income payor may be denied tax deduction or be required to impose source-based taxation in respect of the payment made under the undertaxed payment rule or be denied treaty benefit which would otherwise be available under the subject to tax rule since the income earned by the Hong Kong taxpayer is not subject to tax at or above a minimum rate. Accordingly, the overall tax costs in respect of the income may increase.
As a related matter, the ECOFIN has also issued guidance on foreign source income exemption regimes on 15 October, whereby the EU will use the guidance to discuss with different jurisdictions on how (if required) to amend their tax regime in order to address specific issues of concern. Impact of this to the territorial taxation system of Hong Kong will need to be seen.
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For various domestic policy reasons, income/profit from the holding or sale of certain financial assets are excluded in arriving at the assessable profits of a financial services taxpayer in Hong Kong. Amongst others, common examples of excluded items include dividends received from corporation chargeable to Hong Kong profits tax; and interest/profit arising on certain government bonds, Exchange Fund debt instruments, Hong Kong Dollar denominated multilateral agency debt instruments, certain qualifying debt instruments, bank deposits (other than those derived by financial institutions) and PBoC debt instruments.
Again, given the above income/profit is specifically exempt from Hong Kong profits tax, this will affect the calculation of the effective tax rate fraction and hence trigger the income inclusion rule. The consultation document issued by the OECD on 8 November has requested comments on the determination of tax base under the GloBE proposal as well as different mechanisms to address timing differences. Depending on the exact scope of the permanent differences that could be removed from the tax base for the purposes of calculating the ETR fraction, such tax-exempt income of the Hong Kong taxpayers may trigger GloBE.
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Profits of a financial services taxpayer may be exempt or taxed at 8.25% under various preferential tax regimes in Hong Kong. These regimes, for most of the time, are aimed at achieving non-fiscal objectives, e.g., promoting emerging industries and specific financial transactions or strengthening a particular business sector through tax incentives. For example, the corporate treasury centres regime, the captive reinsurers regime or the unified funds exemption regime, which are preferential regimes applicable to the financial services sector, all aim at achieving specific objectives.
It is worth highlighting that since the roll-out of the BEPS Project in 2015, Hong Kong has taken significant steps to ensure that its preferential tax regimes comply with Action 5 (Harmful Tax Practices). As a result of these actions, no preferential tax regime offered by Hong Kong was found to be harmful in the latest update published by the Inclusive Framework on the peer review of preferential regimes in July 2019.
Nevertheless, albeit not being harmful, these regimes may result in an ETR lower than the minimum rate and trigger the income inclusion rule under which the untaxed/undertaxed profits in Hong Kong will be taxed at a top up rate (being the difference between the minimum rate and the ETR) in the parent jurisdiction. On the other hand, the undertaxed payments rule and/or the subject to tax rule may also apply to deny tax deduction/treaty benefit or impose source-based taxation in the payor’s jurisdiction, subject to the scope of the carve-outs to be agreed. As such, this may defeat the original non-fiscal objective of introducing the tax incentive regimes in Hong Kong and potentially impact the sovereign right of Hong Kong in deciding its tax policy.
Similarly, the super deduction for research and development expenditure recently introduced in Hong Kong may also give rise to unintended consequences under the GloBE proposal.
The next step
Hong Kong practices a simple, territorial-based and predictable tax regime. This is widely recognized as one of the cornerstones of our long-term success and competitiveness. In order to maintain Hong Kong’s position as one of the international financial centers, it is important that we uphold this key competitive edge, whilst making utmost efforts to meet the international tax standards. Hong Kong has, in recent years, introduced many changes to the tax legislations to align with the international tax system including codifying the transfer pricing legislation and documentation requirements, introducing the domestic PE definition, revising its preferential tax regimes, etc. However, depending on the ultimate design of the GloBE proposal, the GloBE proposal could have unprecedented impact on the Hong Kong taxation system. It may significantly undermine the attractiveness of Hong Kong’s simple taxation regime and result in realignment (or changes) to the current territorial source principle adopted in Hong Kong.
While one needs to maintain a briefing watch on the developments around the GloBE proposal, it is important for financial services organizations having cross-border business to evaluate the potential tax impact that may arise from the GloBE proposal and how they could possibly respond to these changes. They are also recommended to engage in dialogue with the competent authority of Hong Kong (the Inland Revenue Department) and/or participate in the consultation process of the OECD in order to keep abreast of the changes and feedback any comments/suggestions.
Disclaimer
The views reflected in this article are the views of the author and do not necessarily reflect the views of the global EY organization or its member firms.
