Tax on corporate lending and bond issues in Hong Kong: overview

A Q&A guide to tax on finance transactions in Hong Kong. This Q&A provides a high level overview of finance tax in Hong Kong and focuses on corporate lending and borrowing (including withholding tax requirements), bond issues, plant and machinery leasing, taxation of the borrower and lender when restructuring debt, and securitisations.

This Q&A is part of the PLC multi-jurisdictional guide to tax. For a full list of jurisdictional Q&As visit www.practicallaw.com/taxontransactions-mjg.

Jacqueline Shek, Baker & McKenzie
Contents

Tax authorities

1. What are the main authorities responsible for enforcing taxes on finance transactions in your jurisdiction?

The Inland Revenue Department (IRD) of the Hong Kong Government is responsible for tax assessment and enforcement. Within the IRD, the Stamp Office is the designated unit responsible for stamp duty assessment and collection.

 
2. Is it possible or necessary to apply for tax clearances from the tax authorities before completing a finance transaction? If so, briefly describe:
  • The circumstances in which clearance may be obtained.

  • Whether obtaining clearance is mandatory or optional.

  • The procedure for obtaining clearance.

It is possible to obtain an advance ruling from the IRD in relation to the application of the Inland Revenue Ordinance (IRO) to a specific arrangement or transaction. The ruling granted is only binding on the taxpayer applicant in relation to that particular transaction for the specified period provided the facts set out in the ruling are complete and remain correct.

The advance ruling mechanism is not available for stamp duty issues.

 
3. Is it necessary to disclose the existence of any finance transactions to the tax authorities? If so, briefly explain:
  • The circumstances in which disclosure is required.

  • The manner and timing of disclosure.

Corporations must generally file annual profits tax returns which disclose specified information about the business. The tax return must be accompanied by the financial accounts and a number of supporting documents including schedules detailing:

  • Interest paid.

  • Capital expenditure.

  • Rents received.

  • Extraordinary gains or losses.

  • Broadly, other reconciliation statements and details of unusual transactions which may affect the tax position.

Tax returns are typically required to be filed within one month of issuance, unless the taxpayer falls under the block extension programme which is extended to tax representatives.

The IRD can request any person to provide further information relevant for administering tax law. The IRD regularly uses this power to request further information and documents from taxpayers to assist them with tax assessment.

 

Taxes on corporate lending/borrowing

4. What are the main corporate taxes potentially chargeable on interest and other amounts receivable under a loan? In each case, explain briefly:
  • Its key characteristics.

  • How it is calculated.

  • How it is triggered.

  • The applicable rate(s).

Profits tax

Profits tax is charged at 16.5% of the net profit. To be subject to profits tax, a person must both:

  • Carry on a business in Hong Kong.

  • Derive Hong Kong sourced profits from carrying on of the business in Hong Kong.

All companies carrying on business in Hong Kong are subject to profits tax on their interest received or accrued if the interest has a Hong Kong source. However, there is a blanket exemption for interest income derived by a non-financial institution from any deposits placed in Hong Kong with an authorised institution. That is, bank account interest income is not taxable in Hong Kong for most corporate taxpayers. Where the deposit is placed with a financial institution outside Hong Kong, the bank interest is also exempt, because it is foreign source income. There is also a specific exemption and a 50% concession for interest and gains on, respectively, qualifying long and medium-term debt instruments.

The IRD generally adopts the "provision of credit" test to determine whether the interest is sourced in Hong Kong. This test looks to the place where the credit is made available to the borrower to ascertain the source of the lender's interest income. However, caution must be taken when determining the source of interest profit because on many occasions, the IRD or the courts have found this simplistic test to be inappropriate.

For financial institutions, a different rule applies in relation to the source of interest income. Interest received by or accrued to a financial institution which arises through or from the carrying on by the financial institution of its business in Hong Kong is taxable in Hong Kong, despite the loan being made available outside Hong Kong. That is, it would be unusual for a financial institution carrying on business in Hong Kong to be able to exclude interest income from tax.

 
5. What corporate tax reliefs are available for borrowing costs (including interest and other amounts payable under a loan)? In each case, explain briefly:
  • Its key characteristics.

  • How it is calculated.

  • How it is triggered.

  • The applicable rate(s).

Interest payable and related fees incurred in earning assessable profits are deductible only if at one of the following applies (section 16(2), IRO):

  • The money is borrowed by a financial institution.

  • The money is borrowed by a public utility company.

  • Where the money is borrowed from persons other than financial institutions or overseas financial institutions, the interest payable on the loan must be chargeable to profits tax in Hong Kong.

  • The money is borrowed from financial institutions or overseas financial institutions.

  • The money is borrowed wholly and exclusively for specified purpose and the lender is not an associate of the borrower.

  • The interest is paid on listed or widely held debentures or debt instruments.

In addition, where a deduction is claimed by satisfying the third, fourth of fifth bullet point above, the loan cannot be secured by a deposit or loan made by the borrower or associated person where the deposit or loan is not taxable. Further, there must not be any arrangement for interest payment to eventually flow back to the borrower. These qualifications were added to the tax law to counteract tax schemes involving a circular flow of funds seeking to generate deductible interest expense in Hong Kong.

 
6. What corporate, transfer, stamp or other taxes are payable on the transfer of a debt under a loan? In each case, explain briefly:
  • Its key characteristics.

  • How it is calculated.

  • How it is triggered.

  • Who is liable.

  • The applicable rate(s).

Profits tax

It is generally possible to assign debt without triggering profits tax unless the debts constitute revenue asset for the transferor.

Stamp duty

Stamp duty is payable on instruments evidencing a transfer of Hong Kong stock. Stock is broadly defined in the Stamp Duty Ordinance (SDO) to include debentures, loan stocks, bonds or notes issued by any corporate or incorporate body, any government or local government authority. However, the definition also contains many carve-outs and exemptions which effectively excludes an instrument that either:

  • Is neither denominated nor redeemable in Hong Kong dollars.

  • Only bears reasonable commercial rate of return and is not convertible to stock.

Hong Kong stock is defined as stock the transfer of which is required to be registered in Hong Kong.

The transfer of most loans does not require registration in Hong Kong and therefore stamp duty is not an issue. However, where a Hong Kong dollar debt instrument is in registered form and provides for other than a reasonable commercial rate of interest, it can attract stamp duty on its transfer.

Where stamp duty is payable, any transfer of the loans attracts a total stamp duty at 0.2% on the consideration or the market value of the shares (that is, 0.1% on the shares sold and another 0.1% on the shares bought). Subject to the terms in the agreement, all parties executing the instrument are liable to pay stamp duty.

Hong Kong also levies stamp duty on bearer instruments. Debt instruments in bearer form can attract 3% duty. The liability is on the issuer.

 
7. Is there withholding tax on interest or any other payments under a loan? If so, provide brief details of:
  • When it applies.

  • The applicable rate(s).

  • Any exemptions.

Withholding tax

There is no withholding tax on interest.

Exemptions from withholding tax

Not applicable.

For a comparative summary of withholding tax on interest, see table, Withholding tax on interest on corporate debt, in this Handbook.

 
8. Do any particular tax issues arise on the provision of a guarantee? If so, provide brief details.

The existence of a guarantee by way of a deposit or loan from the taxpayer or its associate to the lender or its associate can affect the deductibility of interest for the borrower (see Question 5).

 

Bond issues

9. For corporate taxation purposes, are bonds treated any differently from standard corporate loans? If so, provide brief details of the differences, referring to Questions 4, 5, 7 and 8 as appropriate.

One condition for the deductibility of interest relates to corporate borrowings through debentures or other marketable debt instruments. In those cases, interest deduction is allowed for the issuer only where the debentures are listed on a recognised stock exchange, or the debt instruments are issued either:

  • Bona fide and in the course of carrying on business and is marketed in Hong Kong or another major financial centre.

  • Under any arrangements, where the issue of an advertisement, invitation or document in relation to the agreement or arrangements to the public has been authorised by the Securities and Futures Commission.

Interest on bonds issued under the Loans Ordinance or the Loans (Government Bonds) Ordinance and any profit arising in relation to bonds are exempt from profit tax. Both ordinances effectively deal with loans made to the government.

 
10. What stamp, transfer or similar taxes are payable on the issue and/or transfer of a bond? In each case, briefly explain:
  • Its key characteristics.

  • How it is calculated.

  • How it is triggered.

  • Who is liable.

  • The applicable rate(s).

The stamp duty issues for bonds are similar to those discussed for debentures (see Question 6).

It is more common for bonds to be in registered form. However, if the register is not required to be kept in Hong Kong, stamp duty does not apply as it can fall outside the definition of Hong Kong stock.

Convertible bonds give rise to additional stamp duty issues, as their conversion into Hong Kong stock may trigger further stamp duty liability as a transfer of Hong Kong shares from the issuer to the bondholder.

 
11. Are any exemptions available? If so, provide brief details.

There are several exemptions potentially applicable to taking a bond outside of the stamp duty net. However, planning with product features is required. For example, if the bond is not denominated in Hong Kong dollars, it is not subject to stamp duty.

An exemption from stamp duty in relation to transfer within a corporate group is available for transferors and transferees that are associated by not less than 90% of the issued share capital of each other.

 

Plant and machinery leasing

12. What are the basic rules for enabling the lessor or lessee of plant and machinery to claim capital allowances/tax depreciation?

The owner of a depreciable asset is generally allowed to claim depreciation allowances.

For plant and machinery, the owner of the depreciable assets can claim:

  • The initial allowance in the year in which the expenditure is incurred.

  • An annual allowance in subsequent years.

Initial allowance can be claimed despite the asset not yet being put into use.

Where there is a hire purchase agreement (as defined under tax law), it is the hirer or bailee who can claim the depreciation allowances.

 
13. What is the rate of capital allowances/tax depreciation; does it depend on the type of assets?

The initial allowance for plant and machinery (the amount that can be claimed in year one) is 60% of the expenditure. The annual allowance (for subsequent years) ranges from 10% to 30% depending on the type of assets. It is common for assets to be pooled to calculate depreciation allowances.

For certain assets that fall within the category of prescribed fixed assets (section 16G(6), IRO), capital expenditure is entirely deductible upfront.

 
14. Are there special rules for leasing to lessees that do not carry on business in your jurisdiction?

Where the relevant plant or machinery is not used in Hong Kong, the lessor cannot claim depreciation allowances, and is not taxed on the rental income from the lease.

There are special anti-avoidance provisions set out in section 39E of the IRO to limit the opportunities for tax deferral or avoidance through sale and leaseback, offshore equipment leasing and leveraged leasing arrangements. Broadly, a lessor (owner) cannot claim depreciation allowances in relation to any machinery or plant owned by him that has been leased out and one of the following applies:

  • The machinery or plant was previously owned and used by the lessee or his associate (that is, a sale and leaseback arrangement).

  • The machinery or plant is used wholly or principally outside Hong Kong.

  • The whole or a predominant part of the cost of acquisition or construction was financed directly or indirectly by a non-recourse debt (that is, a leveraged lease arrangement).

Similar rules apply to ship and aircraft leasing. That is, depreciation allowances cannot be deducted where the lessee is not an operator of a Hong Kong ship or aircraft, or where the asset was financed by non-recourse debt.

 
15. How are rentals taxed?

Rental income arising from leasing the plant and machinery to others for use in Hong Kong is taxed as if the income is sourced in Hong Kong. If the plant and machinery is wholly or principally used outside Hong Kong, this rental can be treated as offshore income and is therefore not taxable in Hong Kong.

There is a special concession extended by the IRD in relation to income from the leasing of plant and machinery. Where the lessor has been denied depreciation allowances under section 39E of the IRO (the anti-avoidance provisions outlined in Question 14), the lessor is not chargeable to tax on the rental income from the plant or machinery.

Special rules apply to determine the source of charter hire income for aircraft and ship.

 
16. Is a ruling or clearance necessary or common? If so, provide brief details.

A taxpayer can apply for advance rulings under IRO in relation to how the relevant provision (section 39E of the IRO) applies to the leasing transaction. The advance ruling system is a user pays system and is not mandatory for any transaction.

 

Restructuring debt

17. What is the tax treatment of the borrower and the lender if interest or capital is unpaid or deferred?

A lender is liable to tax on the sums of interest received by or accrued to it in a year of assessment. It is unclear whether tax can be deferred where interest is left unpaid or deferred. One view is that interest is taxable when it accrues to the taxpayer. There is case law confirming that interest accrues on a daily basis. There is also a tax case which suggests that the lender is taxable when interest has accrued, despite it not having been paid by the borrower (D73/91).

Where the interest and/or loan is left unpaid, it becomes a bad debt. This bad debt is deductible if it was incurred in the course of trade, business or profession and income was previously recognised.

From the borrower's point of view, it can claim deduction in the tax year that the interest expenses are incurred provided one of the conditions in section 16(2) of the IRO is met (see Question 5). Where interest is left unpaid or is deferred so that the borrower has not incurred an outgoing or expense, the borrower cannot claim a deduction until the expense is actually incurred.

 
18. What is the tax treatment of the borrower and lender if a loan is:
  • Written off or released (wholly or partly)?

  • Replaced by shares in the borrower (debt for equity swap)?

There is a distinction between debt forgiveness or release, and a debt which is written off because it has been left unpaid and remains uncollectable. Where a deduction has been allowed for a debt but the debt is subsequently released, the whole or the part of the debt released is deemed to be a taxable receipt for the lender. Therefore from a lender's perspective, it is preferable not to formally release or waive a debt as it can trigger taxable income.

Debt-for-equity swaps are possible. They represent the satisfaction of the amount outstanding by using shares to repay the loan. This can give rise to a stamp duty issue where there is a transfer of shares. Transfer of Hong Kong stock attracts stamp duty, and where the transfer is in consideration of a debt, the transfer is chargeable to stamp duty on the higher of the value of the shares or the debt released. There is no stamp duty issue where the debt is satisfied by the allotment of new shares as share allotment does not trigger stamp duty.

 

Securitisation

19. Briefly explain the key features of the tax regime applicable to securitisations, including details of any specific tax rules that apply or issues that arise in relation to securitisations.

There is no withholding tax on interest payments. There is also no goods and services tax (GST), value added tax (VAT) or capital gains tax. As such, it is possible to assign receivables without any profits tax exposure for the originator.

Profits tax issues may arise for the special purpose vehicle (SPV). Profits tax is payable if the SPV is carrying on a trade or business in Hong Kong and deriving Hong Kong source profits. Therefore the SPV should not conduct activities which amount to carrying on business in Hong Kong. If an SPV is carrying on business in Hong Kong and is subject to profits tax, mismatches can arise between its assessable income and the deductibility of its interest expense. Further, any expenditure incurred to acquire an interest stream may be capital in nature and therefore not deductible.

Stamp duty is not generally payable on assignment of receivables. Stamp duty is payable if the securitisation transaction involves transfer of stock. Stamp duty can also arise if the securitisation transaction involves transfer of interests in land, including mortgages over real property. However, it is not applicable on equitable assignments, which is more commonly used.

Synthetic securitisations without the transfer of receivables to an SPV lend themselves to different tax analysis. Any consideration received for the transfer of a right to receive income from property is deemed to be trading receipt and is taxable, despite the exclusion relating to the sale of capital assets (IRO). It is prohibited to pass on dividends or interest on Hong Kong stock unless there is a trust arrangement or unless the transferee has lent money on the security of the Hong Kong stock and is entitled under the terms of the loan to claim these dividends or interest (SDO).

 

Reform

20. Please summarise any proposals for reform that will impact on the taxation of finance transactions described above.

Hong Kong is undergoing a transformation in international tax planning as comprehensive double tax agreements are increasingly being negotiated and concluded. Up until about four years ago, Hong Kong only had three double tax agreements. As of March 2011, 20 agreements have been signed. This network of double tax agreements provides considerably more protection for cross-border corporate transactions.

 

Contributor details

Jacqueline Shek

Baker & McKenzie

T +852 2846 2154
F +852 2845 0476
E jacqueline.shek@bakermckenzie.com
W www.bakermckenzie.com

Qualified. New South Wales, 1998; Hong Kong, 2005

Areas of practice. Corporate tax planning; tax controversy; Hong Kong stamp duty.

Recent transactions

  • Advising clients on corporate restructuring, financial products, Hong Kong stamp duty, employee remuneration planning, and private wealth or trust planning.
  • Handling tax audits, tax controversy and litigation matters in Hong Kong.

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