On 20 October 2023, the Inland Revenue (Amendment) (Disposal Gain by Holder of Qualifying Equity Interests) Bill 2023 (“Bill”) was published. It was introduced in Hong Kong’s Legislative Council on 1 November. The Bill introduces a tax certainty enhancement scheme for onshore equity disposal gains. Its aim is to provide more certainty and clarity regarding the non-taxation of onshore gains derived from the disposal of equity interests of a capital nature. Under the Inland Revenue Ordinance (Cap. 112), such onshore gains are not subject to profits tax in Hong Kong, providing that they are of a capital nature.
Hong Kong’s tax system has been widely lauded for its simplicity and competitiveness. The scheme is poised to further enhance the city’s appeal as a premier business hub in Asia. In contrast to comparable schemes currently in operation in other tax jurisdictions, Hong Kong’s scheme covers more types of businesses and equity interests. In addition, it boasts a lower threshold for equity holdings and other advantageous arrangements.
This article below will delve into the key features of the new tax certainty enhancement scheme as detailed in the Bill.
Background
In the 2023-24 Budget, Hong Kong’s Financial Secretary unveiled plans to formulate more transparent guidelines regarding the non-taxation of onshore gains from the disposal of equity interests. The move aims to provide a higher level of tax certainty in Hong Kong. It was prompted by stakeholders’ suggestions to establish an objective test for assessing the capital nature and non-taxable status of onshore equity disposal gains.
This recommendation was put forward in light of the refined foreign-sourced income exemption (“FSIE”) regime that came into force on 1 January 2023. Under the refined FSIE regime, offshore passive income received by a constituent entity of a multinational enterprise group is chargeable to profits tax in Hong Kong. This includes interest, income derived from intellectual property, dividends, and gains from the disposal of equity interests.
A consultation paper titled “Enhancing Tax Certainty for Onshore Gains on Disposal of Equity Interests” was released on 23 March 2023. It proposed the implementation of a tax certainty enhancement scheme to provide more assurance regarding the non-taxation of onshore gains from the disposal of equity interests. According to the paper, the scheme would address the common occurrence of equity interests being acquired and disposed during business expansion and restructuring. Further, the scheme would mitigate tax risks, reduce compliance costs, and expedite tax determination.
Current tax rules
According to the current provisions in the Inland Revenue Ordinance (Cap. 112), profit tax does not apply to onshore gains derived from the disposal of equity interests that are deemed to be of a capital nature.
Broadly speaking, disposal gains of a revenue nature arise when assets held for the purpose of generating profits are sold as part of a company’s normal business operations. These gains contribute to the company’s net income and are included in the revenue generated from regular business activities on the income statement. Disposal gains of a capital nature, on the other hand, arise from the sale of non-current assets that are not intended for sale in the regular course of business. They are considered part of a company’s capital transactions.
To determine the nature of such onshore gains, the Inland Revenue Department (“IRD”) follows a “badges of trade” approach. This method takes into account various factors, such as the frequency of similar trades, the duration of holding, the ratio of shareholding, and the reason behind the purchase or sale of equity interests. These considerations help establish the tax treatment for each specific case.
If the outcome of the “badges of trade” exercise indicates that the onshore gains are deemed to be of a capital nature, they will be tax exempt. However, if the gains are deemed to be of a revenue nature, they shall be taxable. By the same token, onshore losses on the disposal of equity interests of a capital nature cannot be deducted for tax purposes. On the contrary, onshore disposal losses of a revenue nature can be deducted.
Eligibility criteria
The new scheme applies to eligible onshore gains from disposals of equity interests taking place on or after 1 January 2024. These gains must be accrued during the basis period for a year of assessment commencing on or after 1 April 2023.
The scope of the scheme is limited to disposal gains arising in or derived from Hong Kong. Gains that are regarded as Hong Kong-sourced under the FSIE regime fall outside scope.
The following eligibility criteria must be met for the gains to be deemed capital in nature and, therefore, not subject to profits tax:
- The investor entity must be an eligible investor entity;
- The item being disposed of is an eligible equity interest held in an eligible investee entity; and
- Certain equity holding conditions must be met, or, alternatively, the exception detailed further below must apply.
Eligible investor entity
An eligible investor entity refers to a legal entity or a structure that maintains its own separate financial records. This includes partnerships, trusts, and funds. It is important to note that the definition excludes natural persons, i.e., individuals.
No specific resident or listing requirements are imposed on the investor entity. In other words, the scheme applies to all investor entities regardless of their residency status in Hong Kong, their incorporation or establishment in Hong Kong or elsewhere, and their listing status.
Investor entities that are insurers are, however, excluded from the scheme. Conducting investment activities for returns is an integral part of an insurer’s business operations. Therefore, any gains from the disposal of equity interests by an insurer are typically regarded as revenue in nature and, therefore, chargeable to profits tax.
Eligible equity interest
An eligible equity interest refers to an interest that grants rights to the profits, capital, reserves of an eligible investee entity. It is recorded as equity in the investee entity’s books in accordance with the relevant accounting standards. Under this definition, onshore gains from the disposal of various types of equity interests, including ordinary shares, preference shares, and partnership interests, fall within scope.
The scheme excludes the following types of equity interests:
- Equity interests deemed to be trading stock for tax purposes;
- Non-listed equity interests in an investee entity that is involved in property trading, property development, or property holding and where the exception detailed further below does not apply. It should be noted, however, that the scheme does not exclude disposals of listed equity interests in an investee entity engaging in property-related business activities.
Eligible investee entity
Similar to an eligible investor entity, an eligible investee entity must be a legal entity or a structure that maintains its own separate financial records. This includes partnerships, trusts, and funds.
As stated in the above section, the scheme does not cover non-listed equity interests held in investee entities engaging in certain property-related business activities, including property trading, property development, or property holding. Apart from that, the scheme applies to all investee entities regardless of their residency status in Hong Kong, their incorporation or establishment in Hong Kong or elsewhere, and their listing status.
Equity holding conditions
The specific equity holding conditions refer to the holding period and holding percentage of the equity interests in the investee entity. The investor entity is required to have held a minimum of 15% of equity interests in the investee entity for a consecutive 24-month period prior to the date of the disposal.
To determine whether the 15% equity ownership threshold is met, the calculation of equity interests held can be made on a group basis. As long as the combined ownership of equity interests in the investee entity held by the investor entity and its closely related entities amounts to 15% or above during the specified period, the requirement is considered satisfied.
An entity is deemed to be closely related with another entity if:
- Entity A holds over 50% of direct or indirect beneficial interest in Entity B, or is entitled to exercise, or control the exercise of, over 50% of the voting rights in Entity B, either directly or indirectly; or
- Entity C holds over 50% of direct or indirect beneficial interest in each of Entity A and Entity B, or is entitled to exercise, or control the exercise of, over 50% of the voting rights in each of Entity A and Entity B, either directly or indirectly.
- Exception to equity holding conditions: Disposal of equity interests in tranches
An investor entity has the option to sell its equity interests in tranches. As each tranche is sold, the investor’s equity stake in the investee entity may drop below the 15% threshold. This can make it challenging to meet the equity holding requirements for the remaining equity interests held. Hence, to cater for this, the scheme includes a provision that allows for an exception to the equity holding conditions above. Under the exception, onshore disposal gains from the remaining equity interests will be treated as capital in nature and, therefore, not subject to profits tax.
How CW can help you
The taxation of capital gains in Hong Kong, particularly with the new Inland Revenue (Amendment) Bill 2023, underscores the city’s strategic approach to enhancing its tax system for businesses. This development is pivotal for both local and international entities investing in Hong Kong, making doing business in the region more transparent and financially appealing. The tax implications of investing in Hong Kong now include more definitive guidelines and potential tax benefits, making it an increasingly attractive destination for global investors. For individuals and corporations looking to optimize their financial engagements, tax planning for Hong Kong investments becomes crucial. In this regard, consulting with skilled tax advisors in Hong Kong is advisable to navigate the nuances of tax rules. These changes not only fortify Hong Kong’s position as a leading financial hub but also offer a more conducive environment for investment and business growth.
With over thirty years of professional experience, our team of seasoned tax experts offers a wealth of expertise and knowledge in providing tax advisory services to clients across various industries, including manufacturing, wholesale, retail, real estate, information technology, hospitality, logistics, shipping, aviation, and financial services. Well-versed in the intricacies of local tax laws, we can assist you in analysing the implications of the tax certainty enhancement scheme and its applicability to your business as well as optimising your tax efficiency.
