Consensus reached on Hong Kong - Japan double tax agreement

The governments of the Hong Kong Special Administrative Region and Japan announced on 31 March 2010 that they have reached a consensus on a new double tax agreement (New DTA). The New DTA is anticipated to herald a greater level of economic cooperation and trade between Hong Kong and Japan by bringing about tax benefits and certainty for companies with cross-border operations in the two jurisdictions.

Although the New DTA has not yet been signed and would still have to be ratified by the respective governments after signature, information currently available suggests that the New DTA offers tax benefits that are comparable to – if not more attractive than – Japan's double tax agreements (DTAs) with its other major Asian trading partners.


Opportunities for Hong Kong and Japan

Given the comparatively favorable withholding tax rates in the New DTA and Hong Kong's relatively simple domestic tax regime, there may be advantages to using Hong Kong as a gateway for foreign investors to invest into Japan and for Japanese companies looking to invest overseas.

Hong Kong holding company – China and Japan are major trading partners and each country is an important source of foreign investment for the other. To this end, Japanese and Chinese investors may invest directly into the other country, since China and Japan have an existing DTA in place, or via holding companies located in a jurisdiction with DTAs concluded or to be concluded with both China and Japan, such as Hong Kong.

Many of Japan's other DTAs provide for a preferential dividend withholding tax rate of 10%, while those with a 5% rate (e.g. DTAs signed with Luxembourg, Malaysia and Singapore) typically have a requirement that the beneficial owner hold at least 25% of the voting shares of the payer company for a minimum period prior to the distribution of the dividends. As such, the 5% dividend withholding tax rate under the New DTA and its ownership requirement of 10% is comparatively more favorable than most of Japan's other DTAs.

Given the favorable dividend withholding tax rate, a Hong Kong company (HKCo) can be used as a holding company for a Chinese investor (ChinaCo) to invest into Japan to reduce the 10% dividend withholding tax rate under the China-Japan DTA to 5% under the New Hong Kong-Japan DTA.

Further, although Hong Kong does not have an extensive tax treaty network, it does have one of the most favorable double tax agreements/arrangements concluded by China. Interposing HKCo as a holding company of a Japanese parent for the holding of Chinese investments would reduce the withholding tax rate from 10% to 5% pursuant to the Hong Kong-China double tax arrangement.

A tax saving of 5% on dividends repatriated from the Japanese investment (JP Investment Co) or the Chinese investment (China Investment Co) may be achieved either way.

It should be noted that Japan has controlled foreign company (CFC) rules that need to be taken into consideration. Under the CFC rules, a Japanese parent company that owns a Specified Foreign Subsidiary is taxed at approximately 41% on its pro rata share of the CFC's taxable profits. In principle, a CFC is a foreign company that has a head or main office located in a country where its effective tax rate for CFC purposes is 20% or less. Given that the Hong Kong's current profit tax rate is only 16.5%, HKCo would appear to be a CFC. However, the CFC rules also provide for an active business exemption, according to which the CFC rules do not apply if certain tests in relation to the CFC's business, substance, management and control, and unrelated party or local business activities are met. Subject to certain shareholding requirements, dividends received by a Japanese company are normally 95% exempt from tax in Japan; however, foreign tax credits are not available. Dividends from CFCs where the income has previously been taxed generally are 100% exempt (subject to conditions).

In relation to the active business exemption to the CFC rules, Japan has introduced a new concept of a Regional Headquarters Company (RHQ), which is a sub-category of CFCs. Certain requirements need to be met to qualify as a RHQ, including that the CFC own directly 25% or more of the voting power and shares of at least two "active" foreign corporations that are managed by the RHQ, and having office space, employees, etc., in the RHQ location through which it conducts management activities (under a management services agreement) intended to improve the profitability of its subsidiaries.

Where the main business of an RHQ-qualified CFC is that of being a holding company, it would be considered to have met the business purpose test, which is one of the criteria for obtaining the active business exemption. If the main business of an RHQ-qualified CFC is that of a wholesale business (as opposed to shareholding), transactions with subsidiaries that are managed by the RHQ are excluded from being related party transactions in determining whether the unrelated party transaction test (another active business exemption test) is met.

The above changes to Japan's CFC rules, combined with the preferential dividend withholding tax rate of 5% under the New DTA, should make Hong Kong a more attractive holding company location for Japanese multinationals.

Since information on the capital gains article of the New DTA has yet to be disclosed, it remains to be seen whether the New DTA will exempt Hong Kong investors from the 30% Japanese tax on capital gains arising from the sale of shares in a Japanese company. (Under Japanese domestic tax law, a nonresident corporate investor (a "NR investor") that does not have a PE in Japan is subject to Japanese income tax at 30% on gains arising from the disposal of shares in a Japanese company if (i) the aggregate shareholding in the Japanese company of the NR investor and related persons at any time during the three years preceding the last day of the fiscal year of the sale was 25% or more of the total number of issued shares or capital; and (ii) the NR investor and related persons dispose of 5% or more of the shares of the Japanese company during the current year. (Specific rules apply for companies that have significant real estate-related assets.) Under Hong Kong domestic tax law, gains derived by Hong Kong investors from the sale of shares in a Japanese company are not subject to Hong Kong Profits Tax if the gains are capital and/or offshore in nature. Furthermore, if a Japanese investor does not carry on a business in Hong Kong, any gain derived from the disposal of its shares in a Hong Kong company will not be subject to Hong Kong Profits Tax under prevailing Hong Kong domestic tax law.

China also has CFC rules, and both China and Japan impose beneficial ownership and substance requirements that need to be met by a company wishing to avail itself of the DTA benefits.

Global/regional supply chain arrangements – Under a global/regional supply chain arrangement, a principal company would act as the "central entrepreneur" and typically earn a larger proportion of the group's profits, with correspondingly smaller profits earned by its related parties elsewhere. Because the definition of a PE is wider under Japan's domestic tax law than that under the OECD model treaty, there may be a higher PE exposure under Japan's domestic law if the principal company that trades with Japanese companies is located in a jurisdiction that does not have a DTA with Japan. As the New DTA with Hong Kong is expected to include the OECD model treaty PE definition, the effect should be to narrow the relevant PE definition that could apply to a Hong Kong principal company acting as a global/regional hub, such that the Japanese tax risks related to such an arrangement would be reduced.

Hong Kong financing company – HKCo can also serve as a financing company of a foreign company (Foreign Co) investing into Japan. If structured properly, HKCo may not be subject to Hong Kong Profits Tax on the interest income earned, while JPCo would be entitled to an interest expense deduction at 41%, provided the Japanese thin capitalization rules are not triggered. If triggered, however, the thin capitalization rules – which have a debt-to-equity ratio safe harbor of 3:1 – restrict the deductibility of interest paid by a Japanese subsidiary to its overseas controlling shareholder or affiliates. Assuming the dividends are not subject to tax in the hands of Foreign Co such that the interest income is essentially only subject to withholding tax at 10%, the deduction would result in a potential tax saving of 31%.

Hong Kong intellectual property (IP) holding company – Hong Kong would potentially make an attractive location for the holding of IP.

HKCo may be used as an IP holding company to enjoy the lower royalty withholding tax rate under the New DTA, which at 5%, is appreciably lower than the rate in most of Japan's other DTAs.

If structured properly, JPCo may be able to obtain a deduction of 41% on the royalty expense. HKCo would only be subject to a low domestic tax rate of 16.5% on its royalty income and may receive a foreign tax credit for the 5% withholding tax paid, subject to the provisions of the New DTA on the elimination of double taxation, which have not yet been revealed. Provided certain conditions are satisfied, HKCo also may be able to claim a deduction for the acquisition costs of patent rights and rights to know-how. The Financial Secretary of Hong Kong announced in the 2010/11 Budget Speech that the scope of this deduction would be extended to registered trademarks, copyrights and registered designs.

Under certain facts and circumstances, HKCo may be able to claim the royalty as nontaxable offshore income, although it may be more difficult to claim a reduced royalty withholding tax under the New DTA and a deduction for the royalty expense.


Increased certainty

The New DTA between Hong Kong and Japan should reduce double taxation of income for Japanese outbound investors. Additionally, the New DTA should offer increased certainty for Japanese companies because it is expected to include competent authority assistance via a mutual agreement procedure (MAP). This formalized process will allow a taxpayer that is subject to double taxation to present its case to the competent authority in its jurisdiction of residence.

Hong Kong does not currently have an advance pricing arrangement procedure, and has only just introduced guidelines (Departmental Interpretation and Practice Note No. 45, "Relief from Double Taxation Due to Transfer Pricing or Profit Reallocation Adjustments") for conducting MAPs with the competent authorities of its limited DTA network. As such, the tax authorities (IRD) may not have had extensive experience in undertaking such procedures. As of the date of this article, we have not seen, nor are we aware of, any published cases that report the use of the MAP under Hong Kong's existing DTAs. It is thus not entirely clear how the IRD will approach negotiations on transfer pricing with other competent authorities in practice.


Exchange of information (EOI)

Amendments to the Inland Revenue Ordinance that would allow Hong Kong to adopt the updated (2004) OECD EOI standards, as well as exchange broader information under its DTAs, recently were enacted. The New DTA, like Hong Kong's recently concluded DTAs with Brunei, Indonesia and the Netherlands, is expected to adopt the updated version of the OECD's standards on EOI.

The updated OECD EOI standards make it clear that a state cannot refuse a request for information solely because it has no domestic tax interest in the information or solely because the information is held by a bank or other financial institution. As such, although the liberalization of Hong Kong's EOI provisions would help establish transparency in Hong Kong's tax regime, taxpayers may potentially be subject to increased scrutiny and disclosure of their tax affairs to the respective tax authorities under the New DTA.


Anti-treaty abuse measures

In response to greater concerns about treaty shopping issues in recent years, the New DTA is to contain certain anti-treaty abuse provisions. It is expected that these provisions would include a limitation of benefits (LOB) article similar to the provision contained in Japan's more recent DTAs (such as those with Australia, France, the U.K., and the U.S.). The LOB is designed to prevent the application of treaty benefits to treaty shopping structures. To meet the requirement of the LOB, and therefore obtain treaty benefits, certain shareholdings and/or business operations tests provisions will have to be met.

None of Hong Kong's current DTAs contain a full LOB article similar to those in Japan's DTAs with the above mentioned countries. However, the DTA that Hong Kong recently concluded with the Netherlands does impose certain additional conditions that are not specified in the OECD model tax treaty and that would serve to limit the potential abuse of tax benefits for dividends under article 10. (Some conditions that the recipient of the dividends should meet include, but are not limited to being: a) listed on a recognized stock exchange, b) at least 50%-owned by another company listed on a recognized stock exchange or c) a headquarter company that exercises independent authority in carrying out substantive business operations.) That said, similar conditions do not apply for other sources of income, such as interest, royalties and business profits, under the respective articles of the Hong Kong-Netherlands DTA. If the full LOB article were to be included in the New DTA with Japan, it remains to be seen how the IRD would use it in practice to challenge a taxpayer seeking to claim tax benefits under the New DTA.


Conclusion: another step forward for Hong Kong

Hong Kong needs to have 12 DTAs that incorporate the updated OECD EOI standards as soon as possible to be considered as having adequately implemented the OECD's transparency and EOI standards. The pending conclusion of the New DTA with Japan, which is expected to adopt updated OECD's standards on EOI, signals Hong Kong's commitment to combating perceptions of being a "non-cooperative" jurisdiction.

While strong compliance with international taxation standards would undoubtedly enhance Hong Kong's standing as a prime investment location, the New DTA with Japan also marks its ongoing efforts to building closer economic ties with other jurisdictions and should serve to create a favorable tax framework for structuring investments between Hong Kong and Japan.