Submissions by HKEx 
28/10/2004 
 

28 October 2004

Mr Frederick Ma
Secretary for Financial Services and Treasury
18/F Admiralty Centre, Tower 1
18 Harcourt Road
Admiralty
Hong Kong

Dear Fred,

EXEMPTION OF DEALING IN HONG KONG LISTED SECURITIES FROM PROFITS TAX

We are writing with reference to the Government's current initiative to exempt offshore funds from profits tax.  Our recommendation is that this initiative be expanded into a general exemption of all dealing in Hong Kong-listed securities from profits tax, regardless of the nature, residency or domicile of the holder.  Our views and reasoning are set out in detail below.

The current position

We understand that at present, under section 14 of the Inland Revenue Ordinance (IRO), a person carrying on a trade in Hong Kong is chargeable to profits tax on assessable profits arising from such trade.   Where the person is non-resident and the business is carried on through an agent, section 20A of the IRO provides that the non-resident be charged to tax in the name of the agent and that the tax be recoverable from the agent.  However, under section 20AA of the IRO, brokers and approved investment advisers are relieved of the requirement to pay the possible profits tax liability of their non-resident clients in relation to transactions that they handle on behalf of these clients - although the possible tax liability of the non-resident clients themselves remains.

Section 26A(1A) of the IRO exempts from profits tax the profits derived in the ordinary course of fund management activities of specified investment funds.  Funds qualifying for the exemption include, mutual funds or unit trusts authorised under section 104 of the Securities and Futures Ordinance, and mutual funds or unit trusts which are widely held and are supervised by an authority in an acceptable regulatory regime. 

The exemption in section 26A(1A) does not apply to non-authorised funds or investment companies (whether closed-ended or open-ended, whether onshore or offshore) that do not meet the qualifications.  This is a matter of concern to the managers of and investors in those entities. Whether the realisation of a stock market gain is a tax-exempt "capital gain" or taxable "trading profit" then rests entirely on an assessment - initially by the IRD - of the "intent" of the investor when the stock was acquired and while it was held. The resulting legal uncertainty has the following effects:

  • Managers of Hong Kong portfolios tend to base themselves overseas (including Singapore, Australia and Japan) rather than in Hong Kong, to reduce their profile and avoid the risk of the funds being deemed by the IRD to be "trading" in Hong Kong. This reduces employment and all of the associated infrastructure expenditure and economic activity in Hong Kong, to the detriment of our economy and its tax base;

  • Funds and investment companies try to mitigate their risks by establishing or incorporating themselves in offshore jurisdictions such as the BVI, Luxemburg, Dublin, or Cayman Islands rather than Hong Kong, reducing expenditure in Hong Kong's legal services sector (including expenditure on setup, ongoing administration, dispute resolution and litigation which normally takes place in the jurisdiction of domicile) and the tax revenue therefrom;

  • Funds and investment companies, particularly those based or managed in Hong Kong, are safer investing in mainland stocks listed in London, New York or Shanghai, where they are not subject to the risk of Hong Kong profits tax. This draws liquidity away from the Hong Kong markets, to the detriment of our financial services sector, and also reduces stamp duty revenue;

  • Companies seeking a stock-market listing will factor the tax-treatment of their investors into their decision on whether to apply for listing in Hong Kong or elsewhere, again impacting on economic activity, the tax base and stamp duty;

  • Funds, investment companies and their managers in Hong Kong could face extensive profits tax liabilities, not only currently but in respect of back years, much or all of which they would be unable to recover from the investors in the funds if the fundholders have redeemed their units or the assets have otherwise been distributed.

Fund managers' and investors' concerns have become more acute in recent years, as the Inland Revenue Department has been making enquiries of non-authorised funds and investment companies with a view to identifying dealings which might be assessed to tax.  Although the Government has acknowledged the problem (as discussed below), there is as yet no solution.  So the issue is still hanging over the industry, causing concern and uncertainty.  These concerns, discourage fund managers from investing in or operating in Hong Kong and discourage funds and investment companies from choosing Hong Kong as a domicile, which in turn is detrimental to the stock market and to Hong Kong's role as an asset management centre, and consequentially to Hong Kong's economy and tax base taken as a whole.

Equal treatment of shareholders

The current policy is also inequitable as between different types of shareholders. An authorised mutual fund or an individual investor holding a particular portfolio will not be subject to profits tax on its disposal, but an unauthorised investment company or fund holding an identical portfolio could be taxable. We believe the Government's approach to taxation should be seen to be fair and treat all investors in the same assets equally.

Equal treatment of dividends and gains

Section 26 of the IRO makes clear that dividends paid by Hong Kong taxable corporations are not subject to tax in the hands of the shareholder. We presume that this is based on the fundamental principle that Hong Kong does not seek to tax the same profit twice. However, in an efficient market the value of stocks reflect nothing more than the market's assessment of the net present value of their expected future earnings, which earnings will themselves be taxable at the corporate level. Thus, to tax the increase in value of a stock upon disposal represents in essence an advanced tax on the issuer's future earnings, a form of double taxation.

The inconsistent treatment of dividends and stock market gains is perhaps best illustrated by the fact that a taxable investor who buys a stock just before it goes "ex-dividend" and sells it just after the dividend is accrued, would receive a tax-free dividend and also a "trading loss" represented by the drop in the share price as it goes ex-dividend. Repeated enough times, the investor could generate sufficient tax-losses to offset his taxable profits without suffering any financial loss.

As Hong Kong has a clear policy against double taxation, we believe that this reason stands on its own against the taxation of gains on shares.

Current reform initiative

We were pleased to note that in the 2003/04 Budget, a commitment was made to remove the concerns of offshore fund managers, at least, by amending the IRO to exempt offshore funds from profits tax (paragraph 97).  We also note that the 2004/05 Budget  reaffirmed the commitment (paragraph 29), referring at the same time to the Chief Executive's announcement in the 2004 Policy Address that the Government would strive to develop Hong Kong as a world-class asset management centre.  And in January 2004, your bureau issued a Consultation Paper on Exemption of Offshore Funds from Profits Tax.

The consultation paper sets out proposals to exempt some offshore funds from profits tax, while at the same time introducing anti-avoidance provisions to prevent round-tripping, i.e. (non-exempt) onshore funds disguised as offshore funds taking advantage of the exemptions.  The paper proposes that to qualify for the exemption, the non-resident person should not be carrying on a trade in Hong Kong, or - if the non-resident person is a corporation, a beneficiary of a trust or a partnership - the interest of non-resident persons in the relevant entity must be not less then 80%.  In order to enforce such anti-avoidance provisions, brokers and investment advisers would have to maintain records, or make written confirmation to the IRD (to support which records would have to be maintained), of their clients' residence status. The residency of investors if of course a moving target and there is the very real risk that a fund and the holdings of its offshore investors could suddenly become taxable if one of its investors moved to Hong Kong, tipping the Hong Kong ownership over the 20% threshold.

We understand that the Government and representatives of the fund management industry have been in discussion over these proposals.  Unfortunately, it seems that the industry finds the record-keeping requirements onerous, while the Government side is concerned at possible abuse if records are not kept.  So the discussion appears to have reached an impasse.  Moreover, the position of non-authorised onshore funds has not been addressed at all.

We respectfully submit that the proposals outlined in the consultation miss the point. They seek to tax, or exempt from tax, market gains based on residency of the holder, rather than following the existing approach of taxing based on source of profits, and they do nothing to address the inherent inconsistencies explained above in seeking to tax market gains but not dividends and of double-taxing future profits of the investee.

Recommendation

The Exchange would like to emphasise the importance of obtaining a clear and early exemption from profits tax for dealings in Hong Kong-listed securities by offshore funds, at least.  As noted in the consultation paper, leading overseas financial centres have such exemption, and it will detract from Hong Kong's competitiveness - with potential consequent loss of business and employment - if Hong Kong does not have an exemption too.  We understand the Government's concern to combat tax avoidance.  However, anti-avoidance provisions may by their complexity render the exemption of little value.  One of Hong Kong's great strengths is the ease of doing business, including a simple tax regime.  This strength should as far as possible be maintained and preserved.

However, an exemption for offshore funds, only, would in our view be a second-best solution.  The current impasse over anti-avoidance provisions will not arise if a broader view is taken of the whole matter.  Our recommendation is that all income - capital gains, dividends, interest, etc - on all investment in securities listed in Hong Kong should be clearly and specifically exempted from profits tax. 

As noted above, authorised onshore funds are already exempt from profits tax; further, profits arising on Exchange Fund bills and notes are fully exempt and profits on other debt instruments lodged with the Central Moneymarkets Unit are partially or fully exempt.  If a blanket exemption from profits tax were extended to all transactions in listed securities - i.e. by both onshore and offshore funds, companies and individuals - we question whether the Government would in fact suffer any net revenue loss.

A thriving financial services sector, at the core of our service-based economy, will likely generate more tax revenue from the associated economic activity than could ever be extracted from attempting to tax stock market gains.  We would urge consideration of a blanket exemption of securities dealing from profits tax to underpin Hong Kong's role as an international financial centre.

I hope that our above comments are helpful.  Please do not hesitate to contact me if we can be of further assistance in this matter.

 

Yours sincerely,

 

Charles Lee