May 2008

The continuing growth of the mainland's domestic market and its projected Foreign Direct Investment (FDI) outflows provide Hong Kong with a unique opportunity to establish itself as the favored holding jurisdiction for all China-related investment. For many international investors looking to enter these markets, an understanding of their tax system, particularly concerning Profits Tax is of utmost importance.

Hong Kong's Profit Tax System

The structure of taxation in Hong Kong is relatively simple. Hong Kong imposes income tax on a territorial basis. This means that generally income is only taxed in Hong Kong if it arises in or derives from Hong Kong. There are three main direct taxes:

• Profits tax
• Salaries tax
• Property tax

Any income that is not within any one of these categories is not subject to tax. Hong Kong does not impose any payroll, turnover, sales, value-added, dividends and capital gains taxes.

Profits tax is payable by every company carrying on a trade, profession or business in Hong Kong, on profits arising in or derived from Hong Kong. Profits which have a foreign source (often termed "offshore profits") are thus generally beyond the territorial scope of Hong Kong's taxation system.

Assessable profits are taxed at a rate of 16.5%, which has been lowered in 2008 from 17.5%. On the basis of this low rate, Hong Kong does not provide any special tax incentives for particular types of activity. If your company has only done offshore business, you can apply for 0% tax rate. In order to be able to justify 'offshore business", the "rule-of-thumb" is that your company should:

• have no employees in Hong Kong
• do not issue or receive any invoices to and from other Hong Kong companies
• shipments should not go through Hong Kong

China's Profits Tax System

Based on our March 2007 Newsletter, the long awaited tax law has taken effect since 1st January 2008, changing China's existing rates for domestic firms (33 percent) and overseas invested companies (15 or 24 percent) to a unified rate of 25 percent.

However the implementation of this law has been slow and many circulars have been issued addressing certain grey areas.

Grandfathering Treatments for Existing Enterprises in China

The first circular has addressed the grandfathering treatments available to old foreign investment enterprises "Old FIEs" (referring to FIEs whose business registration have been completed on or before 16 March 2007). It provides the detailed rules on the phasing-in of the Enterprise Income Tax (EIT) rate of Old FIEs which are currently enjoying an income tax rate of lower than 25% to the current statutory rate of 25%. The phase-in will occur within a five-year period, with the tax rate being raised every year. Starting in 2008, it will be increased from 15% to 18%, in 2009 to 20%, in 2010 to 22%, in 2011 to 24% and in 2012 to 25%. For those FIEs which were subject to 33% in the old tax regime, the new applicable EIT rate will be 25% starting from 1 January 2008.

New and High Technology Enterprises

The new EIT law also reduces the income tax rate of new and high-tech enterprises encouraged by the State to be 15% in order to encourage innovation. Since January 1st 2006, newly established high-tech enterprises in state new and hi-tech industrial development zones pay no enterprise income tax for two years once they make a profit. After the exemption term, they pay enterprise income tax at a rate of 15%. The tax is based on the first profit-making year.

The definition of a new and high-tech enterprise is as follows (but not limited to):

• Products (and services) fall under "the new and high technology sectors that receive primary support from the State".
• The amount of research and development as a percentage of sales is not lower than the stated proportion.
• The sales revenue of new and hi-tech products (or services) as a percentage of total revenue is not lower than the stated proportion.- The ratio of employees that possess technical qualifications to the total number of employees in the company is not lower than the stated proportion.
• Other conditions stated in Identification and Management of High-tech Enterprises

New and High Technology Enterprises in "5+1 zones"

Additionally new and high technology companies newly established within certain specified regions, i.e. in the five special economic zones, namely, Shenzhen, Zhuhai, Shantou, Xiamen and Hainan and the New Area of Pudong ("5+1 Zones") will enjoy the tax incentives these areas offer on or after 1 January 2008 as explained below.

The tax incentive is in the form of a tax holiday of two-year exemption and three-year 50% tax rate reduction, with the holiday commencing from the first-income generating year (instead of "first-profit making year" which was generally applied under the old tax regime). In addition, the 50% tax rate reduction is based on the statutory rate of 25% rather than the preferential income tax rate of 15% available to new and high technology enterprises under the EIT Law. This implies that the income tax rate for these new enterprises will be as follows: 0% for the first two years, 12.5% for the next three years, and 25% thereafter.

Special tax concession for withholding tax on dividends

The Detailed Implementation Regulations (DIR) of the new EIT Law states that dividends shall be recognized as income on the day in which the investor makes a resolution to make profit distribution (normally on the annual board meeting date). Hence, in theory, where an FIE distributes its retained earnings for the year up to year end 2007 in year 2008 (or beyond), the dividend is recognized as taxable income of its foreign investor in year 2008. Consequently, its foreign investor would be subject to withholding tax at 10% on the dividend.

However, many companies have requested the Chinese tax authorities to grant a special concession to waive the withholding tax on dividends arising from the FIEs' pre-2008 retained earnings in order to facilitate a smooth transition from the old tax regime to the new EIT regime. The government has accepted this and Circular 1 states that the pre-2008 retained earnings of an FIE shall be exempt from withholding tax when they are distributed to its foreign investor in 2008 and beyond. However, the FIEs' profits arising in year 2008 and beyond to be distributed to the foreign investor as dividends shall be subject to withholding tax according to the new EIT Law and DIR.

It is understood that the Chinese authorities are considering whether to adopt an application and examination procedure in 2008 to verify the amounts of FIEs' undistributed retained earnings up to the end of 2007 which are eligible for this special concession of withholding tax exemption.

Withholding tax on interest, royalty, etc. to foreign enterprises in relation to pre-2008 contracts

For contracts involving interest, royalty, and other such passive income entered into before 2008 which met the withholding tax exemption criteria under the old tax regime and are already approved by the tax authorities, the withholding tax exemption will continue to apply until the expiration of the original contracts. However, this transitional treatment shall not apply to any extension, supplementary contracts, or expansion of scope of the original contracts.

Double Taxation Agreement between Hong Kong and China

China and Hong Kong signed their first comprehensive income tax treaty on August 21st 2006. The new treaty extends the scope of the existing 1998 agreement, which was limited to business profits and income from personal services.

Under the double taxation agreement (DTA) between Hong Kong and China, the following are the arrangements:

• Withholding tax for dividends received by a Hong Kong Company from the PRC is reduced from 10% to 5% providing that the Hong Kong Company holds at least 25% of the capital of the PRC enterprise. This will attract more overseas investments into the PRC through Hong Kong
• Withholding tax for interest received by a Hong Kong Company from the PRC will be reduced from 10% to 7%. This will benefit Hong Kong investors and reinforce the status of Hong Kong as an international financial centre.
• Withholding tax for royalties received by Hong Kong Company from the PRC will also be reduced from the respective 10% to 7%.
• The DTA also provides a tax exemption relief to Hong Kong investing companies whereby capital gains derived from the transfer of shares in Mainland companies will be tax free, provided that following criteria are met:
  • - The shares transferred are less than 25% of the entire shareholding of the Mainland company; and
  • The assets of the Mainland Company are not comprised mainly of immovable property situated in Mainland China.

Under the treaty, China-sourced passive income including dividends, interest, royalties and capital gains received by Hong Kong investing companies would generally be afforded preferential treatment by way of reduced withholding tax rates, or if specific conditions are satisfied, tax exemption.

This compares favorably with China's domestic tax law and many of China's bilateral income tax treaties, including those with Macao and Singapore, and is particularly attractive because the items of income covered are not subject to Hong Kong tax, resulting in a net benefit to the Hong Kong investing companies. The reduced withholding tax rates on dividends, royalties and interest are amongst the lowest rates available in double taxation treaties signed by the Mainland.

The agreement contains an article on the exchange of information between the China State Administration of Taxation and the Hong Kong Inland Revenue Department. But the information to be exchanged is limited to that which is necessary for carrying out the provisions of the domestic laws concerning taxes covered by the new treaty. With an exchange of information provision, taxpayers should seek to manage their cross-border business transactions and tax affairs in a consistent manner and maintain a proper, contemporaneous, record-keeping system to support the commercial objectives that underlie the business transactions. This is especially significant for companies in Hong Kong that are claiming offshore income, i.e. a tax-free status.

Conclusion

When a company grows to be international, the negative side of running suboptimal profit allocation strategies, among its entities, can be significant. If the company intends to reap the full benefit of an international presence, it should accurately, and in a timely manner, plan where to turn a profit.

For some international businesses, structuring investments into China via Hong Kong can make a lot of sense. Concerns over direct exposure to China liabilities, ease of a future sale of a China investment, and certain tax planning and profit distribution capabilities as mentioned above can make the insertion of a holding company as part of the China strategy an interesting option. It is recommended to seek professional advice concerning the best available options and strategies associated with the China approach.

If you require assistance with the above subject, please contact us at This e-mail address is being protected from spambots. You need JavaScript enabled to view it with your detailed questions.

All information in this report is verified to the best of our ability and is assumed to be correct at time of release; however, Klako Group does not accept responsibility for any losses arising from reliance on the information provided within.