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The Proposed Relaxation of Deduction of Foreign Taxes for Profits Tax Purpose

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The Proposed Relaxation of Deduction of Foreign Taxes for Profits Tax Purpose News Flash Hong Kong Tax The proposed relaxation of deduction of foreign taxes for profits tax purpose March 19, 2021 Issue 2 In brief The Inland Revenue (Amendment) (Miscellaneous Provisions) Bill 20211 (the Bill) was gazetted on March 19, 2021. The Bill, among other things, seeks to amend the Inland Revenue Ordinance (IRO) to enhance the deduction of foreign taxes for profits tax purposes as a means for relieving double taxation in Hong Kong. Upon enactment of the Bill, the revised rules on foreign tax deduction will take effect from the year of assessment 2021/22. This News Flash focuses on the proposed revised rules for foreign tax deduction in Hong Kong. For other matters addressed in the Bill, namely the tax treatment for amalgamation of companies under the court-free procedures, the tax treatment for transfer or succession of specified assets under certain circumstances and the statutory framework for furnishing of tax returns (including e-filing of profits tax returns), please refer to our upcoming Hong Kong Tax News Flashes, April 2021, Issue 3 and 4. In detail Foreign tax deduction rules in Hong Kong The existing rules and practice The Inland Revenue Department (IRD) revised the Departmental Interpretation and Practice Notes No. 28 – Deduction of Foreign Taxes (revised DIPN 28) in July 20192. Based on the revised DIPN 28, the following rules apply for deduction of foreign taxes for profits tax purposes: • foreign taxes paid on profits or income, including withholding taxes (WHT) on royalties, licensing fees and service fees, are not deductible under section 16(1) of the IRO; • foreign taxes paid (by either a Hong Kong or non-Hong Kong resident person) on specified interest, gains and profits3 are deductible under section 16(1)(c) of the IRO, provided that they are paid in a jurisdiction which does not have a double taxation agreement (DTA) in force with Hong Kong (i.e. non-DTA jurisdiction); and • other foreign taxes and duties which are not calculated by reference to profits or income (e.g. goods and services tax and value added tax) can be deductible under section 16(1). For foreign WHT paid on an income by a Hong Kong resident person in a DTA jurisdiction, despite no deduction is allowed, double tax relief may be available by means of a tax credit under the applicable DTA if the same income is subject to profits tax in Hong Kong. www.pwchk.com News Flash Hong Kong Tax The proposed changes to the existing rules The Bill proposes the following changes to the existing foreign tax deduction regime: 1. section 16(1)(c) will basically remain the same providing deduction of foreign taxes in respect of specified interest, gains and profits3 for both a Hong Kong resident person or a non-Hong Kong resident person who paid taxes on such income in a jurisdiction outside Hong Kong, subject to the conditions in section 16(2J) and section 50AA. 2. section 16(1)(ca), a new provision, is added to provide deduction of foreign taxes paid by a Hong Kong resident person or a non-Hong Kong resident person on its income if it is proved to the Commissioner’s satisfaction that “specified taxes”4 are paid in a jurisdiction outside Hong Kong in respect of such income chargeable to profits tax in Hong Kong, subject to the conditions in section 16(2J) and section 50AA. 3. both section 16(1)(c) and the newly added section 16(1)(ca) are subject the conditions specified in the revised section 16(2J) and section 50AA. As such, deductions under sections 16(1)(c) and 16(1)(ca) are not available for a Hong Kong resident person in respect of foreign taxes paid in a DTA jurisdiction. Under the existing IRO provisions, tax credit for foreign taxes paid by a Hong Kong resident person is available under section 50A. 4. the revision of section 16(2J) has the effect of extending the existing deduction of foreign taxes paid in respect of specified interest, gains and profits3 under section 16(1)(c) to non-Hong Kong resident persons who paid such taxes in a jurisdiction outside Hong Kong that is a DTA jurisdiction. Deduction is available for both Hong Kong and non-Hong Kong resident persons who paid such taxes in a non-DTA jurisdiction under the existing section 16(1)(c). 5. for a non-Hong Kong resident person, section 50AA(2A) is added specifying deduction under section 16(1)(c) or 16(1)(ca) is further subject to the condition that the person had taken all foreign tax minimisation steps in the jurisdiction where the income is received or receivable (i.e. source jurisdiction) and in the residence jurisdiction of that person, including double tax relief in its residence jurisdiction. If relief of the amount of foreign taxes paid in the source jurisdiction is available in the residence jurisdiction of the non-resident person after taking all the foreign tax minimisation steps, section 50AA(2A) further limits the deduction under section 16(1)(c) or 16(1)(ca) to the extent of the portion of foreign taxes that are not entitled to relief in the residence jurisdiction. Subject to the enactment of the Bill, the revised rules for foreign tax deduction will take effect from the year of assessment 2021/22. PwC observations • The table below summarises the double tax relief available for foreign taxes paid on (a) specified interest, gains or profits under section 16(1)(c)3 and (b) other gross income in different scenarios under the existing and proposed revised deduction rules: Double tax relief Foreign taxes paid in a DTA jurisdiction Foreign taxes paid in a non-DTA jurisdiction HK residents Non-HK residents HK residents Non-HK residents Tax credit Available Not available Not available Not available (no change) under section 50 Tax deduction Not available Not available Available under section Available under section (existing rules) 16(1)(c) for (a) 16(1)(c) for (a) Not available for (b) Not available for (b) Tax deduction Not available Available under sections Available under sections Available under sections (proposed rules) 16(1)(c) for (a) or 16(1)(c) for (a) or 16(1)(ca) 16(1)(c) for (a) or 16(1)(ca) 16(1)(ca) for (b), subject to for (b), subject to the for (b), subject to the the restrictions mentioned restrictions mentioned in restrictions mentioned in in (5) above (3) above (5) above Note: Granting of double tax relief by way of a tax credit or deduction will be subject to the ”foreign tax minimisation” condition specified in section 50AA i.e. the claimant needs to have taken all reasonable steps to minimise the foreign tax payable before a double tax relief is sought. 2 PwC News Flash Hong Kong Tax • As shown in the table above, the proposed amendments do not change the tax treatment of Hong Kong resident persons who have paid foreign taxes on gross income in a DTA jurisdiction, i.e. such persons can only claim a tax credit under the applicable DTA and no deduction of the foreign taxes paid is available. • The proposed amendments to the foreign tax deduction rules would address the following situations of double taxation: Situation 1 A Hong Kong company has paid e.g. WHT on royalty income in Jurisdiction A, which is a non-DTA jurisdiction. Assuming the same royalty income is subject to profits tax in Hong Kong. Based on the proposed amendments, the Hong Kong company may claim a tax deduction in Hong Kong for the WHT paid in Jurisdiction A. Situation 2 A Hong Kong branch of an overseas entity (e.g. a bank) has paid WHT on certain gross income (e.g. interest income) in Jurisdiction A (which can be a DTA or non-DTA jurisdiction). Assuming the same income is subject to profits tax in Hong Kong. The overseas entity is a tax resident of Jurisdiction B which exempts foreign income attributed to a permanent establishment (PE) located overseas. Since Jurisdiction B does not tax the income, the entity is not able to claim any relief in Jurisdiction B for the WHT paid in Jurisdiction A. Based on the proposed amendments, the Hong Kong branch may claim a tax deduction in Hong Kong for the WHT paid in Jurisdiction A. The takeaway We welcome the proposed changes to foreign tax deduction rules as they would address the double taxation issue currently faced by Hong Kong taxpayers in the two situations discussed above. Allowing deduction for foreign tax not in the DTA context is a domestic tax issue and should not be considered as not in accordance with any DTA. The proposed relaxation of deduction for foreign taxes should be conducive to developing Hong Kong as an intellectual property or a service hub in the region. As the new rules will only take effect from the year of assessment 2021/22 but not retrospectively, there should be cases where Hong Kong taxpayers may have been exposed to double taxation as a result of the revision of the IRD’s assessing practice specified in the revised DIPN 28 in the years of assessment 2019/20 and 2020/21. We hope the IRD could consider taking a pragmatic approach and allowing a deduction of foreign taxes paid by these taxpayers during the transition period where appropriate as an interim measure before the new rules come into effect. Endnotes 1. The Bill can be accessed via this link: https://www.gld.gov.hk/egazette/pdf/20212511/es32021251114.pdf 3 PwC News Flash Hong Kong Tax 2.
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