TAX Quarterly Newsletter

TAX quarterly NEWSletter

A review of prc and hong kong tax developments

www.dlapiper.com | SEPTEMBER 2012 Editors’ Column In This Issue… Welcome to our September edition of the Tax Quarterly Newsletter. The summer quarter is always a slower one but still a few things have caught our attention. CHINA We start our China review1 with Wrong Wei, considering the recent decisions by two Beijing courts to reject Ai Weiwei’s appeal of a RMB 15.22M tax evasion fine. In Now or Never, we consider the advantages freeze planning may provide 04 WRONG WEI Chinese-US taxpayers looking to deal with wealth generated from initial public 06 NOW or never offerings. The Future Commences Now announces the launch of RMB currency futures in Hong Kong. In 601 + 30 = Some Clarity, we discuss Circular 30 and 09 T he future consider how it will affect the application of Circular 601. commences now For our Hong Kong review, An Intellectual DIPN is a discussion of how DIPN No. 49 aims to clarify the intellectual property right legislation introduced 10 601 + 30 = some last year. Alternate Reality examines the decision of the Court of Appeal in clarity Canray International where the court upheld the decision of the Court of First 12 T idbit: Instance allowing the Commissioner of Inland Revenue to issue alternate Inevitably assessments against multiple taxpayers on the same profits. In Cheers!, we look at the Nice Cheer Investment case where the Court of Appeal ruled in favour 12 T idbit: of the taxpayer in its decision that unrealized gains from the revaluation of Inevitably too trading securities are not subject to profits tax. Provisional Tax seeks to provide some guidance on how the provisional income tax system in Hong Kong works. We also discuss an IRD’s recent faux pas in the distribution of their annual report, the new bill paying system and the new DTA with Malta. We welcome your feedback and any question you may have about this edition of HONG KONG our Quarterly Newsletter.

14 AN intellectual dipn

16 A lternate reality

18 cheers! Patrice Marceau Daniel Chan Stephen Nelson Foreign Legal Consultant Partner Partner 19 STI ll bad Hong Kong and China Corporate and Tax DLA Piper Hong Kong feng shui Regional Taxation DLA Piper Hong Kong T +852 2103 0880 DLA Piper Hong Kong T +852 2103 0821 stephen.nelson@ 20 provisional tax T +852 2103 0554 [email protected] dlapiper.com 21 T idbit: [email protected] Now you see it, now you don’t

21 T idbit: Convenience

22 T idbit: New tax treaty Todd Beutler Anderson Lam Foreign Legal Consultant Partner T +852 2103 0493 T +852 2103 0722 [email protected] [email protected]

1 As usual, we caution that, under current Chinese regulations, foreign lawyers such as DLA Piper are not formally admitted to practise law in the People’s Republic of China and, as a result, we are not permitted to render legal opinions on matters of PRC law. Our comments herein should not be construed as legal advice on any of the topics discussed herein. Furthermore, there is no official translation of the Enterprise Income Tax law, the Implementing Rules or the notices and circulars referred to herein; the translations from Chinese are our own rather than official translations. We do not take any responsibility on whether or not the translation expressions properly convey the exact meaning of their Chinese counterparts. Ultimately, only the Chinese version is relevant and you should not act upon anything you may read herein without further consultation with a proper advisor. PEOPLE’S REPUBLIC of china

www.dlapiper.com | 03 WRONG WEI

On 27 September 2012, Ai Weiwei ( ), a world-renown contemporary Chinese artist, human rights activist and dissident, lost his second, and probably final, appeal against a fine of RMB 15.22M (US $2.4M) for tax evasion. The fine was imposed in connection with activities of a company Mr. Ai allegedly controls by the name of Beijing Fake Cultural Development, Ltd. Our readers will recall that, in 2011, Mr. Ai was detained without charge for over 80 days in a military compound where he was, by his own account, subjected to intense psychological pressure, including more than 50 interrogations on his political beliefs and activities. Mr. Ai also indicated that he had been explicitly threatened with retaliation if he persisted in activities qualified as subversive by the authorities. When it became clear that Mr. Ai would not be silenced, retaliation did ensue: soon after his release, the Beijing Tax Bureau announced that Mr. Ai’s company had been involved in various economic crimes leading to the hefty tax evasion penalty. The company appealed in November 2011 but, in a unanimous decision, the appeal was rejected by the Chaoyang District Court on 20 June 2012. Immediately after, Mr. Ai launched a further appeal before the Beijing No. 2 People’s Intermediate Court but, once again, the appeal was rejected as the recent decision confirms. We note the following from a tax angle.

■■ Mr. Ai was required to post a bond of some RMB 8.45M (US $1.3M) to proceed to the appeal but collection of the full amount of the penalty claimed by the tax authorities was suspended during his appeal. It is interesting to note that, in many jurisdictions, an appeal of a tax related assessment (whether for tax or penalties) does not require the payment of a bond but, at the same time, it does not suspend the right of the tax authorities to pursue recovery of the amount claimed. For instance, in Hong Kong, as soon as an assessment is issued, it becomes a debt payable to the government that is fully enforceable, irrespective of whether or not the taxpayer files an objection or appeal against the assessment. One surmises that, at the speed at which the Chinese appeal system operates2 and given the difficulties in absconding from the jurisdiction3, the tax authorities are not assuming much of a recovery risk since the few months of the process are unlikely to change significantly the credit status of the taxpayer subject to the impugned assessment.

■■ It was reported that an estimated 30,000 supporters contributed over US $1.4M to help Mr. Ai post the bond and pay the fine. Stories of people folding money into paper airplanes and throwing them over the wall surrounding his house circulated widely over the internet and in the press. One wonders whether the goodwill of Mr. Ai’s supporters will compound on the tax issues he and his company are facing. If Mr. Ai received the ‘donations’ as an individual, he should not be liable to tax but, if Mr. Ai was regarded as the agent of Beijing Fake Cultural Development, Ltd., then the donations would be made to the company and would potentially be subject to tax in the PRC. That may be why Mr. Ai has apparently taken the trouble of signing some 13,000 IOUs to attest of debts rather than donations.

2 The first appeal was launched on 15 November 2011 and was resolved within five months while the second appeal was resolved in two months. In Hong Kong, an appeal to the Board of Review (i.e. one layer of appeal) would take at least as much time (7 to 8 months). A further appeal would then be at least another 8 to 12 months to complete.

3 Either physically, because of strict border control, or financially, because of exchange control.

04 | tax Quarterly Newsletter – September 2012 ■■ There is little doubt that the intervention of the tax authorities against Mr. Ai was politically motivated. It is of course not the first time (and nor will it be last!) that a tax system is hijacked to achieve purposes other than money raising. Ever since Al Capone was felled by accusations of tax evasion rather than for any of his many (alleged!) crimes, governments have often found it expedient to use, with or without justification, the tax code to neutralize political and other adversaries. Of course, in the case of Mr. Ai, given how tax non-compliance is still prevalent in the PRC, it may well be that his flanks were exposed and the case of the authorities probably did not even have to be fabricated or contrived. In our view, it is wrong from a policy standpoint to use a tax system for political expediency. A tax system must be perceived as fair and impartial if it is to be accepted and respected by its taxpayers. Where it fails that test, its legitimacy is undermined and it becomes an invitation to taxpayers and tax authorities to misuse the system. In our view, it is a slippery slope that the Chinese tax authorities should have avoided but, for the time being, the message is clear: you had better make sure your tax affairs are in order before engaging in activities frowned upon by the authorities.

www.dlapiper.com | 05 NOW OR NEVER

On December 31, 2012, the largest US tax exemption in history is set to expire. With it will go what many consider to have been a once-in-a-lifetime opportunity for PRC and Hong Kong families with US citizens4 and US green card holders to eliminate millions of dollars of US federal tax exposure. Under the expiring tax exemption, a US Person can shelter over US $5M5 in value from US estate and gift taxes. But starting on 1 January 2013, the exemption will drop all the way down to US $1M, and worse, the maximum tax rate on a US Person’s world-wide assets will increase to a confiscatory 55%. Because an exemption of this level may never be seen again in today’s world of tax deficits and political in-fighting, the time to act is “now or never.”

Planning Opportunity One strategy for a Chinese-US taxpayer to secure the benefits of the current US $5M exemption is to transfer an interest in a family business or other assets to a specially-drafted offshore trust. In addition to removing the US $5M exemption amount from the taxpayer’s estate, through additional transfers to the trust, the potential appreciation on over US $50M of other assets can also be sheltered from US estate tax. The greater the potential for appreciation, the greater the tax benefit from these transfers. While there are several planning techniques for implementing this strategy without incurring US income or gift tax, two planning techniques are particularly well-suited to pre-IPO planning (and the transfer of other highly-appreciating assets): a sale or transfer to an intentionally defective grantor trust (IDGT) and a transfer to a grantor retained annuity trust (GRAT).

IDGT This type of planning strategy involves the owner of a pre-IPO interest funding an irrevocable trust (i.e., the IDGT) and making an additional transfer of a pre-IPO interest to the IDGT. The beneficiaries of the IDGT generally would include family members or other third parties. However, with special trust planning, it could even be possible for the owner/transferor to be an eligible beneficiary of the IDGT. The first transfer would be the so-called “seed gift” to the IDGT when it is formed. Taking advantage of the expiring tax exemption, the transferor could gift up to US $5M to the IDGT before year end without incurring any gift tax liability. This transfer alone could save the transferor over US $2M in future estate taxes. If the US $5M transfer were to consist of a pre-IPO interest that the transferor anticipates could grow ten-fold, the transferor could save another US $25M in future estate taxes. There is no limit on the amount of appreciation that can escape US estate tax. Utilizing the seed gift to the IDGT, the transferor can shift even greater value to the IDGT through a second transfer – a sale transaction. The transferor can sell pre-IPO interests to the IDGT based on the trust’s ability to fund the purchase from the seed gift (and the anticipated appreciation on the purchased assets). The value of the of the pre-IPO interest transferred in the sale transaction should be limited, however, to the value of the trust’s assets as of the sale date. Generally, the trust should have assets equal to at least 10 per cent of the value of the pre-IPO interest to be transferred

4 A child born in the US is a US citizen from birth (whether or not a US passport is obtained). US citizenship can even extend to a child born in China if one or both of the parents had US citizen.

5 Due to a required inflation adjustment, the exemption is actually US $5,120,000 through the end of 2012

06 | tax Quarterly Newsletter – September 2012 Thus, with a seed gift of US $5M, the IDGT could acquire another US $45M to US $50M of pre-IPO interests in the sale transaction. This is a significant “leverage” opportunity. As noted, the transferor would structure the second transfer as a sale to the IDGT. In exchange for the pre-IPO interest, the IDGT would issue an installment note to the transferor equal in value to the transferred asset. As the IDGT’s ability to repay the note in full should depend on the monetization expected from the anticipated IPO, the note generally would be structured to require a balloon payment of principal and interest. The balloon payment would be scheduled for a date after the anticipated IPO. The use of the note is the essence of the “freeze” part of the planning. Although the transferor will receive a note equal in value to the transferred asset, the value of the note is effectively frozen while the value of the transferred asset could grow exponentially. By accepting the note, the transferor is exchanging an appreciating asset for an asset that generally cannot increase in value. The transferor’s only additional return is the interest that must be paid on the note. The transferor is thus removing potential appreciation from his or her taxable estate with only a certain amount of interest being received in exchange. Properly structured and implemented, there should be no upfront US tax cost to implementing this “freeze” sale. First, there should be no gift tax for transferring the pre-IPO interest to the IDGT – regardless of its value at the time of the transfer. By receiving a note equal in value to the transferred asset, the transferor/seller reduces the value of the transferred interest for gift tax purposes to zero, thus eliminating any gift tax liability. So long as the note requires interest payments, and the interest is actually paid, there can be no gift tax liability. This interest rate is tied to the current low interest rates and can be less than the hurdle rate associated with the GRAT discussed below. There should also be no income tax liability triggered on the sale of the pre-IPO interest to the IDGT or the payment of interest on the note. From a US income tax perspective, the IDGT would be structured to qualify as a “grantor trust” as to the transferor/seller. Under grantor trust rules, the IDGT would be disregarded as an entity and all of its assets and income would be considered owned and received by the transferor/seller. With the IDGT disregarded for income tax purposes, there could be no sale of the pre-IPO interest or payment of interest for income tax purposes. The transferor/ seller would remain the owner of the pre-IPO interest for income tax purposes – as if the sale had never occurred – even though the sale would be respected for gift and estate tax purposes. Thus, there should be no income tax liability with respect to the sale transaction. In addition to having no tax cost, the sales transaction could secure significant estate tax benefits beyond the initial transfer and sale. With the IDGT classified as a grantor trust, the transferor’s payment of any tax on the later sale of the transferred assets would be a gift-tax free transfer of additional value to the IDGT and the beneficiaries, further reducing the transferor’s taxable estate. The IDGT also could be structured to secure estate tax benefits for the beneficiaries of the trust, even multiple generations. Irrespective of these estate tax benefits, the transferor could still retain substantial powers over the trust, and these powers could be exercised by subsequent generations. For a PRC or Hong Kong family that includes one or more US Persons, transferring an interest in a family business to an IDGT may secure significant US tax benefits for multiple generations, while allowing the family to engage in business succession and estate planning without excluding US Persons based simply on tax issues.

GRAT A GRAT involves a transfer into an irrevocable trust established for the benefit of family members or other third parties by the owner of the pre-IPO interest. The owner/transferor retains the right to an annuity interest for a fixed term of years as part of the transfer. When the annuity period and the payments end, the remaining assets in the GRAT – including all appreciation on such assets – pass to the remainder beneficiaries of the trust, or possibly to another trust for the benefit of those remaindermen.

www.dlapiper.com | 07 By retaining the right to an annuity payment, the owner/transferor can reduce the value of the transferred interest for gift tax purposes to zero (or close thereto) such that the owner/transferor has little or no gift tax liability. To achieve this, the annuity needs to be structured to provide for payments equal to the value of the transferred interest and a statutory-assumed rate of growth (the “hurdle rate”). So long as the transferred interest grows faster than the required annuity payments, including the hurdle rate, the use of a GRAT will allow the appreciation on the transferred interest above that hurdle rate to pass free of estate tax. Given the current low interest rates, a pre-IPO interest that is anticipated to appreciate significantly is an attractive asset for funding a GRAT. From a US income tax perspective, the transfer between the owner/settlor and the GRAT is disregarded where the GRAT is properly structured. In other words, there is no income tax liability for the completed gift to the GRAT. The owner/settlor remains the owner of the transferred asset for US income tax purposes. As a result, when the owner/settlor later pays tax on income or gain from the transferred asset, the owner/settlor would effectively be making another transfer to the GRAT and its beneficiaries without any additional gift tax. One disadvantage of the GRAT is that should the settlor/owner pass away during the annuity period, the transferred assets will be treated as part of the settlor/owner’s estate, regardless of the trust structuring. In addition, a GRAT generally cannot provide for trust benefits for multiple generations. Similar to IDGT planning, the use of a GRAT can facilitate business succession and estate planning for a PRC or Hong Kong family with one or more US Persons.

08 | tax Quarterly Newsletter – September 2012 THE FUTURE COMMENCES NOW

On 17 September 2012, the Hong Kong Exchange launched the widely anticipated trading of the first RMB currency futures to hedge the conversion risk between USD and CNH (the reference ticker for the increasing pool of RMB circulating outside of the PRC).6 The new scheme marks a significant milestone in the progression of the RMB towards internationalization by permitting for the first time a currency hedging product connected to the RMB. The fact that the product is first offered in Hong Kong may also be significant to achieve Hong Kong’s aspiration of becoming the world’s premier offshore RMB center outside the Mainland. Under the trading code ‘CUS’ and for a value of US $100,000, each contract is quoted in RMB per USD and margined in RMB. The contracts are settled in RMB, requiring the seller to deliver in USD, and the buyer to pay in RMB, the full principal amount at the final settlement price due upon maturity. The standard settlement dates are calculated from the spot month and the final settlement price is determined using the spot USD/CNY fixing published by the Hong Kong Treasury Markets Association at the day that is two Hong Kong Business Days prior to the third Wednesday of the contract month. The RMB futures market provides a broad base of worldwide financial market participants access to the RMB with minimal counterparty risk with Hong Kong at the center of the trade. Indeed, the Hong Kong Future Exchange Clearing Corporation Limited provides the central counterparty in clearing and settling every transaction. Moreover, the RMB futures are offered via the Hong Kong Exchange electronic derivatives trading platform, ensuring transparent pricing under a regulated and centralized market regime, with market makers providing continuous two-sided quotes throughout a trading day to ensure liquidity. For investors anticipating depreciation of RMB and interested in hedging their currency risk exposure, trading RMB currency futures has now become a viable course of action. Because futures contracts are traded on the basis of margin (approximately 1-2% of the notional amount), full exposure is not required up front. Also, with the new offering, new players such as traded funds, foreign institutional investors and active individual investors may be induced to invest and hedge their investments in both the onshore and offshore RMB market, yielding high returns while limiting their currency risks. It is hoped that the new product will trigger a virtuous financial development cycle towards a host of new RMB/CNH products in the near future. It is also hoped that the choice of Hong Kong as the first center outside the Mainland to offer sanctioned currency derivative products involving the RMB will serve to place Hong Kong at the forefront of the development of the RMB as an internationally accepted currency. Given the above, there is no doubt that, for Hong Kong, in building its RMB pedigree, the future commences now.

6 Because of exchange control regulation, such RMBs are deemed to form a separate pool from the RMBs circulating inside the PRC.

www.dlapiper.com | 09 601 + 30 = SOME CLARITY

In the last several years, the PRC tax authorities have revamped their approach to international taxation. One of the cornerstones of their new approach is found in Circular 6017, where the tax authorities have imposed strict conditions on foreign investors before they can be eligible to claim the favored rates of withholding tax found in the tax treaties entered into by the PRC (including the tax arrangement with Hong Kong). In Circular 601, the tax authorities provided for qualification criteria to be met by foreign investors seeking to claim tax treaty benefits for passive income. Circular 601 focuses on the concept of “beneficial owner” found in typical tax treaty clauses for dividends, interest and royalties and, in particular, it provides for seven indicia that the authorities must review and assess before deciding whether or not the favored tax rates of a treaty can apply in particular circumstances. Circular 601 left much uncertainty in its wake, making it difficult for taxpayers to fully understand when treaty benefit will be extended. That is why, on 29 June 2012, the State Administration of Taxation (SAT) introduced Circular 308 to provide further details on the application of Circular 601. We note the following.

The seven indicia Circular 601 sets out seven indicia said to be unfavorable in assessing the beneficial ownership status of an applicant for treaty benefit. Circular 30 emphasizes that all of the seven factors should be comprehensively considered when assessing the beneficial ownership status. We believe that it will make it somewhat easier to reach a favorable conclusion since the tax authorities will no longer be able to focus unduly on only one or two of the indicia. Rather, they will be called upon to make an overall assessment of all of the criteria thereby allowing the applicants to emphasize inapplicable indicia as a way to neutralize the impact of indicia applicable to their circumstances.

Listed companies Circular 30 introduces a specific exemption to the application of Circular 601 in the case of listed companies. Circular 30 provides that there will be no requirement for the tax authorities to review an application for treaty benefit under the light of Circular 601 where the applicant is a listed company or a directly or indirectly wholly owned subsidiary of a listed company situated in the same jurisdiction. Note that this exemption will apply only to dividend income and not to royalty or interest.

Agency Another significant development relates to the treatment of agents. Circular 30 will allow for disregarding the actual recipient of a treaty-favored payment where it can be shown that the payee is merely an agent of someone else who would be able to pass successfully the assessment required by Circular 601. In other words, the tax authorities will be called upon to ascertain the application of

7 Circular of the State Administration of Taxation on How to Understand and Determine “Beneficial Owners” under Tax Conventions, Guo Shui Han [2009] No. 601, 27 October 2009 – see TQN December 2009

8 Announcement of the State Administration of Taxation on the Determination of “Beneficial Owners” in the Tax Treaties, State Administration of Taxation [2012] No. 30, 29 June 2012

10 | tax Quarterly Newsletter – September 2012 Circular 601 not with respect to the payee but with respect to the person who is, in fact and in law, the actual beneficiary of the relevant payment. It will therefore be possible to use nominee companies to front investments in the PRC and still preserve the right to favorable treaty rates. We note that Circular 30 does not define the expression “agent” and the burden of proof will be on the applicant to prove the agency relationship. It is likely that the tax authorities will want to see clear evidence (documentary or otherwise) confirming the agency relationship before they disregard the actual payee of the relevant income.

Review and procedure Circular 30 entitles the tax authorities to reverse previous decisions and impose taxes and penalties as needed. For instance, where tax treaty benefits had been allowed because an agency relationship was alleged but it is later discovered that the agent was in fact the true beneficial owner, the tax authorities are specifically empowered to re-assess the agent. Additionally, if the tax authorities are unable to timely conclude in a particular matter, they can now decide to deny temporarily the treaty benefit subject to adjustment when a final decision is made. This new option is less favorable than the current regime to the extent that Circular 601 deemed as an acceptance an undue delay in deciding on an application.

Collaboration and consistency To achieve a more consistent assessment method, Circular 30 requires that all refusal of beneficial ownership status be approved by a provincial tax bureau and reported to the SAT for recording. This is a welcome change and we hope that decisions will be regularly published to allow the taxpayer to better gauge what seems to upset the tax authorities in shaping the external structure of investments in the PRC. Circular 30 also calls for collaboration among different local tax authorities in assessing the beneficial ownership status of an applicant applying for treaty benefits in more than one local office whether simultaneously or consecutively. Any disagreement should be reported to the higher tax authority and it is hoped that this will improve consistency of treatment from local bureau to local bureau. Unfortunately, this new procedure is not a compulsory and Circular 30 does not specify which local tax authority should initiate the report to the higher tax authority when the local tax authorities cannot agree. We will have to see how this works out in practice before judging whether consistency is indeed achieved.

Documents and evidence Circular 30 also provides some guidance on the documents that the tax authorities would expect to be made available in the context of a review of an application for treaty benefit. The documents would include the articles of association of the applicant, the financial statements, any relevant contract as well as proof of ownership of patent or copyright.9 Circular 30 came into application on the day of its issuance.

9 Article 2, Announcement of the State Administration of Taxation on the Determination of “Beneficial Owners” in the Tax Treaties, State Administration of Taxation [2012] No. 30, 29 July 2012

www.dlapiper.com | 11 TIDBITS

Inevitably

Our readers will recall that China implemented a value added tax (VAT) pilot program in Shanghai on 1 January 2012 as a first test for merging the current business tax and transaction tax into a single VAT system. Shanghai was the trial ground to work out the kinks in the system and prepare for a national expansion of the new system. The tax authorities must have been satisfied with the Shanghai experiment since, on 3 August 2012, the Ministry of Finance (MoF) and the State Administration of Taxation (SAT) issued joint Circular 7110 to announce the rollout of the VAT pilot program to ten more cities commencing 1 September 2012. The circular provides for a schedule of implementation and confirms the adoption by reference of all practices and circulars developed by Shanghai during its trial period11, subject however to specific rules for local industries of particular importance to a specific city. It is expected that the recent expansion of the new system is the next way station towards full national implementation of the new system, particularly, since the introduction is seen as part of the strategic infrastructure required to foster the development of the Chinese economy.

Inevitably too

In January 2011, Shanghai (again!) and Chongqing were invited to introduce some form of property tax with a view not only to expand the sources of revenue of municipalities but also to cool property markets considered too frothy for the authorities. The State Administration of Taxation (SAT) has now decided to expand the property tax trial to other cities for the same reasons. Indeed, while the property market has shown some signs of cooling down, prices are still considered too high and municipalities continue to need additional revenues to absorb the constant flow from the countryside to the cities. It is expected that, for the time being, the tax authorities will continue to allow cities to experiment as to how to apply their new taxation power (for instance, the schemes in Chonqing and Shanghai are completely different). In due course, it is quite possible that, if the SAT sees a consensus emerging as to what system works best, it will wish to impose the selected system nation-wide. While various politicians and property moguls will continue to rail against the negative impact of taxes on property prices, it is in our view inevitable that there will be a property tax system throughout China in the near future.

10 Notice issued by the Ministry of Finance and the State Administration of Taxation announcing the precise implementation dates for the VAT reforms Cai Shui [2012] No. 71

11 For more information, please see Circular on Carrying Out the Pilot Collection of Value-Added Tax in Lieu of Business Tax to be Imposed on Transportation Industry and Part of Modern Services in Shanghai Cai Shui [2011] No. 111; Circular on Zero VAT Rate and Tax Exemption Policy Applicable to Taxable Services Cai Shui [2011] No. 131; Circular on Certain Tax Policies on the Pilot Collection of Value-Added Tax in Lieu of Business Tax to be imposed on Transportation Industry and Part of Modern Services Industry Cai Shui [2011] No. 133; Supplementary Circular on Several Tax Policies Relating to the Pilot Collection of Value Added Tax in lieu of Business Tax in Transportation and Certain Areas of Modern Services Industries Cai Shui [2012] No. 53

12 | tax Quarterly Newsletter – September 2012 HONG KONG

www.dlapiper.com | 13 AN INTELLECTUAL DIPN

The Inland Revenue Department (IRD) recently added various provisions to promote the wider use in Hong Kong of intellectual property rights (IPRs) for the development of creative industries in Hong Kong.12 The three new sections, sections 16EA, 16EB and 16EC of the Inland Revenue Ordinance (IRO), provide for various tax deductions related to the acquisition costs of IPRs. The IRD has now issued DIPN No. 4913 to explain its views of the new legislation as well as, more generally, how it proposes to tax royalties arising from IPRs.

Deduction criteria and anti-avoidance Taxpayers will be allowed to deduct the acquisition costs of a qualifying IPR (i.e. patents, rights to know-how, copyrights, registered designs and registered trademarks), provided:

1. The registration of the IPR is place

Where a registration system is in place, IPRs can only qualify for a deduction if it has already been registered by the seller and purchaser on the date of acquisition, either in Hong Kong or overseas. However the IRD acknowledges that the registration process of IPRs in some jurisdictions can be time-consuming, therefore the taxpayer can still qualify for deduction provided the relevant IPR has already been registered by the seller with the relevant authorities and the purchaser has already submitted applications to register the IPR in their name.

Typically, there is no registration system in place for copyrights and know-how rights. Consequently, DIPN No. 49 does not require IPR rights of this nature, verified by reviewing the purchase and sale agreement, to be registered to be eligible for a deduction.

2. The taxpayer possesses both the legal and economic ownership of the IPR

The taxpayer must possess both the legal and economic ownership of the purchased IPR. The IRD has clearly indicated a licensing arrangement does not give the purchaser the legal and economic ownership and hence will not qualify.

3. The IPR has been used in Hong Kong or by the taxpayer himself outside Hong Kong

4. The IPR has been used for the production of profits chargeable to tax in Hong Kong

Whether the IPR is used in the production profits chargeable to tax in Hong Kong is a question of fact. In general, the IPR will only be “used” when it is actively exercised in the course of production of chargeable profits.

12 Please see the article entitled “New tax deduction for IP rights” in TQN December 2011

13 Departmental Interpretation and Practice Notes (“DIPN”) No. 49. – Readers may download DIPN No. 49 from the Publication and Press Releases section of the IRD website (http://www.ird.gov.hk/eng/pdf/e_dipn49.pdf).

14 | tax Quarterly Newsletter – September 2012 Furthermore, the relevant use is territorial according to the place of registration. Example 5 in DIPN No. 49 outlines the IRD’s view in this regard. Where a taxpayer purchased an IPR registered in multiple jurisdictions, but has only been used in a few of them, a deduction claim on the entire acquisition costs would only be accepted if the taxpayer could provide substantive and reasonable evidence to prove that the IPR registered in jurisdictions where it has not been used has had a “direct and actual impact on the production of profits chargeable to tax in Hong Kong.”14 It is worth noting that the tax deduction for copyrights, registered designs and registered trademarks is spread over five subsequent years commencing from the year of purchase. For patents and know- how rights, the taxpayer is eligible to claim tax deduction in one go in the year of purchase. With regards to anti-avoidance, special attention is given to the anti-avoidance provisions introduced in the new IRO legislation to prevent the exploitation of the tax deduction rules by prohibiting the deduction of acquisition costs in certain situations. The two most controversial provisions are the provisions relating to:

1. use of an IPR outside Hong Kong

No deduction will be allowed where an IPR is used wholly or principally outside of Hong Kong under a licensing agreement by a person other than the taxpayer. This is illustrated in Examples 13 to 15 of DIPN No. 49. It follows from these examples that the calculation of the deduction of the acquisition costs depends on several factors including: the involved rights (e.g. registered or unregistered and if registered, in what jurisdiction), where the IPR is used and the nature of activities the IPR is used for. Specifically, Examples 13 to 15 outline various situations where an the purchaser of an IPR leases it for use, wholly or principally, outside of Hong Kong. Furthermore, the examples demonstrate the parallel applications of Section 16EC(4)(b) of the IRO and section 39E of the IPO relating to capital expenditure on leased machinery or plant.

2. purchase of an IPR from an associate15

No deduction will be allowed, irrespective of whether the sale was transacted at arm’s length, if an IPR is purchased wholly or partly from an associate.

Source of royalty income Pursuant to Section 16EC(4)(b), acquisition costs are not deductible if the purchaser licenses the relevant IPR to another party for use outside Hong Kong, in exchange for royalties. Concerns were raised that royalties derived from such an agreement would be seen as sourced in Hong Kong and subject to profits tax, despite the non-deductibility of acquisition costs. The source rules of royalty income are streamlined below:

■■ Where the IPR is created or developed by a taxpayer carrying out business in Hong Kong and is licensed to another party outside Hong Kong, the resulting royalties will generally be regarded as Hong Kong sourced and taxable.

■■ Where a taxpayer purchases the legal and economic ownership of an IPR and licenses it to another party for use outside Hong Kong, the royalties derived will generally be considered as non- Hong Kong sourced and non-taxable.

■■ Where the IPR is not owned by the taxpayer, the IRD will assess the source of royalty income by looking at where the license was acquired and granted. The clarifications provided by the IRD in DIPN No. 49 are welcome and the new regime should be relatively straightforward.

14 Section 31, DIPN 49

15 The term “associate” is widely defined in section 16E(8) and includes individuals, partners in a partnership, or corporations under common control, and trusts.

www.dlapiper.com | 15 ALTERNATE REALITY

When the Commissioner of Inland Revenue is not sure who should be liable to tax in a particular transaction, it is not unusual that he would issue alternate assessment involving the same assessable income but against two taxpayers. From his perspective, the income should be assessable against one or the other of the taxpayers but not knowing which, he issues assessments against both to protect his right to assess the income. Is this legal? The recent decision of the Court of First Instance (CFI) in Canray International16 provides the answer. In Canray International, two BVI companies and two Hong Kong companies were wholly-owned subsidiaries of a Hong Kong incorporated company manufacturing and selling footwear. The chart below describes how products manufactured in the PRC made their way to the third party customers through transactions involving the BVI and the Hong Kong companies.

PRC Factory 1 PRC Factory 2 (Manufacture Goods) (Manufacture Goods)

Sale of Goods Sale of Goods

Canray International Limited Cashmaster Profits Limited (“Canray International”) (BVI Co.) (“Cashmaster Profits”) (BVI Co.)

PRC Sale of Goods Sale of Goods HK

Liang Shing Industries (HK) Lucky Port Trading Limited Limited (“Liang Shing”) (HK Co.) (“Lucky Port”) (HK Co.)

US/Europe Customers US/Europe Customers

16 Canray International and others v CIR, HCAL 18/2011

16 | tax Quarterly Newsletter – September 2012 The rationale of the structure was to capture some of the profits in the VIB companies outside of the Hong Kong tax net on the basis that the two companies did not carry on business in Hong Kong. The structure also provided for the Hong Kong companies to argue that their role was administrative in nature so they should be entitled only to minimal profits. Upon review, the IRD was not particularly impressed and issued assessments of the same income against

1 the BVI companies on the basis of section 14 IRO to the extent that they were carrying on business in Hong Kong and their profits were sourced in Hong Kong; and,

2 the Hong Kong companies on the basis of (i) section 20 IRO to the extent that the Hong Kong companies were the agent of the BVI companies; and, (ii) section 61A IRO to the extent that the profits of the Hong Kong companies were inappropriately understated because of the intervention of the BVI companies. After submitting objections against the assessments, the applicants filed an application for judicial review in March 2011 to test the appropriateness of assessments based on alternative theories. The applicants argued that the Commissioner did not have the power to issue alternative assessments pursuant to the IRO. The CFI followed the Australian case of Richard Walter17 and found that Section 59(3) IRO clearly allowed the Commissioner to issue estimated or alternative assessments when the Commissioner does not have sufficient information to pinpoint who should be liable to tax in a particular transaction. In the view of the Court, provided the multiple assessments do not lead to multiple recovery of the same tax, the Commissioner must have the power to issue alternative assessments against anyone connected to the relevant income where there is ambiguity as to the role of the various participants.

17 Deputy Commissioner of Taxation of the Commonwealth of Australia v Richard Walter Pty Ltd (1995) 183 CLR 168

www.dlapiper.com | 17 CHEERS!

On 19 June 2012, the Court of Appeal (CA) delivered its decision in the matter of Nice Cheer Investment Limited v Commissioner of Inland Revenue.18 The ruling in favor of the taxpayer confirms that profits tax is not chargeable on unrealized gains arising out of the revaluation of trading securities.19 During the years under review, the taxpayer was a Hong Kong company primarily engaged in the investment of trading securities listed on the Hong Kong Stock Exchange. Over the years, even if in its audited accounts it recognized its unrealized gains or losses, for tax purposes, it excluded its unrealized gains from assessable income even if it continued to claim the a deduction for the unrealized losses. The Commissioner did not agree with the approach and argued that both unrealized gains and losses should be included in the company’s profits tax assessment. In the CA, the Commissioner argued that the Secan decision20 confirms that departing from the presentation of the audited financial statements is required only where the IRO explicitly departs from accounting principles (say, for instance, specific depreciation rates for tax purposes). He then argued that a proper construction of Section 14 of the Inland Revenue Ordinance (IRO) does not prevent charging profits tax on unrealized gains. The CA did not accept the submission. It found that a taxpayer cannot be taxed on notional profits since one cannot trade with oneself. In its view, one of the fundamental principles underpinning the IRO is that only real income can be brought to taxation; profits must be realized not anticipated. On that basis, it applied Secan in finding that, as it pertains to unrealized gains, the IRO departs from the accounting principles and it is therefore appropriate to exclude unrealized gains from assessable profits, irrespective of the accounting treatment. The Court also confirmed that the position for unrealized losses was different and the taxpayer was entitled to claim a deduction even where the loss has not been realised. The Commissioner has filed for leave to appeal in the Court of Final Appeal so the CA decision is not yet final but, for now, it certainly gives taxpayers something to cheer about.

18 Nice Cheer Investment Limited v Commissioner of Inland Revenue CACV 135/2011 19 See Best of Both Worlds in TQN September 2011 for a discussion of the Court of First Instance in this matter. 20 Commissioner of Inland Revenue v Secan Ltd & Another [2003] 3 HKCFAR 411

18 | tax Quarterly Newsletter – September 2012 STILL BAD FENG SHUI

Things are not getting any better for self described fung shui master Tony Chan Chun-Chuen since our last report in June 2011. Our readers know that Mr. Chan lost his claim to the estate of the late Nina Wang last October, after the Court of Final Appeal (CFA) rejected his application for leave to appeal a lower court ruling that his claim to the estate was groundless. He is now left with an order to pay Chinachem Charitable Foundation HK $2M in legal fees, bringing the total amount owed for the trial and two appeals to around HK $130M. Mr. Chan is also running out of luck with his objection to the Inland Revenue Department (IRD)’s assessment of over HK $340M he owes in profit taxes on payments of over HK $2B for “services” he would have rendered to Mrs. Wang during her lifetime. In July, Mr. Chan applied for a judicial review of the assessment in an attempt to extend the deadline for appeal, alleging he had no actual knowledge of the assessment demand notes sent by the IRD informing him of the assessment. He also claimed that the HK $2B under review were gifts from Mrs. Wang, thus not liable to profit taxes. The Court of Appeal (CA) held that it was unreasonable to expect the IRD to send all demand notes by registered post to ensure their delivery and it was the responsibility of the taxpayer to update their contact information. Consequentially, Mr. Chan’s objections were out of time. The countdown to the payment deadline was deemed to begin when the demand notes were served on Mr. Chan’s lawyers, regardless of whether Mr. Chan had actual knowledge of them. Between losing his claim to Mrs. Wang’s HK $100B fortune and the rejection of his appeal for judicial review, it appears that Mr. Chan will need to realign his qi if he wants to find balance in his financial future.

www.dlapiper.com | 19 PROVISIONAL TAX

August is usually a busy time for the IRD with the issuance of most of the individual tax assessments. With tax returns for individuals issued in April and due in May, by August, the IRD is ready to notify the taxpayer of whatever tax is owed for the previous year of assessment (here, 2011/12) while also claiming an referred to as “provisional” for the following year (2012/13). What is provisional tax and how does it apply? Here are as few answers.

■■ There are three types of provisional taxes in Hong Kong: provisional salaries tax, provisional profits tax and provisional property tax.

■■ Provisional tax is an estimate of the tax payable by a taxpayer for the current year of assessment. For convenience, the IRD assumes that the taxpayer will earn in the current year the same assessable income as in the preceding year (except for profits tax as it pertains to losses).

■■ Provisional profits and salaries tax is payable in two instalments: 75% in the final quarter of the year of assessment (around January or February) and the remaining 25% three months later (around April or May). The system should be viewed as fair to the extent that, by the time a taxpayer has earned salary for approximately 3/4th of the year, he is required to pay 3/4th of the estimate of tax for the year. Similarly, by the end of the year, the taxpayer is required to pay the balance of the estimate of his tax payable for the year.

■■ Provisional property tax is usually payable in one instalment in November. The system then involves some prepayment to the extent that the tax paid includes anticipated income from November to March of the following year.

■■ Under the provisional tax system, a taxpayers whose current year income is higher than the preceding year gains a deferral benefit to the extent that he will be required to pay tax on less than his actual income for the year. By contrast, a taxpayer will end up overpaying his taxes under the provisional tax system if his income for the year will be less than the preceding year.

■■ It will usually take some time for a new taxpayer to enter the system. A taxpayer can then enjoy a significant deferral period but the first assessment will then usually include up to two years of taxes and some financial planning may be required to ensure that sufficient funds will be available come payment time.

20 | tax Quarterly Newsletter – September 2012 PROVISIONAL TIDBITS TAX Now you see it, now you don’t

On 27 September, the Hong Kong Inland Revenue Department (IRD) attached a template for a mobile notification service for tax information with the 2011-2012 annual report. It contained information regarding notifications of chargeability to tax, alerting all taxpayers who had not yet received tax returns to inform the Commissioner of Inland Revenue (Commissioner). However less than three hours later, the recipients of the cryptic template received another email from the IRD saying “Please disregard the attachment in previous mail.” It is likely that the IRD mistakenly attached the template when distributing the annual report. Looking closely, we can see that the template, created in August, instructs taxpayers who had not received their tax returns to inform the Commissioner by 31 July 2012, two months before the template was distributed. As such, we can conclude that either the IRD performed a magic trick when retracting the attachment, or even the IRD makes mistakes.

Convenience

Beginning 1 August, paying government bills will be even easier! Members of the public will now be able to pay fourteen designated government bills at more than 1,000 convenience stores across Hong Kong including any 7-Eleven, Circle K, and VanGO convenience stores as well as all China Resources Vanguard Supermarkets. However, because of a cap at HKD 5,000, the pilot scheme may not be as useful as could be. For many bills, the cap will not be enough to settle a single bill, especially when part-payment of business registration renewal fees are not permitted. Nevertheless the initiative is welcome and the new method is a great way for individuals to pay off smaller, more urgent bills, and leave the more substantial debts to be settled through the traditional post office, internet banking, PPS or post methods.

www.dlapiper.com | 21 TIDBITS

New ta x treat y

The double taxation agreement (DTA) between Hong Kong and Malta came into force on 18 July 2012 after the completion of lengthy ratification procedures by both parties. The DTA will have effect in Hong Kong for any year of assessment beginning on or after 1 April 2013 and incorporates the latest Organization for Economic Co-operation and Development (OECD) policy regarding the exchange of information involving tax matters. This DTA came one month after Hong Kong signed a DTA with Mexico, allowing income tax paid in one jurisdiction by citizens of the other jurisdiction to be used as credit for income tax payable in their home jurisdiction. In addition to Mexico, the DTAs with Kuwait and Switzerland are still pending completion of ratification procedures. Hong Kong has now signed DTAs with 25 countries. Hong Kong’s DTA Partners Austria Jersey New Zealand Belgium Kuwait Portugal Brunei Liechtenstein Spain Czech Luxembourg Switzerland France PRC Thailand Hungary Malaysia United Kingdom Indonesia Malta Vietnam Ireland Mexico Japan Netherlands

 Pending represents country’s which are waiting for ratification procedures to be completed.

22 | tax Quarterly Newsletter – September 2012 If you have finished with this document, please pass it on to other interested parties or recycle it, thank you. www.dlapiper.com

This publication is a general overview and discussion of the subjects dealt with and is up to date as of 25 October. It should not be used as a substitute for taking legal advice in any specific situation. DLA Piper or its Tax group accepts no responsibility for any action taken or not taken in reliance on it.

DLA Piper uk llp is part of DLA Piper, a global law firm operating through various separate and distinct legal entities. Further details of these entities can be found at www.dlapiper.com.

Please note that as a foreign law firm, and notwithstanding the fact that we have offices in Shanghai and Beijing respectively, DLA Piper uk llp (like all other foreign law firms with offices in the PRC) is not permitted under existing PRC law to advise on the laws of the PRC. In view of this, this publication would, insofar as the laws and regulations of the PRC are concerned, necessarily be based on our own research, experience and the advice of our correspondents in the PRC.

A list of offices across Asia Pacific, Europe, the Middle East and the Americas can be found at www.dlapiper.com