Hong Kong Focus 2017
By Lowtax Editorial
15 August, 2017
In this feature we explore what makes Hong Kong tick as one of the world's major business and financial centers.
A former British colony, Hong Kong is now in fact a "Special Administrative Region" of China and has been so since 1997. Its constitution, known as the "Basic Law", is modelled on the constitution of the People's Republic, under the guiding principle of "one country, two systems," which was established before the handover. This has not brought about more state interference from Beijing, however; under the Basic Law, the Chinese government agreed that Hong Kong's capitalist system would remain unchanged until the year 2047. Thus, except in the areas of foreign policy and defense, which remains the exclusive domain of Beijing, policy makers in Hong Kong have been free to continue pursuing the same laissez faire economic policies which have positioned it on the map as the world's third financial center after New York and London, and Asia's most important.
One of the consequences of Hong Kong's economic openness and its reliance on international financial services has been its vulnerability to regional or global economic shocks, and for this reason its economy has tended to see-saw in recent years. The territory enjoyed growth rates of between 6 percent and 8 percent prior to the global financial crisis, and rebounded from the crisis sharply in 2010 when it grew by 6.8 percent. Since then the economy has grown at a more modest pace, with growth tailing off to a modest 1.6 percent (estimated) in 2016.
A Financial, Business and Investment Hub
Low-value manufacturing used to be the mainstay of Hong Kong's economy, but this industry has now largely decamped to neighboring Chinese provinces, with the territory's economy now based largely on re-exporting and services, particularly financial services.
Banking is a major constituent of Hong Kong's substantial financial services industry, and Hong Kong is one of Asia's largest banking hub in terms of external transaction volume. At the end of July 2017, there were 155 licensed banks, 21 restricted license banks and 17 deposit-taking companies in business. In addition, there were 52 local representative offices of overseas banks in Hong Kong.
At the end of January 2016, total bank deposits stood at more than HKD12.3 trillion (USD1.6 trillion). Deposits in the Chinese currency, the renminbi (RMB), grew rapidly in the 10 years to 2015 as China accelerated the pace of internationalization of the currency, and RMB deposits reached a peak of HKD1 trillion at the end of 2014. Since then, the level of RMB deposits have halved, to HKD526bn at the end of June 2017. The number of financial institutions authorized to take RMB deposits also soared, from 30 to 40 in 2004 to almost 150 at the end of 2014. The number of these institutions has fallen slightly and stood at 140 in mid-2017.
Hong Kong is also recognized as the leading fund management center in Asia with the industry defined by its international and offshore characteristics, and it has become a popular choice for hedge fund managers, especially since the government granted an income tax exemption to offshore funds owned by non-resident entities administering a fund in Hong Kong. According to the Hong Kong Securities and Futures Commission's (SFC) last survey report of the sector, released in March 2015, hedge fund assets under management (AUM) in Hong Kong reached a record high in 2014. The report shows that as of September 30, 2014, hedge fund AUM in Hong Kong were USD120.9bn, an increase of 39 percent from the amount reported in the previous survey in September 2012.
Hong Kong has also established itself as the favored base for multinational companies looking to expand into Asia-Pacific markets. The number of business operations in Hong Kong with parent companies overseas and in Mainland China climbed to 7,986 in 2016, compared to 7,904 in 2015, according to a joint survey conducted by Invest Hong Kong and the Census and Statistics Department. These companies comprised 1,379 operating as regional headquarters, 2,352 as regional offices and 4,255 as local offices.
In terms of source country/territory, Japan ranked first with 1,376 companies in Hong Kong, followed by the US (1,353), Mainland China (1,123), the UK (656), Taiwan (387) and Singapore (382). By sector, import/export trade, wholesale and retail topped the list (3,575), followed by financing and banking (1,520), and professional, business and education services (1,283).
In recent years, companies in asset management and biomedical sciences have been prominent among new investors. However, Hong Kong is attracting a growing number of companies in emerging businesses, including the Internet of Things and financial technology industries.
Indeed, Hong Kong continues to attract far larger volumes of foreign direct investment (FDI) than most industrialized economies. According to the United Nations Conference on Trade and Development's (UNCTAD) World Investment Report 2017, Hong Kong was the 4th largest recipient of FDI in the world in 2016 with inflows of USD108bn. Only the United States, the United Kingdom and China saw higher FDI inflows that year.
According to UNCTAD, Hong Kong continues to be one of the "major destinations" for the headquarters of MNCs targeting Asia Pacific markets.
"Offshore" But Onshore
Unlike most onshore jurisdictions, income tax in Hong Kong is levied on a "territorial" basis, which means that income tax is due on locally-sourced income only. What's more, a number of taxes that are levied in other jurisdictions do not exist in Hong Kong; for example, there are no capital gains taxes, no withholding taxes, no sales taxes, no VAT, no annual net worth taxes and no accumulated earnings taxes on companies which retain earnings rather than distribute them. While corporate income tax (known as Profits Tax), at 16.5 percent, is higher than in most offshore jurisdictions, it is still substantially lower than in most OECD countries, even accounting for the fact that corporate tax rates around the world have tended to fall in recent years.
Personal taxation is also low by international comparison. Income tax, known in Hong Kong as Salaries Tax, is paid at either a flat rate of 15 percent, or on a progressive scale between 2 percent and 17 percent. Taxpayers may elect to choose to pay tax under either of these systems, depending on which one gives them the lower tax liability. Individuals are only assessed on annual employment income which is defined as wages, salaries, bonuses, commissions, payments by the employer into a pension fund for the employee and gratuities. Non-employment source income such as share dividends and capital gains realized on the sale of shares are not taxable in the territory. In addition, the definition of income does not include either a pension from a source outside Hong Kong or compensation for loss of employment.
Under article 151 of the Basic Law the territory can negotiate its own double taxation treaties independently of China using the abbreviation Hong Kong, China, and the government is now entering an increasing number of tax treaties of various types.
Legislation which came into operation in March 2010 allows Hong Kong to enter into comprehensive DTAs, incorporating the Organisation for Economic Cooperation and Development (OECD) international standard on exchange of information. In 2013, it also put in place a legal framework for entering into standalone tax information exchange agreements with other jurisdictions.
At the time of writing, Hong Kong had concluded 34 comprehensive double tax treaties, with three agreements pending. The three pending agreements were with Belarus, Latvia, and Pakistan.
Recent Tax Developments
While Hong Kong is favored by investors partly because of its stable and predictable tax regime, and low taxes, this doesn't prevent the Government from seeking to improve the tax rules from time to time, normally to improve tax conditions for certain economic sectors.
For example, in July 2017, Hong Kong's Financial Services Development Council (FSDC) proposed that the Offshore Private Equity Fund Tax Exemption should be extended to certain Hong Kong portfolio companies to boost the development of the industry.
This followed the enactment for legislation to introduce a profits tax exemption for privately offered open-ended fund companies if their central management and control exercised in Hong Kong.
At the time of writing, the Government also is considering introducing tax relief for small and medium enterprises and providing additional tax deductions for research and development. The Government has confirmed that a new "tax policy unit" has been instructed to consider the proposals of Hong Kong's new Chief Executive, Carrie Lam, who took office on July 1, 2017, to: introduce a two-tier profits tax rate system and lower the profits tax rate for the first HKD2m of profit from the current 16.5 percent to 10 percent; and provide additional tax deductions for business spending on research and development activities.
Earlier in the year, the Government published a legislative bill containing measures designed to boost the territory's attractiveness as a location for aircraft leasing. The bill, published on March 10, 2017, proposes the deeming of a taxable profit of 20 percent of net rental income, and the application of a concessionary 8.25 percent tax rate on that amount.
Present tax laws are perceived to be a barrier to the growth of the aircraft leasing sector in Hong Kong, which is forecast to growth strongly elsewhere as the region's aviation industry expands.
Explaining the need for the new legislation in a briefing on the proposals in January, KPMG explained that:
"Aircraft financing presents a major opportunity that complements Hong Kong's traditional strengths in the fields of financial and professional services. It's expected that over 6,000 commercial aircraft will be delivered globally over the next 20 years, with a high proportion being delivered to Asia. Hong Kong, with its established business infrastructure, should be a natural venue for aircraft operating lessors."
"However, the current tax law in Hong Kong is a major impediment, because it taxes the full rental income while denying deductions for aircraft depreciation and certain interest costs. Ironically, Hong Kong has the most competitive withholding tax rate for aircraft leases into China, but other jurisdictions such as Ireland and Singapore are currently much more attractive options overall."
Hong Kong And BEPS
Hong Kong is also keen to be seen as a cooperative tax jurisdiction, and in July 2017, the Government said that it would introduce legislation into the Legislative Council by the end of this year to implement the minimum standards proposed by the OECD as part of its base erosion and profit shifting (BEPS) project.
The minimum standards, which Hong Kong has committed to transpose into its own laws, aim to tackle harmful tax practices and tax treaty abuse, and would introduce new country-by-country transfer pricing reporting rules and improve dispute resolution mechanisms.
According to the Hong Kong Inland Revenue Department, multinational groups will be required to file country-by-country transfer pricing reports in Hong Kong for the accounting periods commencing on or after January 1, 2018.
Hong Kong And Tax information Exchange
In a similar vein, Hong Kong gazetted legislation to automatically exchange financial account information with other territories to support international tax collection efforts in June 2017. Introduced on July 1, 2017, the law will enable Hong Kong to implement automatic exchange of financial account information (AEOI) in tax matters in line with the OECD's Common Reporting Standard, while simplifying procedures for financial institutions and maintaining a degree of confidentiality for account holders.
"The Amendment Ordinance [ensures] that Hong Kong can preserve the financial account information from the second half of 2017 for exchanging with other jurisdictions. This enables the effective implementation of AEOI without introducing an undue compliance burden to financial institutions," the Government said, adding:
"The Amendment Ordinance does not alter the privacy and data protection requirements on AEOI under the Inland Revenue Ordinance. Hong Kong would only conduct AEOI with jurisdictions which have signed dedicated exchange agreements with us and have fulfilled the OECD's standard and relevant safeguards for protecting data privacy and confidentiality of the information exchanged."
"For a member of the public, if he is not a tax resident of any jurisdictions outside Hong Kong, financial institutions in Hong Kong will not report his information to the Inland Revenue Department under this regime."
Hong Kong And China
The importance of the economic relationship between the Hong Kong SAR and mainland China is difficult to overstate. China has long been Hong Kong's largest trading partner, and the mainland accounts for about half of Hong Kong's total trade by value. And the relationship is symbiotic: China has chosen Hong Kong as the venue for the internationalization of its currency, the renminbi, and Hong Kong is the largest offshore RMB center. As noted above, Hong Kong residents are allowed to establish RMB-denominated savings accounts with Hong Kong banks, while RMB-denominated corporate and Chinese government bonds have been issued in Hong Kong. RMB trade settlement is also allowed.
Further initiatives, such as the Hong Kong-Shanghai Stock Connect (see below), the Mutual Recognition of Funds, and The Hong Kong Shanghai Gold Connect will continue to liberalize the Mainland's capital markets reinforce Hong Kong's leading role as China's offshore RMB market.
The trading framework between Hong Kong and China has also been liberalized under the Closer Economic Partnership Agreement (CEPA). After signing the first CEPA agreement in June 2003 for implementation in 2004, the Central and Hong Kong governments have signed several yearly Supplements, with the latest phase of liberalization measures by virtue of Supplement X signed on August 29, 2013. The last expansion of CEPA brought to 403 the total number of liberalization measures for trade in services under the agreement.
The scope of CEPA was expanded further in 2016 thanks to a comprehensive new agreement to liberalize trade in services between Hong Kong and mainland China. The main text of the agreement, signed on November 27, 2015, sets out provisions for, among others, national treatment, most-favored treatment, safeguard measures, exceptions, and investment facilitation. The new agreement, effective July 1, 2016, opens up fully or partially 153 services sectors in mainland China to businesses in Hong Kong.
Hong Kong has established itself as the premier stock market for Chinese firms seeking to list abroad. As of December 15, 2016, there were 1,968 companies listed by HKEX on the Main Board and Growth Enterprise Market, with a total market capitalization of HKD24.7 trillion. Just over half of these were Mainland enterprises, constituting 63 percent by market capitalization, and 71 percent by annual equity turnover value. There were 121 new listings in total from January 1, 2015, to December 15, 2016, of which 54 were Chinese companies.
Stock And Bond Connect Schemes
The Shanghai Hong Kong Stock Connect (SHKSC) scheme, launched in November 2014, was seen as the attainment of another milestone on the path towards liberalization of the Chinese economy. The SHKSC is a mutual market access program that allows investors in mainland China to trade stocks listed on the HKEX directly through the Shanghai Stock Exchange (SSE). At the same time, it also allows Hong Kong and overseas investors to trade stocks listed on the SSE directly through the SEHK, also for the first time.
Under Shanghai Connect, The Stock Exchange of Hong Kong Limited (SEHK), a wholly-owned subsidiary of HKEX, and SSE have established mutual order-routing connectivity and related technical infrastructure to enable investors of their respective market to trade designated equity securities listed in the other's market.
For China, it is hoped that the SHKSC will help increase the participation of institutional investors in the Shanghai securities market, enable investors in mainland China to invest in overseas markets in an orderly way. In Hong Kong, it is hoped that the SHKSC will strengthen the co-operation and interaction between Hong Kong and the markets in mainland China, increase the two-way RMB funds flow between the onshore and offshore markets, and further increasing the liquidity of the offshore RMB market in Hong Kong.
The Shenzhen-Hong Kong Stock Connect (Shenzhen Connect) program, which further opens up Mainland China's markets for international and Hong Kong investors, was successfully launched on December 5, 2016. The stock link is similar to the Shanghai-Hong Kong Stock Connect, and expanded list of eligible stocks is intended to offer international and Hong Kong investors direct access to most companies traded in the Mainland for the first time. There are also more choices for Mainland investors, with 100 small cap stocks listed in Hong Kong now available through Shenzhen Connect.
Another "Connect" scheme arrived in July 2017 in the form of Hong Kong's "Bond Connect" program with Mainland China, which, as its name suggests, is a mutual bond market access program between the two territories. At the time of writing, only the "Northbound" link was open, allowing investors to invest in the China interbank bond market through Hong Kong. The Southbound trading link, allowing investors from China to invest in Hong Kong bond markets, was due to open at a later date.
"Bond Connect is a major breakthrough in the development of the China bond market, which is the world's third largest," said C K Chow, Chairman of Hong Kong Exchanges and Clearing Limited. "International investors will be able to use our link to trade directly with eligible dealers on the Mainland through platforms they have been using for other trading."
While Hong Kong's open economy continues to be vulnerable to fluctuations in regional and global economic and financial fortunes, its low-tax, light-touch tax and regulatory regimes continues to draw in investors in large numbers, as demonstrated by SAR's impressive FDI figures, and the growing list of companies using the jurisdictions as a springboard for expansion into china and the wider Asia-Pacific region. What's more, Hong Kong's unique relationship with mainland China, as a result of which it is the world's major venue for the internationalization of the RMB, and a key tool in the liberalization of China's economy, should stand the territory in good economic stead in the future.
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