Inclusion of Hong Kong in the EU “Watchlist” of Non-Cooperative Jurisdictions for Tax Purposes
Hong Kong was recently added to the “watchlist” of Non-Cooperative Jurisdictions for Tax Purposes established by the Council of the European Union. In response, the Hong Kong government has pledged to make changes to its offshore income exemption regime in relation to certain types of passive income by the end of 2022. The new legislation is expected to come into effect on 1 January 2023. Having said that, this will not affect the long-established territorial source principle of taxation in Hong Kong. As of the date of this client alert, the Hong Kong government has not yet announced the proposed legislative changes. Businesses should therefore keep abreast with the latest developments and consider making changes to their structure and operation once more details of the proposed legislative changes are known.
Background
On 5 December 2017, the Council of the European Union (the EU) established the EU List of Non-Cooperative Jurisdictions for Tax Purposes (the List / Annex I) to promote global good governance in taxation and to inform member states of which non-EU jurisdictions engage in harmful or abusive tax practices. The List will be formulated based on the following main criteria:
- that a jurisdiction should fulfil to be considered compliant on tax transparency;
- that a jurisdiction should fulfil to be considered compliant on fair taxation (the Fair Taxation Criterion); and
- that anti-BEPS measures are being implemented.
Separate from the List (which is viewed as a blacklist), there is a state of play document (Annex II) which details the jurisdictions that have not yet complied with all international tax standards but have committed to implementing necessary tax measures to make themselves compliant. Annex II can be considered as a watchlist.
The List and Annex II will be updated by the EU twice a year. If a jurisdiction listed in Annex II has implemented all the necessary tax reforms before the deadline, it will be removed from Annex II. Otherwise, it risks the chances of being included in the List. The consequences are that the EU members states are encouraged to introduce defensive measures against the jurisdictions on the List, including increased withholding taxes, denial of deductions of costs, application of controlled foreign company rules etc., in order to prevent the erosion of the EU member states’ tax bases.
The Latest Development
On 19 May 2021, the EU wrote to the HKSAR Government (the Government) seeking commitments to repeal or amend the foreign source income exemption regimes as they are considered as not meeting the Fair Taxation Criterion. In essence, the EU considered that corporates without substantial economic activity in Hong Kong not being subject to tax in respect of certain offshore passive income (such as interest and royalties) will lead to circumstances of "double non-taxation". Subsequently, the Government sent a letter to the EU on 24 June 2021 committing to make the necessary changes.
On 5 October 2021, given the Government’s commitment, Hong Kong was officially added to Annex II (as opposed to directly on the List). Accordingly, Hong Kong was granted until 31 December 2022 to adapt the legislations for this purpose. It is expected that such legislative amendments shall take effect on 1 January 2023.
On the same day, the Government promptly made the following announcements:
- The Inland Revenue Ordinance (Cap. 112 of the laws of Hong Kong) will be amended by the end of 2022 and relevant measures will be implemented in 2023 to cooperate with the EU (the Proposed Legislative Amendments).
- Despite these upcoming measures, Hong Kong will continue to adopt the territorial source principle of taxation.
- The Proposed Legislative Amendments will merely target corporations, particularly those with no substantial economic activity in Hong Kong that make use of passive income to evade tax across a border. Individual taxpayers will not be affected. The Proposed Legislative Amendments also will not increase the tax burden of financial institutions.
The Government’s aim is to ensure that Hong Kong will be removed from Annex II following the implementation of Proposed Legislative Amendments.
The Way Forward
As of today, there is limited public information on the extent of the Proposed Legislative Amendments and so it may be too soon to anticipate and consider the necessary changes to the structure and operation of your business at this moment. Having said that, based on the above, we can only speculate that the Proposed Legislative Amendments may include slightly different economic substance requirements for different types of offshore passive income. These amendments are not expected to affect corporations with substantial business activities in Hong Kong in respect of other types of income (e.g. trading revenue or service income).
Taking reference from other jurisdictions that have been delisted from Annex I or Annex II, the draft legislative changes will likely be shared with the EU for feedback. The EU will assess the draft legislative changes and work with the Hong Kong Inland Revenue Department to settle any identified issues. Only then will the legislative changes be implemented. Following the implementation of the new legislation and the delisting of these jurisdictions, the new legislation may continue to mature and consequential amendments and guidance notes may be introduced to ensure consistency with any additional requirements from the EU.
In the meantime, taxpayers are strongly encouraged to stay tuned for further announcements by the Government and contact their tax representatives for tax planning once more details of the Proposed Legislative Amendments are known. We will keep a close eye on this issue and alert you as soon as we know more.
