Time for a long-term tax plan for Hong Kong

Thursday 18 February 2016

This week, Financial Secretary Mr John Tsang will present the 2016-2017 budget for the Hong Kong SAR.  It is high time to address the government’s obligations to society.

The popular narrative is that Hong Kong has the best of both worlds, with a low tax economy and large fiscal surpluses.  In recent years, the biggest headache for Financial Secretary Mr John Tsang has been how to spend a succession of large and unexpected budget surpluses and, in that respect, this year will be no different.

But these headline numbers mask growing dissatisfaction that the government is failing to meet its obligations of care to the population, as well to as preserve Hong Kong’s competitiveness as a leading global trade and financial centre.  Many of these problems can be traced back to Hong Kong’s revenue model, which is highly dependent on property-related taxes, principally land premium and stamp duty, which accounted for about 25% of the government’s revenue in the financial year 2015/16.

This model brings windfall gains, but it has also contributed (at least partially) to creating the world’s least affordable property market. This affects both residents and international businesses established in Hong Kong.

This tax revenue model is also too narrow. A reliance on highly cyclical property-related and direct taxes is inherently risky, and leaves Hong Kong vulnerable to a future long-term deficit, particularly as it addresses the needs of an aging population.

While these criticisms are not new, in the past, previous financial secretaries have justified a “do nothing” approach due to an obligation in the Basic Law for the Hong Kong government to run a balanced budget. 

This year is different. We expect this underlying structural weakness in Hong Kong’s finances to be exposed as the economy faces a myriad of internal and external headwinds. 

Hong Kong has deep financial and trade linkages with China, and will inevitably be impacted by slower growth or a financial crisis across the border; this is evidenced by recent capital outflows of the Hong Kong dollar in sympathy with yuan volatility.  Meanwhile, a higher interest rate in the US brings a direct headwind to the local property market. 

Indeed, the Financial Secretary’s current prediction of budget surpluses for the next five years may, for once, be overly optimistic. The good news is that Hong Kong starts in a strong fiscal position, with about HK$850 billion in reserves, enough to fund the government budget for 23 months.  

Nonetheless, we urge the government to directly address the need to deliver a sustainable tax base so that it can make long-terms plans to meet its social obligations, ranging from housing to better retirement planning to healthcare.   As well as broadening the tax base to better meet the government’s obligations, tax reform must also ensure that Hong Kong retains and bolsters its competitiveness as a global financial centre.

Tax Reform

Taking a Domestic View

The need for changes is reinforced by the fact that only 46% of the workforce pays Salaries Tax, and about 60% of the Salaries Tax collected comes from the top 5% of taxpayers. Meanwhile, only 9% of the companies registered in Hong Kong pay Profits Tax, and about 85% of the revenue comes from the top 5% taxpayers.  Numerous submissions to the government from various professional bodies and chambers of commerce have called for a comprehensive review of tax laws.

We encourage the Financial Secretary to move forward with the politically sensitive issue of broadening Hong Kong’s tax base, which will stabilise the government’s revenue to protect against an economic downturn.  This should involve a combination of increasing indirect taxes and levies whilst reducing direct taxes. Where revenues exist, they should be used to offset the impact of these taxes and levies by providing subsidies to lower-paid workers and the elderly, and providing allowances for private healthcare insurance premiums.

Indirect taxes: In previous budgets, Mr Tsang acknowledged that the proposal to introduce a Goods and Services Tax (GST) did not find support in 2006.  But now is the time to re-examine this, as well as potentially to increase existing Excise Duties on fuel, alcohol, tobacco, and hydrocarbon oils. Similar levies on certain other consumption goods such as luxury goods may also be considered. 

Direct taxes: Broadening the tax base through indirect taxes and levies should give greater scope to reduce direct taxes to stimulate the economy and increase its overall competitiveness. There have been suggestions to reduce the Profits Tax rate for smaller businesses with an annual turnover of less than HK$2 million, and this should be further considered.

Impact of International Tax Developments

Hong Kong is likely to become an even more important financial centre as traditional tax-havens are rapidly losing their appeal. To maintain Hong Kong’s competitiveness, the government should expedite the development of policies to respond to changes in the international tax landscape, particularly to avoid being put in the same corner as the British Virgin Islands and the Cayman Islands.

As of June 2015, at least ten EU countries had placed Hong Kong on their blacklists of non-cooperative (tax) jurisdictions. Fortunately since then, Spain and Italy have removed Hong Kong from their country blacklists; it is imperative that the government continues to implement the necessary amendments to ensure that Hong Kong is taken off the blacklists of other countries. 

The government also needs to address other tax matters in response to international tax developments. In October 2015, the OECD issued 13 reports on 15 base erosion and profit shifting (“BEPS”) actions, which would require changes to Double Tax Agreements to deal with issues such as permanent establishments (basically taxable branches), abuse of treaty benefits, dispute resolutions, hybrid instruments and the like.  The OECD is also particularly concerned about double non-taxation, which could put pressure on Hong Kong’s territorial basis of taxation. 

Under the existing Hong Kong rules, if income is “offshore-sourced” (that is, the relevant operations take place outside Hong Kong), the profits in question may not be held chargeable to Profits Tax in Hong Kong. It is then up to the country where the operations take place to decide whether to tax the profits.  Taxation might not apply, for instance if the other country is not aware of what is happening within its territory, or it has consciously decided not to tax such operations under its domestic rules. 

Regardless of the overseas tax liability, such territorial tax treatment is one of the pillars of the Hong Kong tax system, and we strongly urge the government to preserve this tax benefit.

Maintaining Hong Kong’s Position in Asia

Positioned on the doorstep of China with a large offshore RMB pool, a deep supply of financial professionals and well-functioning and efficient capital markets, Hong Kong is already a leading global financial centre, but this strong position cannot be taken for granted. Further measures are needed to maintain Hong Kong’s competitiveness versus regional competitors, particularly in wealth management industries where Singapore competes directly with Hong Kong for regional business.

Profits Tax Exemption for Offshore Funds

In previous budgets, the government initiated measures to extend the Profits Tax exemption for non-resident funds to private equity funds. This was a good start, but further measures are needed to enhance Hong Kong’s tax competitiveness here.

The Financial Services and the Treasury Bureau (FSTB) recognises that taxation is an important consideration for fund managers when they decide where to domicile and manage their funds. As such, the FSTB is considering an extension of the said exemption to open-ended funds (OFC); this would give investors great flexibility in allotting and redeeming shares when transacting in the fund without triggering Stamp Duty consequences. 

The government could also consider the introduction of fiscal consolidation and group loss relief, since funds typically have various entities for the holding of portfolio investments.

Attracting Regional Corporate Treasury Centres

A bill was submitted to the Legislative Council on 16 December 2015 to bolster Hong Kong’s attractiveness for corporate treasury operations of regional holding companies. This is a good first step in enhancing the city’s appeal as a corporate treasury centre (CTC) for multinationals. 

Given certain stringent specific conditions in the bill, corporations may need to weigh the benefit of the concessionary tax rate for the qualifying profits and the overstretching anti-avoidance provisions against any inconvenience or costs (and possibly the loss of entitlement to tax treaty benefits) of spinning off the CTC operations into a separate legal entity. We encourage the government to consider tax facilities to compensate taxpayers for the costs associated with the commercial operating needs of a group treasury centre.

Attracting Family Offices and Private Wealth

Similar to being the epicentre of Asia’s asset management and private equity industry, Hong Kong should also be made more attractive as a hub for the region’s family office and private wealth activities. The Financial Secretary should consider policies and regulations to develop the reputation of the Hong Kong trust industry and, more specifically, to ensure a high standard of compliance and competence in this regard. 

Asia’s IP Hub

We enthusiastically support efforts to develop Hong Kong into the region’s premier hub for start-ups. One important initiative here would be to promote Hong Kong’s status as a tax-friendly jurisdiction for utilising and capitalising on intangible assets (that is, intellectual property).  The government has established a “Working Group on Intellectual Property Trading”, but given that the Hong Kong economy has become increasingly knowledge-based, more policy work is needed. 

In recent years there has been a reduction in “hard assets” (e.g. plant and machinery) and an increase in IP as a share of Hong Kong’s economic output. The current approach and legislation seems to provide a relatively narrow base for claiming tax deductions for only certain IP types.  Meanwhile, capital expenditure to develop IP is generally not deductible, nor is it eligible for depreciation allowances, as the law exclusively applies to the purchase of certain registrable IP. 

Intangible assets are as essential as hard assets for carrying on business in an increasingly knowledge-based economy, yet at the moment tangible assets are in principle entitled to a much more beneficial tax treatment in Hong Kong.

Hong Kong’s IP tax regime should address this imbalance. This could include adopting more Double Tax Agreements, which minimise withholding taxes on foreign royalties paid to Hong Kong IP owners, allowing credits for foreign withholding taxes on royalties, and further deductions for IP expenditures.

In addition to tax measures, the government should also consider formalising privacy and data protection law. Not only will this support Hong Kong’s attractiveness as a start-up hub, it will also help the city prepare for the protection of taxpayers’ interests in complying with the OECD's automatic exchange of information standards.