In the second of this two-part series, Henry Kwong, Tax Partner, and Matthew Cheung, Tax Manager, Cheng & Cheng Taxation Services Ltd, assess the salient features of the anti-avoidance tax provisions, recently introduced as part of the PRC Individual Income Tax reforms.
In the first part of this two-part article, published in the May edition of CSj, we examined recent reforms, which were approved on 31 August 2018 by the National People’s Congress of the People’s Republic of China (PRC), to the PRC Individual Income Tax (IIT) law, and which came into effect on 1 January 2019. We explained the definition of a PRC individual tax resident, as well as the implications for Hong Kong individuals and foreigners working in the Mainland.
In this second part, we will look at the anti-avoidance tax provisions that have been integrated into the IIT law and their significant impact on overseas investments by PRC individual tax residents, and will also provide a general comparison of Hong Kong and Mainland tax rates on various forms of income earned by an individual.
Anti-avoidance tax provisions
In the past, anti-avoidance tax provisions were included only in the PRC Corporate Income Tax law. While the definition of a PRC individual tax resident in the IIT law has attracted the major portion of the public’s attention, we consider that the introduction of anti-avoidance tax provisions is also an important part of the reforms to the IIT law.
Article 8 of the IIT law empowers the Mainland’s State Administration of Taxation to make adjustments to the taxable income of an individual under the following situations:
- where the tax payable by an individual or his/her related parties in the Mainland is reduced due to non-arm’s length related party transaction(s)
- where the set-up of a Controlled Foreign Corporation (CFC) does not distribute, or has reduced the distribution of, its profits without reasonable business needs, or
- where an individual has obtained inappropriate tax benefits by entering into an arrangement lacking reasonable commercial purposes.
Of the above three situations, we consider that the CFC rule will have the most pronounced ramifications for PRC individual tax residents (which includes Mainland domiciled individuals) making overseas investments, including in Hong Kong (see Diagram 1). The rationale behind this assertion lies in the following two important facts:
- the profit distribution (normally in the form of dividends) from an overseas investment is subject to IIT of 20% for a PRC individual tax resident, and
- for a number of reasons, investors commonly set up intermediary holding companies in low-tax jurisdictions (such as Hong Kong or the British Virgin Islands) to hold investments.
In view of the above, PRC individual tax residents could leave any profits earned by their overseas investments in an intermediary holding company without distributing those profits, in order to postpone or avoid IIT liabilities. As such, in order to protect the interests of the Mainland, if the intermediary holding company is now considered a CFC under the new IIT anti-avoidance tax provisions, the undistributed profits of the CFC will be deemed as income of the PRC individual tax resident.
Below are some of the features of a CFC as it relates to a PRC individual tax resident:
- it is under the control of a PRC individual tax resident
- it is set up in a low-tax jurisdiction (such as the British Virgin Islands or the Cayman Islands). In this regard, it is also possible for a Hong Kong corporation to be considered a CFC since dividend income received from a Hong Kong corporation is not subject to Hong Kong profits tax, and
- it does not have substantial enough business operations to justify the need to retain earnings to support its business operations and/or future growth.
Taking this into account, in order to avoid the intermediary company being treated as a CFC of a PRC individual tax resident, you would have to set up substantial operations and substance in the intermediary company. In this regard, a PRC individual tax resident could consider setting up substance in Hong Kong, given its geographical convenience. Meanwhile, obtaining a Hong Kong Certificate of Resident Status to demonstrate that the management and control of the entity is exercised in Hong Kong is one of the indirect ways to support the fact that the entity is not a CFC.
Common Reporting Standard
In the past, it would not have been easy for the State Administration of Taxation to detect the income of a PRC individual tax resident from an overseas investment because such income would generally not be repatriated back to the Mainland. However, with the implementation of the Organisation for Economic Co-operation and Development (OECD)’s Common Reporting Standard (CRS), it is now easier for the State Administration of Taxation to be aware of any CFC maintained by a PRC individual tax resident, as well as the relevant financial information.
Financial institutions in Hong Kong generally require bank account holders to complete a self-certification form to declare their place of tax residency. In the case of a corporation, the bank account holders are further required to declare whether it is a financial institution, an Active Non-Financial Entity (NFE) or a Passive NFE. If the corporation is a Passive NFE, it also has to fill in another self-certification form declaring its controlling person(s).
In the case of a CFC – as it is likely to be an investment holding company and will thus have limited business activities – the majority should fall within the definition of a Passive NFE in the self-certification form. It is therefore likely that a CFC would be required to fill in the information about its controlling person(s), which includes individuals owning more than 25% of the issued share capital of the CFC. If the controlling person is a PRC individual tax resident, the State Administration of Taxation can easily establish the relationship between that individual and the CFC when the information is transmitted to them.
Therefore, it is strongly recommended that all PRC individual tax residents ensure they are aware of their potential tax liabilities from overseas investments, as well as carry out necessary tax planning to reduce their Mainland tax risk.
Individual tax rates in Hong Kong and the Mainland
To sum up this IIT series, we would like to highlight the differences in personal tax rates for individuals between Hong Kong and the Mainland.
As explained above, dividend income from an overseas investment is subject to IIT at a rate of 20%. Other investment income, like capital gains and rental income, are also generally subject to the same rate of 20% in the case of a PRC individual tax resident.
In contrast, dividend income and capital gains are not subject to profits tax in Hong Kong. In this regard, the Inland Revenue Department is more concerned about whether the relevant investment represents capital or revenue assets of the individual. For capital assets held for long-term investment purposes, the gain from disposal of the investment represents capital gains, which is not subject to Hong Kong profits tax.
As many of you will be aware, the Hong Kong salaries tax rate (that is, at progressive rates from 2% to 17%, or a standard rate at 15%) is one of the lowest across the globe, while the Mainland’s IIT is calculated based on progressive rates from 3% to 45%. In cases where the same income is subject to both Hong Kong salaries tax and IIT, a tax credit is generally available to reduce the taxpayer burden.
For a PRC individual tax resident, business income is subject to an IIT rate of 5% to 35%, while in Hong Kong, business income for an unincorporated business is subject to a tax rate of 15% (if no personal assessment is selected). It is worthwhile highlighting that the first HK$2 million of assessable profits earned by an unincorporated business is subject to a half tax rate of 7.5%, if no other connected entities claim the same tax benefits in Hong Kong. Table 1 summarises the tax rates for the common types of income under the tax systems of the Mainland and Hong Kong.
Last piece of advice
As the taxation system in the Mainland becomes more sophisticated, individuals doing business there should be aware of their potential tax exposure, while PRC individual tax residents should also be aware of their tax exposure in respect of local and overseas investments. Taxpayers are encouraged to look for tax advisers to examine whether their current investment structure and operations are tax efficient, as well as to ascertain their potential IIT exposure.
Henry Kwong, Tax Partner, and Matthew Cheung, Tax Manager
Cheng & Cheng Taxation Services Ltd