Introduction
Hong Kong is an SAR that enjoys independence from mainland China (until 2047). The area has become a major economic hub in the past decade and still continues to grow in leaps and bounds. Iyer et al (2008) attribute the development of a country’s economy to proper tax measures such as those that Hong Kong has put in place. Being an SAR, Hong Kong levies its own taxes independently. The system of taxation employed is “territorial” where tax is levied on income generated in Hong Kong independent of the resident status of the tax payer. The territorial principle applies where it can be shown that: the entity being taxed traded within Hong Kong; the income subject to tax arose from that trade and that such income was derived from Hong Kong.
The Inland Revenue Ordinance of Hong Kong levies profits tax on the realized assessable profits of sole proprietorships, partnerships and corporate bodies. The territorial principle does not recognize residential status or the fact that the income has been taxed elsewhere or not. This means that the tax regime in Hong Kong in itself does not prevent double taxation. Ho and Hutchinson (2010) confirm that indeed there are some loopholes in Hong Kong’s taxation system. Since double taxation is a hindrance to smooth trading, Hong Kong has entered into various double taxation avoidance treaties with other countries. These countries are; Brunei, Luxembourg, the U.K, China (second protocol), Vietnam, Thailand, Belgium and Austria.
Hong Kong has also signed similar treaties with several countries which are still awaiting ratification. These are; France, Netherlands, Hungary, Indonesia, Ireland, Kuwait, Liechtenstein, New Zealand, Switzerland and Mainland China (third protocol). In addition, the SAR has signed other non-comprehensive treaties with other countries mainly dealing with the twin issues of aviation and shipping. These countries are Sweden, Bangladesh, Croatia, Belgium, Canada, Kenya, the UK, Denmark, Korea, Norway, Russia, Mexico, Netherlands Ethiopia, New Zealand, Singapore, Finland, Germany, Jordan, China, Iceland, Kuwait, Switzerland, Israel, Mauritius, Sri Lanka, and finally the US.
While many people consider Hong Kong to be an offshore jurisdiction, its government still maintains that it is just a low tax area and not an offshore jurisdiction per se. However, the tax regime in Hong Kong is quite different from that of other onshore jurisdictions since it does not levy such taxes as sales tax, estate tax, value added tax, capital gains tax, and withholding tax for interests, royalties and dividends. Its tax rates are also quite low as per OECD (Organization for Economic Cooperation and Development) standards.
Discussion
As seen from earlier statistics, Hong Kong has entered into 7 comprehensive double taxation avoidance treaties, 10 more await ratification while 27 other similar treaties though non-comprehensive have been entered into. However, these treaties are mostly likely going to expose Hong Kong to treaty shopping. While these treaties themselves may have anti-abuse provisions in them, this has been found to be very unreliable as a method of curbing treaty shopping (OECD 1998). I shall take an in-depth look at the risk of treaty shopping ran by Hong Kong.
Analysis of the risk of treaty shopping in Hong Kong
Rosenbloom (1983, p. 766) describes treaty shopping as “a premeditated effort to take advantage of the international tax treaty network and a careful selection of the most favourable tax treaty for a specific purpose.” In short, it is the use of third parties normally referred to as “conduit companies” to gain advantage from a tax treaty that one would legally not have benefited from. Treaty shopping is normally done for various reasons such as to benefit from an exemption or reduction in tax that would have been otherwise unavailable, to benefit from a lower rate of tax that would not have been applicable and to claim an undeserved tax credit (Egger & Merlo 2007; Neumayer 2007).
Treaty shopping is mainly done by individuals and companies from foreign states but it can also be done by taxpayers in the source country. The use of conduits is not limited since there is even a chance of more than one conduit being used so as to get an even bigger benefit. These additional conduits are known as “stepping stones” (OECD 1998). There is also another form of treaty shopping that involves the emigration of a person from one state to another so as to enjoy certain benefits that would not have been available in their domicile of origin (OECD 2005).
Whatever the type of treaty shopping, the impact is always the same-the state loses revenue that it was otherwise entitled to. This is why many states have either avoided these treaties or have put in place strict tax enforcement mechanisms that reduce the risk of treaty shopping. Entering into many of these double taxation avoidance treaties may cause a country to lose so much revenue that it surpasses what would have been lost had double taxation been allowed (Davies 2003). Alm and Senoga (2010) find that all forms of tax evasion usually have a distributed effect that ends up affecting international trade.
Treaty shopping is to be differentiated from rule shopping. According to OECD (2005) rule shopping “concerns a person who as such is entitled to the benefits of a certain tax treaty and who employs that treaty in the most favourable manner.” It is simply making maximum advantage of the favourable clauses in a treaty. Treaty shopping on the other hand takes advantage of benefits not available to the treaty ‘shopper.’
Marcarian (2006) gives examples of present situations where treaty shopping is likely to be done. He points at the treaty between the UK and Hong Kong and finds that it allows a person outside the treaty to use a person in the UK as a conduit to purchase property cheaply in Hong Kong (p.171). Due to the tax regime in Hong Kong, many countries that sign treaties with it are most likely susceptible to treaty shopping since it does not levy most taxes such as capital gains tax and withholding taxes. An example is this is where a treaty shopper may benefit from a 5% withholding tax in dividends in China if they stated that the payer of the dividends is a Hong Kong company or owned by a Hong Kong company with at least a 25% shareholding in the paying company.
While most of the treaties that Hong Kong has entered into contain several anti-treaty shopping clauses, these clauses have been found to be ineffective in curbing the vice. Hong Kong authorities need to come up with measures that reduce instances of treaty shopping through tighter tax administration measures. However, under the Vienna Convention on the Law of Treaties, once a country binds itself in a treaty, it cannot use domestic legislation to defeat the treaty (Pacta sunt servanda) (OECD 2008). This means that Hong Kong can only put into effect enforcement mechanisms to prevent treaty shopping and not legislative ones that touch on existing treaties.
Tax administrative measures to curb treaty abuses
As we have seen above, Hong Kong is quite vulnerable to abuses of double taxation agreements (DTAs). While this may hurt revenue collection in Hong Kong itself, the practice is looked down upon internationally since it means that other countries become vulnerable once they sign such a pact (Davies 2004). Still, there are several measures that the Hong Kong government can put in place to prevent the wanton abuse of the DTAs it has signed with other countries.
Various measures that have been put up in other countries such as neighbouring China can assist in bringing about a reduction in these abuses. Most of the tax administration measures used usually deal with the beneficial owner and the criteria for receiving a benefit under a particular DTA. Some of the countries that have introduced such measures such as the US (Busse et al 2008; Blonigen et al 2004; Dagan 2000) and China (Toumi 2006; Shelton 2004) have sealed the loopholes that many treaty shoppers rely on to benefit illegally from DTAs. Chan et al (2009) add that the sealing of these loopholes sometimes brings about unnecessary barriers to trade like in China’s case.
The first tax administration measure involves places of strict conditions of proof for the beneficial owner. The beneficial owner is the person or entity that owns or controls the income that is subject to a tax benefit under a DTA (Egger et al. 2006). Tighter measure can be implemented in Hong Kong to ensure that the beneficial owner is not a foreigner using a conduit company to draw tax benefits. Such a measure would include placing a target requirement on the shareholding of the foreign entity in the Hong Kong subsidiary generating the income.
Toumi (2006) suggests that in addition to shareholding, the non-residents voting rights in the subsidiary need to be investigated (p.83). There is also an added requirement for a timeline to be set for the non-resident to have held the shares in the subsidiary. Usually the minimum set is 12 months (p.85). These two requirements make it harder for use of conduits since the non-resident would have to beat the set minimums before benefiting under the treaty. These administrative measures would also help in preventing Hong Kong companies from being used as conduits since it would mean compromising their voting rights and shareholding.
Another administrative measure that has been employed elsewhere with success is tightening the process of application for an exemption under a DTA. In China for example, for a non-resident to claim under a DTA, they must show that they have filled the application form necessary to claim under the Act (Toumi 2006, p.101). Secondly, they have to fill another form that gives information about their shareholding or shareholders (where it is a company), nature of business carried out in the country of origin and in China, nature of transactions e.t.c (p.102).
There is also an added requirement for a tax residency certificate issued in the home jurisdiction in the preceding 12 months. Where the income in question is derived from an asset, the non-resident is required to produce title documents to prove ownership. There is also a clause in the administrative regulations stating that the non-resident is required to provide all such information as may be required by the tax bureau investigating the claim. Once the tax bureau assesses the information provided, it can then make a decision to approve or reject the request for the tax benefit under the treaty (Toumi 2006, p.100).
However, there are several checks to ensure that these strict measures do not prevent non-residents who would have otherwise benefited under the treaty from benefiting. Such a check would be to give at least three years for the non-resident to apply for the tax benefit. Also, when an application is rejected, the applicant must be notified in writing, the reasons for the rejection. In an effort to make the process simpler, tax authorities should allow tax benefits for the successful applicants to run for the same income without annual renewal. This would help to prevent a complex system that would defeat the purpose of the treaty. These measures should strictly target areas that can be used by treaty shoppers and should not be used to deny non-citizens their rightful benefits under the treaty.
There are various scenarios that are most likely acts of treaty shoppers and not legitimate claimants. These are situations where: the applicant has to pay a large amount of the money (e.g. over 60%) to a non-resident in a foreign country within a short time; the applicant does not carry out any other business except holding properties and the rights that flow from the incomes; the applicant company or business entity owns or holds very few assets or a disproportionate number of employees compared to the amount of income; the applicant entity holds very limited control and voting rights or no rights at all in the disposal of income or assets; the contracting state levies no tax or exempts tax for the income in question, or levies tax on the income but at a rate that is very low; there is evidence of another loan/deposit contract between the applicant and a third party whose amount, rate of interest and/or duration of contract conclusion are similar to those of the original loan contract from where the interest in question is generated and paid; there is evidence of another existing contract between the applicant and a third party conferring or transferring the right to own or use or a copyright or patent that is similar and coexistent with the original contract on the transfer of the right to own or use the same copyright or patent from where the royalty in question is generated and paid.
Clearly from the scenarios above, there is sufficient reason to suspect that the applicant intends to benefit a third party as a conduit. Tax authorities in Hong Kong need to look into applications for treatment under treaties with enough scrutiny so that they may avoid promoting treaty shopping. Yoder (2009) states that there is need for international tax reform measures to deal with this problem on a global level rather than to expect individual states to enact legislation affecting foreigners.
Conclusion
From the discussions above, we can see how conflicting international relations can be. While countries are entering into a bilateral agreement, they do so to escape the ills that come from double taxation but in their attempt to do so, they invite another ill in the form of treaty shopping (Arnold et al 2002). Most states find it difficult to enter into DTAs with other states that are considered tax havens or tax shelters such as Hong Kong, Jersey Islands, and Cayman Islands among others (OECD 2008). This is because this may become an entry point for treaty shelters looking to benefit themselves at the expense of the state.
One of the reasons why treaty shopping is so vile is because it is a preserve of the rich. These are the people with the capability to make huge offshore investments and own conduit companies. Treaty shopping thus serves to make the rich richer while denying governments much needed revenue for programs that are beneficial to the entire community. A report by UNCTAD (2007b) shows that treaty shoppers do not make any meaningful impact on the economy of the ‘source’ state. By using conduits, they do not make any real investments or create employment for the residents (Blonigen et al 2005). There is thus nothing positive that can be drawn from treaty shopping except for the gains made by the treaty shoppers themselves.
Nevertheless, we have seen how governments such as Hong Kong’s can make tax administration steps to ensure that this vice is eradicated. Employment of stringent standards can enable the government to collect its deserved share of revenue (Coupe 2008). There is need for caution so that in the efforts to root out treaty shoppers, the government does not end up inviting back double taxation. Baumann and Shaw (2008) state that the disclosure of untaxed earnings from foreign countries could go a long way in preventing this kind of tax evasion.
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