Introduction

In this article, we will look at the anti-tax avoidance provisions that have been incorporated into the PRC Individual Income Tax (“IIT”) law since 31 August 2018 and their significance on overseas investments made by PRC individual tax residents. We will also provide a general comparison of Hong Kong and Mainland tax rates on various forms of income earned by an individual.

Anti-tax avoidance provisions

In the past, anti-tax avoidance provisions were contained only in the PRC Corporate Income Tax law. While the definition of a PRC individual tax resident in the IIT law has drawn most of the public’s attention, 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 circumstances:

·           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.

CFC rule

Of the above three situations, the CFC rule is likely to have the most pronounced ramifications for PRC individual tax residents (including Mainland domiciled individuals) making overseas investments, including in Hong Kong (see Diagram 1) due to two important facts:

·           the profit distribution (normally in the form of dividends) from overseas investments is subject to 20% IIT for a PRC individual tax resident; and

·           for various reasons, investors commonly set up intermediate holding companies in low-tax jurisdictions (such as Hong Kong or the British Virgin Islands) to hold investments.

 

Diagram 1

In view of the above, in order to postpone or avoid IIT liabilities, PRC individual tax residents may leave certain profits earned by their overseas investments in an intermediate holding company without distributing those profits. As such, in order to protect the interests of the Mainland, if the intermediate holding company is considered a CFC under the new IIT anti-tax avoidance 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 business operations to justify the need to retain earnings to support its business operations and/or future growth.

To avoid the intermediate holding company from being treated as a CFC of a PRC individual tax resident, substantial operations and substance have to be set up in the intermediate company. In this regard, a PRC individual tax resident may consider setting up substance in Hong Kong, given its geographical convenience. 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’s Common Reporting Standard, 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).

The majority of CFCs would fall within the definition of a Passive NFE in the self-certification form as they are likely to be investment holding companies and thus have limited business activities. 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, PRC individual tax residents are strongly recommended to ensure that they are aware of their potential tax liabilities from overseas investments, as well as carry out necessary tax planning to reduce their Mainland tax liabilities.

Individual tax rates in Hong Kong and the Mainland

The differences in personal tax rates for individuals between Hong Kong and the Mainland are highlighted below.

Investment income

As explained above, dividend income from an overseas investment is subject to IIT at a rate of 20%. Other investment income, such as 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.

Employment income

Hong Kong’s 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, whereas 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.

Business income

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 personal assessment is not opted for). 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.

Table 1: Tax rates for the common types of income under the tax systems of the Mainland and Hong Kong

	Mainland	Hong Kong
1.      Employment income	Progressive rates from 3% to 45%	Progressive rates from 2% to 17%; standard rate at 15%
2.      Remuneration for labour services		15%; 7.5%
3.      Author’s remuneration
4.      Royalties
5.      Business income	Progressive rates from 5% to 35%	15%; 7.5%
6.      Rental income	20%	15%; 7.5%
7.      Dividends	20%	0%
8.      Capital gains
9.      Bank interest
10.   Incidental income

Conclusion

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 consult tax advisers on their current investment structure, tax efficiency of operations and their potential IIT exposure.

For enquiries, please feel free to contact us at:

E: tax@onc.hk                                                                      T: (852) 2810 1212 W: www.onc.hk                                                                    F: (852) 2804 6311 19th Floor, Three Exchange Square, 8 Connaught Place, Central, Hong Kong

Important: The law and procedure on this subject are very specialised and complicated. This article is just a very general outline for reference and cannot be relied upon as legal advice in any individual case. If any advice or assistance is needed, please contact our solicitors.

Published by ONC Lawyers © 2024