Updated: Aug 19, 2019
A new two-tier profits tax system in Hong Kong is enacted by end of 2017. It will be covered in ACCA ATX/TX (HKG) (was P6/F6) syllabus from September 2019.
Any ACCA students or members are interested to understand this new tax regime are encouraged to read through this technical article.
The current Government has repeatedly mentioned about “New Fiscal Philosophy,” and the “New Direction for Taxation” plays a key role in realising this new philosophy.
The most eye-catching new tax initiative must be the two-tier profit tax system.
The Government introduced the two-tier system of profits tax in the Inland Revenue (Amendment) (No. 7) Bill 2017 (the “Bill 7”) on the 29th of December 2017 and it is scheduled to be implemented in Fiscal Year 2018/19.
Most people would know that the two-tier profit tax system introduced the lower 8.25% tax rate (half of the normal rate) on the first HK$2 million of assessable profits each year (a tax saving of HK$165,000 if the annual taxable profit of a company reaches HK$2 million), and each Group can only designate one company within the group to enjoy preferential tax rate.
Structure of two-tier profits tax system
Is this design good or bad?
First look at what the Government says.
The two-tier system was first proposed by Ms Carrie Lam in her campaign for the Chief Executive of Hong Kong for the purpose of “reducing the tax burden on enterprises (especially the small, medium and start-up enterprises)”.
After Ms Lam’s election victory, the Government started to study the implementation, and put forward in the 2017 Policy Address that “To ensure that the tax benefits will target SMEs, we will introduce restrictions such that each group of enterprises may only nominate one enterprise to benefit from the lower tax rate”.
According to the blog “Thinking about the 2018/19 Budget” released by the Financial Secretary, Mr Paul Chan, on January 7, 2018 (there is no English version), taking the 2015/16 assessment year as an example, there are about 100,000 companies paying Hong Kong Profits Tax, with distribution as follows:
(Source: “Thinking about the 2018/19 Budget” http://www.fso.gov.hk/chi/blog/blog070118.htm )
The information can be grouped as follows:The number of companies with assessable profits:0 – HK$2m: 82,500 (~80%)>HK$2m: 21,300 (~20%)
Reduction in tax revenue
Speaking at the “Summit on New Directions for Taxation” held in October last year, Financial Secretary Mr. Paul Chan said that if every company is allowed to enjoy the preferential profits tax rate, the Treasury would reduce its tax revenue by about HK$7.1 billion.
The Financial Secretary also mentioned that “as the cost of setting up and maintaining a company in Hong Kong is relatively low, there would be tax revenue loss if groups spin-off companies”.
In addition, “the United Kingdom introduced a similar taxation measure more than a decade ago, the corporation tax on the first £10,000 of profits was 0% with the amount exceeding that to be subject to tax.
In the two years since the introduction of the initiative, new local company formation increased 40% and 20% respectively, and the UK abolished the arrangement after some years”, “therefore, after due consideration, we decided to include some provisions to such that each group is only allowed to nominate one company to benefit from the lower tax rate, which helps to concentrate tax incentives on SMEs on the one hand and at the same time make it impossible for enterprises to spin off new companies for tax concessions”.
According to the statement made by the Secretary for Financial Services and the Treasury Bureau Mr James Lau, JP, on the second reading of “Bills 7” at the Legislative Council on January 10, “Assuming that 20% of the taxpayers are related enterprises, the implementation of the proposal will result in annual government tax revenue reduction of approximately HK$5.8 billion”.
The question is, is this estimate made based on the assumption that around 20% of companies have taxable profits exceeding HK$2 million?
That is, the Government assumes that all enterprises with an assessable profit of more than HK$2 million are large group enterprises and the rest (80%) are SMEs or start-ups and can enjoy a low tax rate?
I have no objection to two-tier profits tax.
The level of tax rates should be determined based on various factors including the international environment and consider the local policy direction.
Tax increases, tax reduction or two-tier system can all achieve policy objectives. The key is to be clear about the objective.
The objective of this reform is obviously to reduce the tax burden on SMEs and start-up companies.
The only question, therefore, is whether the two-tier profits tax system as proposed by “Bill 7” can achieve this objective.
The “connected enterprise” mentioned by Secretary Lau should be the “connected entity” mentioned in Bill 7. The definition of “connected entity” in simple terms is an entity that controls another entity or is jointly controlled by another entity or natural person.
The threshold of “control” is more than 50% (for details, see Article 4 of Bill 7 for the new S.14AAB).
Accordingly, if a businessman sets up two companies to run small businesses, one is a fashion retail shop which he holds 90% interest (Friend A holds 10%), and a snackfood trading company for which he holds 60% (Friend B holds 40%), under the Bill 7 the two companies are “connected entities”, so the businessman can only choose one company to enjoy the preferential tax rate, how should he choose without upsetting one of his friends?
As a matter of fact, many small business operations require more than one company to operate.
This is for business reasons such as licenses, the composition of shareholders, business categories, and risks containment.
Are these small businesses “large enterprises” in the Government’s eyes? On the other hand, according to my own personal experience, many companies that belong to the same group have assessable profits of well under HK$2 million (in fact, anyone who has handled Hong Kong profits tax compliance for large and small groups would know), thus I would say Secretary Lau’s estimation is too conservative.
Since there is no concession for large and small enterprises, I believe the number of companies that can enjoy the preferential tax treatment under the two-tier profits tax system would be very small.
The annual cost of revenue to the Government should be well below HK$5.8 billion.
The UK Example
The provision that only allows one of the “connected entities” to enjoy the lower tax rate should be the anti-avoidance measure (Specific Anti-avoidance Rule) mentioned by the Financial Secretary to prevent companies from abusing the tax preference by splitting up profitable ones.
The Financial Secretary also mentioned the example of the UK. According to the Institute for Fiscal Studies in the UK, the measure was introduced in 2000 with an applicable tax rate of 10% on the profits of the first £10,000 for the first two years (2000 and 2001) and zero for the next four years (a specific anti-avoidance provision was introduced), and the measure was abolished after 2005.
The purpose of introducing the low tax rate in those days was to encourage entrepreneurship and increase employment opportunities.
However, it also unexpectedly encouraged the conversion of existing self-employed persons into corporate forms, which, in addition to saving corporate tax, also reduced National Insurance contribution.
As for splitting up of companies to enjoy the low rate, although not impossible, I was not able to find materials covering this point.
More importantly, there was no “General Anti-Avoidance Rule” (GAAR) in the UK at that time (GAAR was introduced in the UK in 2013), meaning that the HMRC could not prosecute a company for entering into transactions or arrangement for the sole or dominant purpose of obtaining a tax benefit.
Situation in Hong Kong
On the contrary, Hong Kong has always had a GAAR (Section 61A of the Inland Revenue Ordinance).
When the Hong Kong Inland Revenue Department (“IRD”) considers any transaction has been entered into or effected and that transaction has, or would have had, the effect of conferring a tax benefit on a person, and it would be concluded that the person, or one of the persons, who entered into or carried out the transaction, did so for the sole or dominant purpose of enabling the relevant person, either alone or in conjunction with other persons, to obtain a tax benefit, the IRD shall assess the liability to tax of the relevant person as if the transaction or any part thereof had not been entered into or carried out; or in such other manner as the assistant Commissioner considers appropriate to counteract the tax benefit which would otherwise be obtained.
In other words, even if there is no Special Anti-avoidance Rule in Bill 7, when an enterprise, regardless of its size, sets up a company to split its profits in order to enjoy a lower tax rate, the IRD can apply GAAR to counteract the benefits and may impose a fine.
Any enterprise that avoids tax knowingly would certainly calculate the cost-effectiveness of arrangement.
Although it is not ruled out that enterprises may enter into an arrangement for saving just HK$165,000 (which would be the case only if the company has assessable profits of more than HK$4 million), apart from facing GAAR, dividing a business into two business is actually not easy in practice.
For example, a businessman operates a fashion retail shop and signed a five-year lease for the premises. If he now wants to split into two companies to operate the same shop, he will need to seek consent from the landlord.
If you were the landlord would you agree to it unconditionally? Then the business owner needs to bill customers separately, employees shall be hired by two companies, and vendors shall contract with two companies?
To save HK$165,000 for doing all these the business owner will likely end up losing money.
Of course, another approach is to maintain the operation of a company and to split the account into another company by means of internal allocation and accounting entries. But would this pass the sharp eyes of the IRD assessors?
SMEs tax burden cannot be released
As to the question “Can the two-tier profits tax system proposed in Bill 7 help reduce the tax burden on SMEs and start-ups?”, my answer to “No”.
This is because of the Special Anti-avoidance Rule contained in which is restrictive to SMEs and start-ups.
This provision is complicated and deviates from the requirements of a good tax system.
One of the criteria for a good tax system is “fairness”. “Fairness” means that tax treatment should be the same for different taxpayers doing the same thing.
It is fair for everyone to pay a high tax rate for higher profits, but it is unfair if benefits would be denied for being part of a group.
In fact, groups that set up a company to operate a business is no different from an SME, the group also needs to invest capital, hire qualified personnel and take risks, and the difference is that large groups can generally be able to do these more efficiently.
Perhaps “fairness” in the eyes of the government is that all large corporations and small enterprises can only choose one company to enjoy the benefits without discrimination.
Hong Kong does not have a group consolidation profits tax regime, but the lower tier profits tax rate is applied on a group basis, so there seems to be a conflict in administration.
In fact, there are quite a lot of channels for the Government to use financial means to help alleviate the burden on SMEs or start-ups, some of which may not have any assessable profit at all.
The Government could consider providing low-cost office space or industrial premises consider help reduce their operating costs, and even set up some special support funds for eligible enterprises or small size groups to apply?
When these enterprises become tax paying, the Government will recover the investments through tax revenue.
If a business earns HK$2 million profits a year, but it is actually earned through four companies (each HK$500,000), according to the two-tier system, the business can only save HK$41,250 (instead of HK$165,000).
It is time for SMEs to review the assessable profits of its companies and to choose one to enjoy the preferential tax rate in the future.
If commercially viable with the business transformation, businesses have the opportunity to enjoy the HK$165,000 benefits in full.
The premise, of course, is to strictly abide by the requirements of the tax regulations.
Subtitles are added for easy following. The publish of this article is permitted by author. Source: https://manageyourtax.com/tax-tips-4/
Who is Edwin?
Edwin was born in Hong Kong and studied in the UK in the mid-1980s. He graduated in the University of Southampton, UK, and was awarded the BSc degree with First Class Honours in Business Economics and Accounting, and won the 1992/93 Arthur Andersen Tax Prize for best exam performance in Tax Policy.
He worked in PwC and then joined EY as a senior tax manager. With 12 years experiences in professional firm, he joined multinational companies such as United Parcel Service and CK Hutchison Group. He left CK Hutchison Holdings as Deputy Head of Group Taxation and founded “Manage Your Tax”.