Finance Bureau


PROFITS TAX REVIEW

CONSULTATION DOCUMENT

Financial Bureau,
Government Secretariat

July 1997


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FOREWORD

In the 1997-98 Budget Speech, the Financial Secretary proposed that a comprehensive review on profits tax should be conducted to examine whether we can make our taxation system and business environment more competitive.

This consultation document highlights salient features of our profits tax system and invites public opinion on the review, with a view to enabling the Government to formulate proposals on profits tax for the 1998-99 Budget.

Profits tax

Under the Inland Revenue Ordinance, profits tax shall be charged on a person in the following circumstances -

  1. the person carries on a trade, profession or business in Hong Kong; and

  2. there are profits from such trade, profession or business and such profits arise in or are derived from Hong Kong.

2. We adopt a territorial source principle. Only income which has a source in Hong Kong is taxable here. Income sourced elsewhere, notwithstanding that it may be remitted to Hong Kong, is not subject to Hong Kong profits tax. There is no tax on capital gains or dividends. Nor do we have an interest tax.

Basic tax principles

3. Article 108 of the Basic Law of the Hong Kong Special Administrative Region stipulates the constitutional requirement for our taxation system. Under this Article, Hong Kong shall practise an independent taxation system. Also, the low tax policy previously pursued in Hong Kong shall be a reference for our taxation system. In practice, we seek to maintain a low, simple and predictable tax regime.

Profits tax rate

4. The current standard corporate profits tax rate is 16.5%. The standard profits tax rate for an unincorporated business is 15%. A differential between the two has been maintained since 1975-76. Changes in the tax rate since the 1980s are shown in Appendix A. The current rate is the lowest since the 1980s. It is also the lowest in the region. A comparison with the standard tax rate of other places in the region and other world economies is shown in Appendix B. Our tax rate is highly competitive. Our taxation system won world recognition recently when the Heritage Foundation ranked Hong Kong as the world's freest economy and when the World Economic Forum voted Hong Kong as the second most competitive location in the world.

5. However, there are places in the region which offer a wide range of incentives in their profits tax system. Their effective tax rate, i.e. the actual tax paid after all tax concessions and deductions have been applied, can be substantially lower than their standard tax rate. This narrows the margin between Hong Kong and these places. Some places in the region have also reduced their profits tax to attract business and investment. For example, Singapore's corporate tax rate was recently reduced from 27% to 26%, the Republic of Korea has also cut its lower tax rate from 18% to 16% and its upper rate from 32% to 28%, and the Philippines is planning to reduce its corporate tax rate from 35% to 30%. While we may still have a competitive edge over these places insofar as the standard tax rate is concerned, there is no room for complacency. Obviously we want to ensure that Hong Kong continues to be a premier international business and financial centre in the region. We therefore need to consider whether our competitive edge is still enough or whether changes elsewhere in the region have eroded it to the point that we have to respond and take appropriate action. We should aim to send the right signal to investors and the international business community that Hong Kong remains the best place where they can do profitable business.

Profits tax as a revenue source

6. Profits tax is our largest revenue source. It is also a stable revenue source. It contributed on average some 25% of total Government revenue each year over the past decade. Our profits tax receipts for 1996-97 were about $50 billion, or 24% of total Government revenue for the financial year.

7. A single percentage point change in the standard corporate profits tax rate would result in a revenue gain/loss of $1.8 billion in 1998-99 and $10.8 billion cumulatively over the medium term forecast period up to 2001-02. No adjustment to the profits tax system should affect profits tax as a stable and productive revenue source. We have to maintain a stable tax base.

Certainty

8. Our simple and predictable tax regime offers certainty to investors. Our tax legislation is not complicated, and, where necessary, we supplement it with clarification in the form of practice notes. We also review our tax legislation regularly to bring it up-to-date and to respond to changes in the business environment. Recently, we revised the legislation -

  1. to provide certainty in respect of deduction of foreign withholding tax on income for companies in Hong Kong regardless of their residency;

  2. to confirm the exclusion of stock brokers and managers of offshore funds from potential profits tax liability in respect of share trading and fund investment profits derived by non-resident investors for whom the stock brokers or managers act as agents; and

  3. to provide a specific exemption from profits tax liability in law for certain income derived from Hong Kong share trading transactions by non-residents through bona fide offshore funds managed in Hong Kong.

9. There are some who call for legislation to define the territorial source concept in our taxation system in order to provide certainty. Whether certain profits are sourced here is ultimately a matter of fact. The legislation in this area is not unclear, and it is also supplemented by clarification in practice notes and guidelines laid down in authoritative court decisions. We are open to specific views as to how we can further improve certainty in this area but we will consider the introduction of additional legislation only if it is judged to be necessary.

Deductions

10. All expenses incurred in the production of assessable profits are fully deductible under our taxation system. These include employees' remuneration, material inputs for production and other operating expenses like interest payment, rents paid on business premises, bad debts, trade mark and patent registration fees, expenditure on scientific research and training, etc.

11. In respect of scientific research, expenditure of a capital nature is also deductible excepting expenditure on land or buildings or on alterations, additions or extensions to buildings. The deduction also applies to payments to approved research institutes for scientific research purposes.

12. While the full cost of research and development and training activities has long been deductible in the year in which the expenditure is incurred, there are calls for providing additional deductions for amounts over and above the actual expenditure incurred in order to encourage research and development and training, e.g. deductions of the order of 150% - 200% of the actual expenditure incurred. Such tax incentives are likely to have the effect of complicating our simple taxation system and increasing the costs of tax administration. We need to consider carefully whether this is the best way forward to encourage research and development and training in a low tax regime like Hong Kong.

Depreciation allowances for plant and machinery

13. We provide generous depreciation allowances for plant and machinery to encourage investment in such items. The initial allowance is 60% in the year in which the expenditure is incurred and the annual allowance ranges from 10% to 30% for different types of plant and machinery. The total allowance for the first year can thus be as high as 72%.Notwithstanding this, there are calls for a multiple depreciation allowance, i.e. a tax-deductible allowance well in excess of the full value of the plant and machinery.

14. We have to examine whether the existing system is fair and equitable. We need to consider whether the existing balance between the initial allowance and the annual allowance is appropriate, and whether the classification of plant and machinery under the annual allowance structure reflects their true economic life. We should also examine whether the existing "front-end loaded" system has presented opportunities for tax avoidance or has been used as a tax deferral device. In doing so, we should bear in mind the effect of depreciation allowance as an incentive for investment in plant and machinery.

Rebuilding allowance

15. At present, industrial buildings are entitled to a 20% initial rebuilding allowance and a 4% annual depreciation allowance. This is a special concession introduced to support the industrial sector. Commercial buildings have no initial allowance but are entitled to a 2% annual depreciation allowance, which assumes that the building has an economic life of 50 years. We have recently introduced a special allowance for hotels so that their refurbishment expenditure can be written off over a five year period at an annual rate of 20%. This recognizes the fact that hotel refurbishments have only a very limited life before the hotel has to be renovated again to maintain quality and standards. Given the changing nature of our economy, with a greater focus towards the service sector, a case can be made out for us to review the current commercial rebuilding allowance to examine whether it remains appropriate.

Tax incentives

16. Tax incentives are not common in Hong Kong but we provide them where necessary to help strengthen our status as an international business and financial centre. In respect of financial services, we have introduced a concessionary tax rate equivalent to 50% of the normal profits tax rate for interest income and trading profits derived from certain qualified debt instruments issued in Hong Kong. We have also excluded from tax those profits derived from debt instruments issued by multilateral agencies with top credit ratings, e.g. the Asian Development Bank, the International Bank for Reconstruction and Development etc., and from Exchange Fund papers issued by the Hong Kong Monetary Authority.

17. We have to consider whether it is the right way forward in a low tax regime like Hong Kong to introduce additional tax incentives in the financial services sector or in other areas so as to further increase our competitiveness. We should again be wary of the possibility of introducing complications to our simple taxation system.

Double taxation

18. Our territorial source basis of taxation means that income derived from outside Hong Kong by a local company will not generally suffer double taxation in the territory. Many countries which tax on a world-wide basis also provide their companies in Hong Kong with unilateral tax relief for Hong Kong tax paid on income derived from Hong Kong. To this extent we do not generally have the problem of double taxation.

19. However, due to the international nature of their operations, airline operators are more susceptible to double taxation than other taxpayers. In response to appeals from the local airline industry and our aviation partners, it is our policy to include double taxation relief arrangements for airline income in the bilateral Air Services Agreements negotiated between Hong Kong and our aviation partners on a case by case basis. Such arrangements have been reached with the Republic of Korea, New Zealand, Canada and the Netherlands. Others are in the pipeline.

20. At present, we also have double taxation relief arrangements in shipping with the United States of America. There are calls from the shipping industry that we should extend such arrangements to other maritime countries.

21. On the way forward, we have to consider whether Hong Kong should engage in negotiation of double taxation relief arrangements in other special areas, including shipping, and whether we should engage in negotiation of such arrangements on a comprehensive basis. We need to examine carefully the implications and the overall benefits to the economy of Hong Kong. Much would depend on what is on offer from these arrangements and what we have to offer in return.

Tax evasion and avoidance

22. We are committed to tackling tax evasion and minimising the opportunity for tax avoidance. We have introduced legislation to specify in detail the keeping of records by businesses for tax purposes. The penalty for non-compliance has also been substantially increased. We have strengthened the resources of the Inland Revenue Department for carrying out its investigative work. But we cannot be complacent. There will always be those who would seek to avoid their tax obligations at the expense of the rest of the community. We must ensure that taxes due are paid.

Consultation

23. We intend to conduct a comprehensive review of our profits tax regime. We want to make our taxation system and business environment more competitive. We need your support in the review and we welcome your views and suggestions on how the profits tax system should be improved to help Hong Kong to better meet the challenges ahead in its development as a premier international business and financial centre.

24. Please send your views on the review to the following address by letter or by fax (Fax number: 2530 5921) on or before 6 September 1997 :

Principal Assistant Secretary for the Treasury (Revenue)
Finance Bureau
4th Floor, Central Government Offices, Main Wing
Lower Albert Road
Hong Kong

25. You can also send your views to the following E-mail address : info@fb.gcn.gov.hk


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