Hong Kong has long been viewed as a tax haven due to its relatively lower tax rates and a territorial tax system that typically exempts foreign income of residents from paying tax. However, since its resumption with China, Hong Kong has continued to operate semi-autonomously under the “One Nation-Two Systems” umbrella, which juggles capitalism within the overall evolving umbrella framework of communist China.
Over time, Hong Kong has tried to shed the association of being a tax haven, by complying strongly with international financial disclosure norms and also the recent BEPS guidance (Base Erosion and Profit Shifting) put out by the OECD. Hong Kong has also been a part of the first wave of signatories that signed on the multilateral instrument in July 2017.
In 2010, through a press release, issued by the CBDT, Hong Kong was notified as a “special territory” under section 90 of the Income-tax Act paving the way for the government to negotiate a tax treaty with Hong Kong.
It took a few more years before India finally signed the treaty with Hong Kong in March 2018. The treaty was subsequently ratified by the two countries in November 2018 and has become applicable in India from April 1, 2019.
This is a significant treaty for India since, for long, Hong Kong has ranked among the top 15 countries that have sent foreign direct investment into India ahead of mothership China.
The anti-avoidance provisions
Being a treaty of a more recent vintage, it is brimming with a number of anti-avoidance features including a domestic law override for anti-avoidance, a Principal Purpose Test and a rule targeting dual residency. Domestic tax avoidance and evasion provisions would not be allowed to be overridden by the treaty and non-bonafide entities would not be able to avail treaty benefits.
The Principal Purpose Test has been incorporated in several parts of the treaty and in particular for the passive income streams. India has spent time and effort in tightening the rules governing dual resident entities that are primarily seen as being contrived to avoid taxes. Residence for such non-individual entities would be determined under mutual agreement procedures by examining the Place of Effective Management (POEM) of such entities.
Permanent Establishment (PE)
The PE definition covers a fixed place and construction (including installation and assembly) PE. The threshold for the construction PE is six months. A service PE has also been incorporated into the treaty. A standard list of PE exemptions applies for liaison activity, storage of goods solely for processing, storage or display.
Passive Income Changes
Significantly withholding tax on interest received from India by a Hong Kong resident taxpayer that is the beneficial owner of the interest will be capped at 10 percent as opposed to the general non-DTA rates of 5 percent/20 percent/40percent, plus the applicable Indian surcharge and cess. This may be a relief for funds that often flow through Hong Kong.
Dividend withholding tax is capped at 5 percent. However, neither Hong Kong nor India currently imposes a dividend withholding tax. India does levy the dividend distribution tax (DDT), which is however not abated under the treaty.
Withholding taxes on royalties and technical fees will be capped at 10 percent, whereas the non-treaty rate is 10 percent, plus the applicable Indian surcharge and cess. Hence, the treaty rate will be slightly more favourable as the DTA provides relief from the surcharge and cess. Interestingly, the technical fee definition is not restricted by a “make available” clause as seen in some of India’s tax treaties.
The treaty allows India to tax capital gains on the sale of shares of an Indian company. Unlike Mauritius or Singapore, there is no special status accorded to Hong Kong on taxing such gains.
Another change is that profits derived by Hong Kong resident taxpayers from the operation of ships in international traffic where such profits are subject to tax in India, will receive a 50% reduction in Indian tax. Most treaties that India has signed however would exempt these completely.
While primary rights to tax “other income” are granted to the state of residence, such income may also be taxed in the state of a source where such income arises.
The treaty with Hong Kong was signed after the date of the MLI and hence the treaty will not be a Covered Tax Agreement for the purposes of the MLI. There will hence be deviations from the MLI as seen in the language used for defining agency PE which is at variance from the standard prescribed in Article 12 of the MLI.
With an accent on tax information exchange, the Hong Kong treaty incorporates a powerful all-encompassing information exchange clause that covers all taxes (including wealth tax, excise and customs duty, GST and sales and VAT). A secrecy requirement has also been enshrined in the treaty.
Rohinton Sidhwa is partner at Deloitte India