The Fifth Protocol to Avoidance of Double Taxation Arrangement between the Mainland and Hong Kong came into effect

13 February 2020, China Trade & Investment , Cross-Border Employment , Tax, Legal Alert by Edwarde Webre, Stefano Mariani, Minning Wei

The Fifth Protocol to the Avoidance of Double Taxation Arrangement (DTA) between Hong Kong and the Mainland (Fifth Protocol) is now in force, effective from 6 December 2019. Its provisions apply to income derived in a fiscal year commencing from 1 January 2020 in Mainland China and to income derived in a fiscal year commencing from 1 April 2020 in Hong Kong.

The Fifth Protocol incorporates into the DTA important aspects of the OECD’s Base Erosion and Profit Shifting (BEPS) initiative. In summary, BEPS aims to diminish the scope for aggressive tax avoidance across jurisdictions, and to align international taxation such as to procure that, to the extent possible, business profits and other income are taxed in the jurisdiction in which they were in substance economically generated. It also contains specific provisions relating to teachers and researchers, which provides for an express regime for the taxation of emoluments received by academics operating in both jurisdictions.

1. 

Preamble and entitlement to benefits under the DTA

The Fifth Protocol amends the Preamble of the DTA, which now specifies that its purpose is to develop economic ties between Hong Kong and the Mainland, and to enhance co-operation in tax matters. Reflecting the influence of Hong Kong’s signing on 7 June 2017 of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS, the Fifth Protocol also specifies that the DTA aims to counter double non-taxation and treaty abuse.

In that regard, the new Article 24A of the DTA contains a “principal purpose test” (PPT) provision. PPT, in summary, provides that a taxpayer cannot claim the benefit of the DTA if it is reasonable to conclude that, having regard to all relevant facts and circumstances, the obtaining of that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit. That general prohibition is subject to being able to show that granting the treaty benefit would nevertheless be in accordance with the object and purpose of the relevant provisions of the DTA.

Readers should therefore note that the DTA now contains a general anti-avoidance, or more precisely, anti-abuse provision – and that tax structuring that relies on the DTA to secure treaty benefits may need to be revisited to ensure that benefits previously claimed remain available following the coming into force of the Fifth Protocol.

2. 

Resident

The DTA originally stipulated that where a person other than an individual is treaty resident in both the Mainland and Hong Kong, the relevant tiebreaker was the place where its effective management is situated. The current position, however, is that the competent authorities of both jurisdictions must arrive at a mutual agreement on the application of the tiebreaker, having regard to the taxpayer’s place of effective management, the place where it was incorporated or otherwise constituted, and any other relevant factors. In the absence of such agreement, the taxpayer is not entitled to any treaty benefit, except to the extent and in such manner as may be agreed upon by the competent authorities of both jurisdictions. There is, therefore, no longer any automatic tiebreaker, which suggests that the administrative practice of both the Hong Kong Inland Revenue Department (IRD) and the Chinese State Taxation Administration (STA) will play a greater role in the granting of treaty relief. 

Neither the IRD nor the STA has to date published any guidance of the specific procedures or details relating to how the mutual agreement would operate in practice.

3. 

Permanent establishment

The Fifth Protocol has lowered the threshold for constituting a permanent establishment (PE). Where a person is acting in one jurisdiction on behalf of an enterprise resident in the other and, in doing so, habitually concludes commercially material contracts, or habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise, and these contracts are:

  • in the name of the enterprise; or

  • for the transfer of the ownership of, or for the granting of the right to use, property owned by that enterprise or that the enterprise has the right to use; or

  • for the provision of services by that enterprise,

then that enterprise will be deemed to have a PE. This is a critical departure from the traditional position that some degree of the fixed physical presence of a non-resident enterprise was required to constitute a PE. Thus, where a Hong Kong company has agents in the Mainland who are either authorised to bind their Hong Kong principal to commercial contracts, or who otherwise do so de facto with minimal supervision from the principal, it will likely thereby constitute a PE in the Mainland.  

For those purposes, the Fifth Protocol has amended the definition of an “independent agent”, which historically would not constitute a PE, to exclude agents who operate exclusively or almost exclusively for more than one enterprise where those enterprises are closely related. This is an anti-fragmentation provision, which aims to prevent the artificial segmentation of an enterprise’s affairs for the purposes of avoiding constituting a PE.  

4. 

Capital gains

Gains from the disposal of interests in a partnership or trust now qualify as interests comparable to shares for the purposes of the application of Article 13 of the DTA (Capital Gains). 

For example, if a Hong Kong tax resident sells its interest in an English partnership and more than 50% of the value of partnership assets is attributable directly or indirectly to immovable property in the Mainland at any time during the three years preceding the transfer, taxing rights with respect to any gains arising from the disposal of the partnership interest would be allocated to the Mainland.

5. 

Teachers and researchers

The Fifth Protocol introduced Article 18A, which defines a teacher or researcher as a person employed by a university, college, school in either Hong Kong or China or by a recognised educational institution or scientific research institution recognised by the government of either jurisdiction. Where the teacher or researcher is resident in one jurisdiction but travels to the other for the purposes of research or teaching at a school, university, or government-recognised institution, he/she will not be taxable in that other jurisdiction for a period of three years beginning on the date of his/her first arrival for the qualifying purpose of teaching or research. That is provided that his remuneration is borne by the school, university, or institution by which he was employed in his jurisdiction of original residence, and subject to tax therein.

Thus, if a Hong Kong resident teacher employed by a Hong Kong school travels to the Mainland to teach at a school in Guangzhou, he/she will not be chargeable to Chinese tax to the extent that: (i) the Hong Kong school pays his/her income from employment; and (ii) he/she is taxable in Hong Kong with respect to that income. Together with the various individual income tax incentives in the Great Bay Area, Article 18A is expected to encourage a more fluid movement of teachers, academics, and researchers within the region. That said, Hong Kong’s salaries tax regime is in any event territorial, such that in certain circumstances a Hong Kong resident teacher exclusively resident in the Mainland may have difficulty showing that he/she remains subject to tax in Hong Kong.

Further, the benefit of Article 18A does not apply where the teaching or research in question is not in the public interest, but primarily for the private benefit of a specific person or persons.

How we can help

The Fifth Protocol presents new challenges and new opportunities for cross-border tax structuring at both the corporate and individual levels. You should consult your tax and legal advisors to seek advice on its implications on current structures and arrangements that cover both Hong Kong and the Mainland. With strong and experienced tax practices in both jurisdictions, we are well placed to assist you in any risk assessment, structuring, or restructuring arrangements or transactions you may contemplate pursuant to the enactment of the Fifth Protocol.