Hong Kong: Tax incentives and ship leasing activities
Hong Kong: Tax incentives and ship leasing activities
The latest of tax incentives includes a concession for ship leasing and ship leasing management activities, with measures published in the official gazette on 19 June 2020.
The new incentive measures establish:
- A tax exemption for the profits of a ship leasing business conducted in Hong Kong
- A tax exemption for the profits of a ship leasing management business conducted in Hong Kong when that business in conducted for related parties
- A reduced tax rate (of 8.25%) for other ship leasing management businesses
- An exemption from tax on any gains arising on the disposal of ships used in a ship leasing business
- Inclusion of hire-purchase and other leasing arrangements that may result in a transfer of ownership within the exemption—thus creating a tax advantage for lease purchasing arrangements over conventional bank loans
Each of these incentive measures is subject to conditions, but generally sets up Hong Kong very well against other shipping centres in terms of its taxation rules.
The 2020 tax incentive supersedes a regime that was perceived to have worked well for many years. Although consultation took place, it did not seem to produce mutual understanding. In the end, the bill was passed without referral to the bills committee and haste at enacting the law appeared to supersede the meeting of industry concerns. While some issues may subsequently be addressed in Inland Revenue Department (IRD) interpretations, these take time to produce and generally are not a satisfactory way of drafting law. In the meantime, many in the industry may find themselves navigating their tax positions without a chart or compass.
Activities conducted by Hong Kong businesses
The drafting follows a familiar route of first bringing a fairly broad category of activities into the charge to tax through a deeming provision, and then excluding a subset of activities from tax based on a much more limited definition. In this situation, the following activities, when conducted by a Hong Kong business, will now be deemed to have a Hong Kong source:
- Granting a right to use a ship to another person even if the ship is used outside Hong Kong
- The business of managing such a business
This is a very broad definition and conceivably includes almost any activity to which a ship may be put, provided that the activity is managed from Hong Kong. With this, Hong Kong’s territorial system is effectively repealed in relation to the use of ships, and all worldwide profits from the use of ships in Hong Kong is potentially made subject to tax.
Yet, Hong Kong retains two significant shipping concessions that ought to take most ship owners and operators out of being subject to Hong Kong tax—the new rules applying to ship lessors, and the old rules (section 23B) applying to ship owners. Because the two regimes have been drafted to be mutually exclusive and because the distinction between a business of owning ships and a business of leasing ships is not as clear as the IRD would have taxpayers believe, many would suggest that the former is frequently a necessary factor in enabling the latter.
Problems with definitions
For many years (since its introduction in 1992), it was widely understood that section 23B taxed the profits of a ship-owner carrying on business in Hong Kong, applied to income earned from the chartering of ships. The section defines “business as an owner of ships” to mean “a business of chartering or operating ships.” This view continued to be widely accepted until the annual meeting between the IRD and the Hong Kong Institute of Certified Public Accountants (HKICPA) in 2016, when the IRD put forward its view that section 23B could only apply to the operators of shipping, and that “leasing rental derived from a pure ship leasing business carried on in Hong Kong should be chargeable under section 14.”
This view was seen as being so controversial that the HKIPCA took the unprecedented step of issuing an additional note after the meeting, setting out an alternative view. Nonetheless, the government set about introducing a new law to exempt income that had always been viewed as being already exempt. The new rules were drafted around the IRD’s dichotomy of “pure leasing” versus “operating.” In particular, the new rules expressly state that the exemption for ship leasing cannot apply to any person who is an operator of a ship or who has income arising from any source other than qualifying ship leasing income.
Part of the issue was that the bifurcation of activities was not nearly so clear as claimed by the IRD. Many ship owners have a fleet of ships that they deploy from time to time in various ways, as market conditions dictate. They do not necessarily confine their activities solely to bare-boat charters or solely to voyage charters or the conveyance of goods. Furthermore, there are a large number of arrangements that could be considered to involve both leasing and operating, and a clear definition of the dividing line is therefore critical in understanding the position of individual taxpayers.
The new rules define a lease as being an arrangement under which the right to use a ship is granted by the owner of a ship to another person for a term exceeding one year. This follows the definition in the accounting standards. Therefore, a time charter in excess of a year (including a wet lease) will be a lease, but a time charter for less than a year will not. Both will be deemed Hong Kong-sourced by virtue of the deeming provision.
A ship operator is defined to provide “services for the carriage by ships of passengers, cargo or mail.” This differs significantly from the definition used in section 39E, which relates to the person “responsible for defraying all or a substantial portion of the expenses of operating the ship.”
Thus, there are questions regarding the treatment of wet leases, and an issue about which the IRD has given conflicting views.
- Are ship operators limited to those who expressly charge for the uplift of passengers, cargo or mail, in which case anyone earning profits from charging time-based charter-hire would not be operating the ship within the meaning of the law? If so, ship owners that currently operate a mix of time charters for more than a year, time charters of less than a year, and voyage charters may find themselves excluded from the exemption.
- Alternatively, is it the case, as the IRD has more recently suggested, that a wet lease goes beyond being a “pure leasing activity” because it involves providing the master and crew? In this case, no wet leasing activity would qualify for the new exemption, and it would be necessary to move any ships on bare lease into a separate company.
The IRD’s latest responses indicate that:
…the eligibility for section 23B or the new regime hinges on whether the person is a ship operator conducting chartering activity incidental to the business of operating ships, or the person is a ship lessor carrying out ship leasing activities solely. This is a question of fact to be considered with regard to all relevant circumstances of each case, including the functions performed and risks assumed by the person. However, the new regime only applies to leases (other than a sublease which is an operating lease) with a term exceeding one year. In order to be eligible to elect for the new regime, a ship owner or ship operator carrying out other businesses may set up a standalone corporation as a special purpose vehicle engaging solely ship leasing activities.
This response overlooks the large number of ship operators for whom chartering is hardly an incidental activity. Urgent clarification on this dividing line would appear to be needed, although wherever it falls, a number of ship owners may need to restructure their operations (and possibly change their commercial activities) if they are to determine that their various activities, which are not supposed to be taxed in Hong Kong, are in fact not taxed in Hong Kong.
It is also noted that the interaction of section 23B and the new deeming rule (section 15(1)(o)) is not expressly stated in law. Whereas section 15(1)(o) deems income from any granting of a right to use a ship anywhere in the world to be Hong Kong-sourced, section 23B sets out a formula for calculating the assessable profits arising to anyone carrying on business as an owner of a ship in Hong Kong. This formula has the effect of excluding profits arising from ships navigating in or to international waters. It is clearly possible for a company to be taxable under both sections; and while section 23B as the more specific provision ought to take priority, it would have been helpful for this to be made clearer.
The new rules also contain a number of other requirements that do not apply to shipping businesses operating under section 23B. In particular, the exemption will only apply to businesses carried on in Hong Kong. This will require the core income-generating activities to take place in Hong Kong, as well as at least two employees and minimum annual operating expenses (which the IRD has initially indicated may include interest charges) or at least HKD 7.8 million. Ship-leasing management is subject to lower thresholds of one employee and HKD 1 million of expenditure. In response to feedback from the OECD, it has left to the discretion of the tax assessor whether these minimum thresholds are adequate to qualify the business concerned. This is an area that would benefit from further guidance. In any event, companies falling within the new regime would need to review their operating procedures to determine that they have appropriate presence in Hong Kong.
The clear exemption from tax on disposals of ships held for three years or more and used in the leasing business is viewed as beneficial. However, its technical extent is limited to instances when it has been used in a qualifying leasing business continuously for three years immediately prior to disposal; thus, care must be exercised over any periods of non-use, or when the lease comes to an end at a time before the disposal can take place. The provisions contain various anti-avoidance clauses, including targeted rules around losses and capital allowance, rules relating to arm’s length pricing, and a general rule allowing the rules to be set aside when tax avoidance is the sole or main purpose for entering into an arrangement.
The new provisions have the potential to provide an important exemption on income from ship leasing activity and a concession on management activities. However, they are complex and contain a number of potential pitfalls. Taxpayers need to review their current mix of business and consider the commercial and tax implications of any potential restructuring to meet the qualification requirements. Taxpayers also need to review their operating protocols and Hong Kong presence to determine that they meet the requirements. Some taxpayers may want to consider applying for a ruling given the uncertain nature of some of the legislation.
For more information, contact a KPMG tax professional:
David Ling | +1 (609) 874-4381 | firstname.lastname@example.org
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