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5 differences between Hong Kong and China Taxation

ONC Lawyers Reveals 5 differences between Mainland China and Hong Kong Taxation System

China economy has been ranking the second in the world in the last decade. When it comes to attracting foreign inbound investment, Hong Kong holds an important role. Known as the intermediary between China and the West, it serves as both the multinational corporations' inbound investment platform into China, and the Chinese enterprises’ outbound investment platform. It can thus be concluded that the economic systems of the two places are distinctively appealing. The respective features of the Hong Kong and Mainland China Taxation System are one of the highlighting differences. In this article, ONC Lawyers provides you with 5 quick facts about the differences between Mainland China and Hong Kong Taxation System.

1. Hong Kong is Famous for its Low Tax Rate while Mainland China Offers Huge Incentive to Pillar Industry and Small Enterprises

According to the Enterprise Income Tax Law of China, enterprises deriving income from production activities and business operations within China and other jurisdictions are subject to Corporate Income Tax (“CIT”). The standard tax rate is 25%.  Among all, two types of enterprises benefit from preferential tax treatments, namely Small and Micro-Sized Enterprises (“SME”), and High and New Technology Enterprises (“HNTE”).

SME

HNTE

Definition

Enterprises engaging in industries not restricted nor prohibited by the state and meeting all the below requirements:

(i) annual taxable income not exceeding RMB 3 million

(ii) number of employees not exceeding 300

(iii) total assets not exceeding RMB 50 million

HNTE should satisfy regulatory requirements on high and new technology area, core technology, science and technology personnel, R&D expense, high and new technology income, innovation capability, etc. Some of the major requirements are listed below:

- At least 10% of the total number of the enterprise’s employees should be engaged in R&D and related activities;

- Income derived from high- and new-technology products (services) should amount to at least 60% of the enterprise’s total revenue;

- R&D expenditures in the last 3 financial years should account to a certain percentage of the enterprise’s total sales revenue in the same period:

i. Total revenue < RMB 50OM: > 5%;

ii. Total revenue between RMB 50M and 200M: > 4%;

iii. Total revenue > RMB 200M: > 3%

In addition, 60% of the enterprise’s total

R&D expenditure must be incurred in Mainland China.

Tax Rate

First RMB 1 million: 12.5%×20%=2.5%

Remaining revenue: 25% × 20% = 5%

15%

 Hong Kong is world-famous for its low tax rate. The corporate income tax rate in Hong Kong is 16.5%, which is among the lowest across the globe. For the first HK$2 million of profits, the two-tiered tax rate is reduced by half to 8.25%. One group can select one connected entity to elect for the two-tiered tax rate benefits.

Taxpayers in certain specified industries (such as shipping, aircraft, fund, single family office and corporate treasury centers) can enjoy a special tax rate of 0% / 8.25%, while taxpayers carrying out R&D activities in Hong Kong can enjoy an enhanced tax deduction of 200% or 300% and reduced tax rate under proposed “Patent Box” Scheme. All these incentives come only when the taxpayer is physically managed or controlled in Hong Kong and maintains minimum number of employees and minimum level of operating expenditure in Hong Kong. As such, it is important for Multi-National Enterprises to maintain sufficient economic substance in Hong Kong.   

Setting up operations in Hong Kong is therefore a common practice to reduce the tax burden.

2. Worldwide Taxation System in Mainland China vs. Territorial Taxation System in Hong Kong

The worldwide taxation system indicates that China tax residents are taxed on worldwide income while non-residents are taxed on China-sourced income. This concept also applies to Individual Income Tax (“IIT”), which charges on individual incomes, including but not limited to employment income and investment income. Even when they physically perform duties outside Mainland China, their employment incomes are still subject to IIT if they are domiciled in the Mainland China. Moreover, dividend income from an overseas investment is also subject to IIT at a rate of 20%.

In Hong Kong, the territorial taxation principle is adopted. Regardless of whether a company is a Hong Kong resident or not, only Hong Kong-sourced profits are subject to Hong Kong Profits Tax, in most circumstances. In other words, if a Hong Kong company carries out its operations outside Hong Kong, it will have the technical basis to pursue an offshore claim, even when the relevant profits are deposited with the bank accounts in Hong Kong.

Effective from 1 January 2023, Foreign-Sourced Income Exemption Regime applies such that offshore passive income will be subject to additional requirements in pursuing the non-taxable claim under Hong Kong Profits Tax (Corporate Income Tax).

 

3. Hong Kong generally does not Tax on Dividend Income and Capital gains while China does

In Mainland China, tax resident corporate earning income from foreign entity’s dividends are generally subject to 25% CIT and so as tax resident individual (at 20% CIT), with a tax credit granted for foreign tax paid. For capital gains, residents are subject to 25% CIT while non-residents are generally subject to 10% CIT.

In case of indirect equity transfer of a Chinese tax resident enterprise (“TRE”) via a non-Chinese tax resident enterprise (“non-TRE”) which lacks reasonable business purposes, the gains from equity interests are subject to 10% CIT. The 2015 Bulletin No.7 quantifies the definition of ‘transaction without reasonable business purposes’ as (i) 75% or above of the non-TRE’s equity is constituted by TRE Taxable Assets, and (ii) 90% or above of assets (excluding cash) and income of the non-TRE are constituted or sourced by the TRE Assets.

In Hong Kong, asset disposal gains are divided into long-term capital gains and short-term trading gains. While short-term capital gains are subject to normal tax rates of 16.5%, long-term capital gains are generally subject to a tax rate of 0% (subject to FSIE requirements). There is no clear definition to distinguish between long-term and short-term capital gains, but the six “badges of trade” tests are generally adopted to judge the difference. Effective from 1 January 2024, tax certainty scheme is provided for onshore disposal gains such that taxpayers which can fulfil certain requirements can enjoy assurance on non-taxable capital gain claim.  

On the contrary, capital loss/expenses, such as expenses related to M&A, group restructuring, reinstatement costs, are not deductible under Hong Kong Profits Tax.

4. Strict Limit on Expense Deduction in the Mainland China vs. Reasonableness Test in Hong Kong

Applying a limit for expense deductions is common in global tax law. While Mainland China strictly follows the rules, the Inland Revenue Department (“IRD”) enables higher flexibility. For example, Mainland China adopts the Thin Capitalization Rule to regulate the limit on interest expense deductions. According to Articles 43 and 44 of the Enterprise Income Tax Law Implementation Rules, entertainment expenses incurred by an enterprise are deductible to the extent of 60% of the expense incurred, and is capped at 0.5% of sales revenue of the current year; the advertising and promotional expenses are deductible up to 15% of the sales revenue of the current year, and that of the tobacco industry are entirely not tax-deductible.    

 In Hong Kong, the so-called “Reasonableness Test” is adopted. In accordance with Section 16(1) of Inland Revenue Ordinance, in ascertaining the assessable profits for any year of assessment there shall be deducted all outgoings and expenses to the extent proven to be incurred in the production of profits chargeable to Hong Kong Profits Tax. In particular, the “arm’s length principle” is applied to examine corporations' transactions with related parties. In relation to the question of what is an appropriate mark-up, provided that the relevant services represent routine administrative services, a margin not exceeding 12.5% of the cost element will generally be accepted as being commercially realistic. 

Private expenses and payments made on behalf of group companies without recharge are, however, non-deductible.

5. Hong Kong generally does not Have Withholding Tax (except for Royalties) while Withholding Tax is a Common Concern in Mainland China

In Mainland China, non-TREs without establishments or places of business in China shall be subject to a withholding tax (‘WHT’) at 10% on gross income from dividends, interest, lease of property, royalties, and other China-source passive income unless reduced rates apply under a Double Tax Agreement. China Value added tax (VAT) of 6% applies to most of the income as well.

In Hong Kong, there is generally no withholding tax except for royalties. When a Hong Kong company pays royalties to an overseas entity, it has to withhold tax on behalf of the overseas entity. The general tax rate is between 2.475% and 4.95%, though the tax rate could be as high as 16.5% under some circumstances. As such, Hong Kong is famous not only for a low profits tax rate, but also minimal withholding tax when the payment is made by a Hong Kong company to non-residents.

In order to reduce China withholding tax, many corporations will set up a Hong Kong related company to do business with Mainland China entities and apply for a Hong Kong Certificate of Residency Status (“CoR”). If a CoR has been obtained and other conditions are also fulfilled (e.g., beneficial ownership requirements under Bulletin 2018 No.9, China withholding tax rate on dividends could be halved to 5%, and that on interest and royalties reduced to 5% or 7%.

For more details on the requirements for obtaining Hong Kong CoR, please visit the “Tax Residency Certificate Video” section of our website [https://henrykwongtax.com/home/trc-videos/].

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Legal Disclaimer:

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received, or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

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