On 9 November 2010 the Secretary for Financial Services and the Treasury of Hong Kong, Professor K C Chan and The Consul-General of Japan in Hong Kong, Mr. Yuji Kumamaru, signed the text of the much anticipated Hong Kong/Japan tax treaty (below the ‘Treaty’).
Entry into Force
The new Treaty requires ratification by the Governments of Japan and Hong before entering into force. A timetable has not yet been established for such ratification but it may be possible to check the relevant pages of the Japanese Ministry of Finance website (link in Japanese) or the negotiation status on the Hong Kong Inland Revenue Department (‘IRD’) website for information concerning the ratification process.
Article 29 para 2 states when the terms of the Treaty will actually begin to take effect post the date of ratification and entry into force.
For Hong Kong the benefits are available for any year of assessment beginning on or after 1 April in the calendar year that next follows the year in which the Treaty enters into force.
For Japan the day the terms of the Treaty begin to take effect depends on the type of tax concerned, with taxes on income (including corporation tax) other than those withheld at source being subject to the Treaty for any taxable year beginning on or after 1 January following the year in which the Treaty enters into force. The Treaty may apply to withholding taxes for amounts taxable after 1 January in the calendar year following the year in which the Treaty enters into force.
The text of the treaty can be found on the Hong Kong IRD website at this link.
Post Treaty Hong Kong – a useful base to invest into Japan
Post the entry into force of the Treaty there seems a reasonable chance that Hong Kong could become a preferred base from which to invest into Japan. This may be the case for investment ultimately originating from other parts of China and Taiwan as well as from Hong Kong itself
This is due to both a combination of Hong Kong’s favorable local tax law, which has a territorial basis, does not tax dividend income and can sometimes exclude interest from taxation as well, and of the tax benefits under the Treaty itself, which on balance seem at least as good as those available the tax treaties Japan has concluded with its other main trading partners.
Some surprises – the limitation of benefits clause
One unusual feature of the Treaty is that it does not include a limitation of benefits clause (‘LOB Clause’) similar to the comprehensive LOB Clauses which are based on a series of objective tests that have to be met to claim treaty benefits that have been included in Japan’s most recently renegotiated tax treaties.
Rather, at article 26 the Treaty includes a very brief clause headed ‘Limitation of Relief’ that lists five specific paragraphs in the treaty and states that
“…No relief shall be available under [the five paragraphs] if the main purpose of any person concerned with the creation or assignment of any right or property in respect of which income arises was to take advantage of the such provisions…”.
The five paragraphs specified in this abbreviated LOB Clause are:
- Article 10 para 2 – the reduction of withholding tax on dividends to 5 per cent for shareholdings of at least 10 per cent held for six months or 10 per cent in other cases
- Article 11 para 2 – the reduction of interest withholding tax to 10 per cent
- Article 12 para 2 – the reduction of withholding tax on royalties to 5 per cent
- Article 13 para 6 – capital gains other than those specified (those specified being mainly related to real estate or ships and aircraft) being taxable only in the jurisdiction of residence of the recipient
- Article 21 para 1 – other income being taxable only in the jurisdiction of residence of the person realising the gain
While this list covers many of the main benefits a taxpayer would want from the Treaty it does not include them all. For example, it would not seem to prevent a foreign group establishing a Hong Kong subsidiary with the main purpose being to open a branch or other office in Japan that could apply the Treaty definitions of permanent establishment of article 5.
Also unlike the LOB Clauses in Japan’s other recent tax treaties which refer to objective factors such as listing on a recognized stock exchange or similar as an example of a requirement to apply treaty benefits, the scope and nature of the Treaty article 26 test is very subjective, referring to “…the main purpose of any person concerned…” in deciding whether Treaty benefits are available.
One could imagine, for example, that a Chinese company may have a host of reasons to establish a subsidiary in Hong Kong besides the benefits of the Treaty and hence Hong Kong might be a good base for such a Chinese group’s investment into Japan.
Below are some other points to note about the Treaty.
In many cases and in the absence of benefits under the Treaty a Hong Kong group owning 25 per cent or more of the shares of a Japanese company would be subject to Japanese tax on a disposal of 5 per cent or more of its shares in the Japanese company concerned. This is the case even if the Hong Kong Company does not have a taxable presence in Japan.
Article 13 para 6 when it comes into effect (and assuming LOB Clause and other required criteria are met) should prevent the above tax charge applying. This tax charge in the past would have been a major disincentive to a Hong Kong company establishing a subsidiary or joint venture company in Japan.
Hong Kong companies with existing investments in Japan on which this capital gains tax would otherwise apply may want to consider waiting until the Treaty is in effect before disposing of such investments.
Article 4(1)(a)(iii) and (iv) of the Treaty sets out the criteria for Hong Kong tax residence for companies and other persons wanting to claim Treaty benefits. Hong Kong tax residence requires the “…primary place of management and control…” of a company or other person to be in Hong Kong.
The Protocol to the Treaty gives at paragraph 3 some useful guidance on how to interpret the above phrase, noting that it is “…a place where executive officers and senior management employees of a company or any other person make day-to-day key decisions for the strategic, financial and operational policies…and the staff of such company…conduct the day-to-day activities for making those decisions…”.
The above wording in the Protocol seems to imply that residence in Hong Kong for Treaty purposes requires more than, for example, simply holding quarterly strategic board meetings or similar in Hong Kong.
The term “…day-to-day…” implies the ongoing presence of sufficiently senior staff and the accompanying supporting personnel required for the decision making process. While, no doubt, many corporate CEOs will maintain that they make key strategic decisions on a day-to-day basis the Editor is somewhat skeptical that this is the case, not least because strategic business decisions by their very nature tend not to change on a day-to-day basis in better run companies. Local advice should be sought to understand how this criteria may apply in practice.
The practical implication of the Hong Kong Treaty residence test is that non Hong Kong incorporated companies would seem able to be become Hong Kong tax resident for Treaty purposes. The Treaty also does not seem to require that a company need pay tax in Hong Kong in order to be entitled to Treaty benefits provided it meets other required criteria, with a critical matter in these circumstances being meeting the LOB Clause in Article 26.
Would an established Cayman Island or BVI company run from Hong Kong that had existing investments (for example in China) be able to qualify for Treaty benefits if it invested in Japan?
Real estate taxation and tokumei kumiai
The Treaty includes a number of paragraphs that are relevant to common Japan inbound real estate investment. These are as follows:
Limitation on dividend withholding tax rate for REIT like entities
Article 10 paragraph 3 which states that “…the [terms of the Treaty lowering dividend withholding tax to 5 per cent] shall not apply in the case of dividends paid by a company which is entitled to a deduction for dividends paid to its beneficiaries in computing its taxable income in Japan….”
Certain Japanese entities resemble US REITS in being able to claim a deduction for dividends paid provided substantially all their income is distributed each year. These entities often invest in Japanese real estate but can also invest in other assets such as distressed loans. Withholding tax on dividends from such entities cannot apply the 5 per cent withholding tax rate but the 10 per cent rate would seem to be available.
Tokumei kumiai transactions
Article 20 allows Japan to tax distributions from Japanese silent partnerships or “tokumei kumiai” often used in real estate investment to be taxed under Japanese domestic law, which is currently the imposition of a 20 per cent withholding tax on the income element of any distribution from the tokumei kumiai.
“Real estate rich” companies
Article 13 para 2 allows Japan to tax gains on the disposal of shares or of interests in a partnership or trust when at least 50 per cent of the value of the asset disposed of comes from real estate or other immovable property specified in Article 6 and located in Japan, with an exception for sales of 5 per cent or less of quoted interests in such assets.
Income from employment
Article 14 is very close to the OECD standard in relation to allowing an exemption from taxation on income from employment for individuals resident in Hong Kong who spend less than 183 days in any one twelve month period in Japan, such period commencing or ending in a taxable year, provided the remuneration concerned is not paid by a Japanese company nor borne by a Japanese permanent establishment of the Hong Kong employing entity.
As discussed in this article, this will now overrule the domestic Japan tax position (which is apparently not widely known) which requires Hong Kong residents working in Japan to file a Japanese tax return regardless of their length of time in the country.
Other matters – exchange of information, arbitration
Article 25 of the Treaty is a comprehensive exchange of information article. The Treaty also allows for arbitration of disputes, another new feature of some of Japan’s tax treaties.