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Following Financial Secretary Paul Chan's 2017/18 Budget presentation, this special feature gets under the surface of Hong Kong to find out how its favorable tax and regulatory regime, and its special relationship with China, continues to attract huge volumes of investment to the city.
What Is Hong Kong?
In fact, it is wrong to call Hong Kong a mere city. The city of Hong Kong, home to an estimated 7.1m people in 2015, makes up only a part of the territory of Hong Kong, which at 1,100 square kilometres is about six times the size of Washington D.C. This territory comprises Hong Kong Island and the adjacent islets, Stonecutters Island, the Kowloon Peninsula on the mainland and the New Territories. The New Territories comprise approximately 90 percent of the land surface area of Hong Kong and consist of a portion of the Chinese mainland.
Nevertheless, it is also true that Hong Kong was, until quite recently, was a colony. Occupied by the British in 1840, Hong Kong was formally ceded to the British Empire the following year. It remained a largely self-governing British possession until 1997, when the territory's sovereignty was formally handed over to the People's Republic of China.
Thus, Hong Kong is now a Special Administrative Region (SAR) of the People's Republic, rather than an independent country in its own right, although the constitution governing China's relationship with Hong Kong does grant the territory a great deal of autonomy over its internal affairs.
One Country, Two Systems
A legal framework based on English common law, and a laissez faire economic system – ingredients which are the very foundation of Hong Kong's success as a regional trading entrepôt and global financial center – would seem the very antithesis of the one-party communist system established in China. However, Beijing has realized that it has much to gain from maintaining the status quo in Hong Kong, and as is touched upon later in this feature, the territory is playing a major role in the internationalization of the Chinese economy.
Hence, the guiding principle of the constitution setting out China's legal relationship with Hong Kong, known as the Basic Law, is "one country, two systems," under which China agreed prior to the handover that Hong Kong's capitalist system would remain unchanged until the year 2047. Thus whilst defense and foreign affairs are the exclusive domain of China, Hong Kong is autonomous in all other matters. The handover agreement also provided for the territory to maintain its British legal system save in so far as those laws contravene the Basic Law and with the Court of Final Appeal of Hong Kong replacing the Privy Council as the final and highest court of record.
Although there have been one or two cases in which Beijing has seemed to over-rule Hong Kong courts, particularly as regards citizenship issues, by and large the transition from colony to Special Administrative Region has been successful. However, the people of Hong Kong have been very dissatisfied with the lack of independence and vigor shown by their leaders in moving towards democracy in the SAR, as demonstrated by the Occupy Central protests in the latter half of 2014. It remains to be seen whether proposed electoral reform will really satisfy the Hong Kong population's demand for universal suffrage, something so at odds with the Chinese system.
Hong Kong's Financial Center
Low-value manufacturing used to be the mainstay of Hong Kong's economy, but this industry has now largely decamped to neighboring Chinese provinces, with the territory's economy now based largely on re-exporting and services, particularly financial services.
Banking is a major constituent of Hong Kong's substantial financial services industry. Tokyo aside, Hong Kong is Asia's largest banking hub in terms of external transaction volume.
Hong Kong is also recognized as the leading fund management center in Asia with the industry defined by its international and offshore characteristics, and it has become a popular choice for hedge fund managers, especially since the government granted an income tax exemption to offshore funds owned by non-resident entities administering a fund in Hong Kong. According to the Hong Kong Securities and Futures Commission, the combined fund management business in Hong Kong reached a record high at the end of 2014 of almost HKD17.7 trillion (USD2.3 trillion), up 10.5 percent. Assets managed in Hong Kong increased by nearly 18 percent to a record level of HKD6.85 trillion.
Hong Kong has also established itself as the favored base for multinational companies looking to expand into Asia-Pacific markets. In 2016, 874 non-Hong Kong companies established a new place of business in Hong Kong under the Companies Ordinance, taking the total number of registered non-Hong Kong companies to 9,983 by the end of 2016.
The importance of Hong Kong on the world economic stage is reflected in the huge volumes of foreign direct investment (FDI) inflows and outflows reported every year. Indeed, Hong Kong ranked second in global FDI inflows, according to the United Nations Conference on Trade and Development's World Investment Report covering 2015, receiving FDI inflows of USD175bn in 2015, a year-on-year surge of 53.5 percent compared to USD114bn in 2014. It places Hong Kong second only to the US (USD380bn) and ahead of Mainland China (USD136bn).
Recent local incorporation statistics also attest to the fact that Hong Kong remains a hotbed of entrepreneurial activity. According to statistics released by the Hong Kong Companies Registry in January 2017, the total number of local companies registered under the Companies Ordinance reached 1,341,223 at the end of 2016, up 52,557 from the corresponding figure at the end of 2015.
Hong Kong's stock market is a crucial component of the jurisdiction's financial center, and its status as the gateway for inward investment to, and outward investment from, China has secured its position as the stock market for Chinese firms seeking to list abroad. In 2016, mainland Chinese companies constituted 51 percent of the firms listed on the Hong Kong Stock Exchange and accounted for 63 percent of the Exchange's market capitalization.
The Hong Kong Stock Exchange also set new trading records in 2016. In the securities market, according to HKEX and Bloomberg data, USD24.8bn was raised through IPOs in 2016, making Hong Kong the number one fundraising center in the world for the second straight year. By December 15, 2016, total futures trading had reached almost 81m contracts, up 10 percent on the record high of 73.5m contracts in the whole of 2015. The trading of various options contracts through HKEX also set new records in 2016, and the turnover of securitized derivatives has now been the world's highest for 10 consecutive years (according to data from the World Federation of Exchanges).
There were 121 new listings between January 1 and December 15, 2016, and the total equity funds raised in this period was HKD462.4bn (USD59.7bn). As of December 15, 2016, there were 1,968 companies listed by HKEX on the Main Board and Growth Enterprise Market, with a total market capitalization of HKD24.7 trillion.
Crucially, The Hong Kong Government believes that there are tremendous opportunities ahead for Hong Kong's financial center as China continues to liberalize its currency, the renminbi (RMB). The "offshore" RMB market was effectively born in Hong Kong in 2003 and at the end of October 2015, RMB customer deposits and certificates of deposit issued by banks in Hong Kong together amounted to around RMB1 trillion (USD145.5bn). In 2015, over USD6 trillion, or more than 90 percent, of mainland China's total RMB trade is settled by Hong Kong banks.
Of course, many of these economic feats probably wouldn't have been achieved if it wasn't for Hong Kong's fiscal advantages.
Unlike most onshore jurisdictions, income tax in Hong Kong is levied on a "territorial" basis, which means that income tax is due on locally-sourced income only. What's more, a number of taxes that are levied in other jurisdictions do not exist in Hong Kong; for example, there are no capital gains taxes, no withholding taxes, no sales taxes, no VAT, no annual net worth taxes and no accumulated earnings taxes on companies which retain earnings rather than distribute them.
While corporate income tax (known as Profits Tax), at 16.5 percent, is higher than in the classic "offshore" jurisdictions, it is still substantially lower than in most OECD countries, even accounting for the fact that corporate tax rates around the world have fallen in recent years.
Hong Kong also offers tax concessions to certain types of business. Special concessionary rates of profits tax which are substantially less than the standard rates apply to the following businesses or sources of income:
In comparison to other jurisdictions however, Hong Kong does not offer much in the way of tax incentive schemes. The attitude of the Government has been that Hong Kong's low, simple, territorial tax regime is incentive enough to establish business operations in Hong Kong, and this is something that foreign investors seem to like. However, this isn't to say that the Government ignores the needs of key business sectors, and it proposes targeted concessions for certain types of company on a fairly regular basis.
In a recent example, the Government gazetted a legislative bill on December 4, 2015 which aims to enhance the existing interest deduction rules for the intra-group financing business of corporations and introduce a concessionary profits tax rate for qualifying corporate treasury centers. This measure was approved by the Legislative Council (LegCo) on May 26, 2016.
And in July 2015, Hong Kong's Government brought into effect the promised extension of the profits tax exemption for offshore funds to private equity funds.
Chief Executive Leung Chun-ying announced in his 2017 Policy Address on January 18, 2017, that the Government will take further measures to create a favorable tax environment and consolidate Hong Kong's status as a premier asset management hub in the Asia-Pacific region. For example, the Government plans to introduce a tax amendment bill into the LegCo in 2017 to offer a tax to companies in the aircraft leasing sector.
More generally, Leung said that Hong Kong must consider how to enhance its overall competitiveness, including offering tax and financial concessions, and other policy support measures to attract innovation and technology enterprises from Hong Kong, the Mainland and overseas. Therefore, further targeted tax concessions are likely to be announced by the Government in the coming months and years.
Personal taxation is also low by international comparison. Income tax, known in Hong Kong as Salaries Tax, is paid at either a flat rate of 15 percent, or on a progressive scale between 2 percent and 17 percent. Taxpayers may elect to choose to pay tax under either of these systems, depending on which one gives them the lower tax liability. Individuals are only assessed on annual employment income which is defined as wages, salaries, bonuses, commissions, payments by the employer into a pension fund for the employee and gratuities. Non-employment source income such as share dividends and capital gains realized on the sale of shares are not taxable in the territory. In addition, the definition of income does not include either a pension from a source outside Hong Kong or compensation for loss of employment.
The 2017 Budget
There was a focus on both the short-term and the long-term in the 2017/18 Budget, announced on February 22, 2017, by Financial Secretary Paul Chang.
Chan outlined HKD35.1bn in short-term relief measures and tax breaks including:
In addition to the above one-off measures, the Financial Secretary also proposes, after taking into account the Government's fiscal position in the short to medium term, the following five recurrent tax measures starting from 2017-18 so as to relieve the burden on taxpayers:
The 2017/18 Budget also continues the Government's new policy of investing greater amounts of money into social services and the public sector. As Chan stated in his maiden Budget speech: "My endeavor is to make use of the wealth we have accumulated together through hard work to take care of the needy in society, ease the heavy burden of middle-class families, and make appropriate investments essential for building a better Hong Kong."
Given the higher than expected fiscal surplus, Chan earmarked HKD61bn for investment in elderly services and rehabilitation services for persons with disabilities; sports and recreation facilities; innovation and technology development support; and vocational and educational training.
Chan said total government revenue in 2017-18 is estimated at HKD507.7bn. The overall expenditure of the Government for 2017-18 is estimated to be HKD491.4bn, representing an increase of 5.3 percent compared with the revised estimate for 2016-17.
The budget surplus is expected to be HKD92.8bn in 2016/17 and fiscal reserves are forecast to reach HKD935.7bn by March 31, 2017.
Until recently, Hong Kong tended not to sign comprehensive agreements with other jurisdictions for the prevention of double taxation, preferring instead to sign more limited agreements covering income from aviation and shipping activities. This, however, is changing.
The Government is now expanding its network of comprehensive double tax agreements (CDTAs) with a view to protecting and facilitating business co-operation between Hong Kong and the so-called "Belt and Road" countries, a Chinese Government economic development project, which is primarily aimed at integrating trade and investment among around 60 Eurasian countries. Hong Kong signed its 37th CDTA, with Belarus, on February 17, 2017.
The international community's increasing demand for global tax transparency is another reason why Hong Kong is entering into more CDTAs with the most up-to-date standards for information exchange included. In fact, Hong Kong has committed to automatically exchange tax information on a reciprocal basis with other countries with which it has an agreement on such, with the first exchanges to take place by the end of 2018.
Hong Kong And BEPS
In October 2016, Secretary for Financial Services and the Treasury K C Chan said that Hong Kong is "supportive" of international efforts to promote tax transparency and combat tax evasion under the OECD's base erosion and profit shifting (BEPS) project. Thus, Hong Kong's intention to implement measures to counter BEPS "signifies our commitment to international tax co-operation," he added. However, Hong Kong's competitiveness remains at the forefront of the Government's mind.
"Hong Kong will need to revise our existing tax laws to meet the [minimum] requirements of the BEPS package. In formulating our implementation strategy, we need to ensure that our model meets the international standard without compromising our simple and low tax regime," said Chan.
A consultation paper released in October 2016 confirmed that the Government would "draw up a pragmatic strategy to implement the international requirements."
"The implementation timetable for BEPS is very tight," Chan continued. "To meet the OECD's requirement, our current target is to introduce the relevant amendment bill or bills into the Legislative Council in mid-2017." The consultation period will end on December 31, 2016.
The priority is to put in place the necessary legislative framework to update transfer pricing rules; exchange information on tax rulings; and introduce CbC reporting requirements (which are expected to capture about 150 Hong Kong enterprises under the OECD's minimum EUR750m consolidated group revenue threshold); bolster cross-border dispute resolution mechanisms; and enter into the multilateral instrument to modify bilateral tax treaties.
The Closer Economic Partnership And Free Trade
Foreign companies are also flocking to Hong Kong to take advantage of the Closer Economic Partnership Arrangement (CEPA) between the SAR and the People's Republic, which has substantially liberalized trade in goods and services between the two locations. According to InvestHK almost one-third (31 percent) of the 303 companies it assisted in 2010 indicated that the CEPA was one of the considerations in their decision to locate in Hong Kong.
The first CEPA agreement was signed in June 2003 for implementation in 2004, and the Central and Hong Kong governments have since signed nine supplements to the agreement. The most of recent of these is Supplement X to the CEPA, which was signed on August 29, 2013. It provides for a total of 73 services liberalization and trade and investment facilitation measures, strengthens co-operation in areas of finance, trade and investment facilitation, and further promotes the mutual recognition of professional qualifications in the two places. It brings to 403 the total number of liberalization measures for trade in services under CEPA, since its signing in 2003.
The Agreement on Trade in Services signed under the framework of CEPA was implemented in June 2016 and the Hong Kong Government is exploring the expansion and enhancement of CEPA in the areas of investment, economic and technical cooperation.
Hong Kong is in fact already one of the world's freest economies (the freest, according to the Heritage Foundation). No tariffs are imposed on imported goods, and excise duties are levied on only four commodities, including spirits, tobacco, fuel oil, and methyl alcohol. However, Hong Kong continues to pursue free trade agreements (FTAs), investment promotion and protection agreements, double taxation agreements, and air services agreements with its major trading partners.
In particular, Hong Kong is negotiating an FTA with with the Association of Southeast Asian Nations (ASEAN). While key issues in those negotiations include the reduction of tariffs and the liberalization of trade in services, the Government is also seeking to protect investments made by Hong Kong businesses in ASEAN member countries. Hong Kong has also signed 19 investment agreements.
After the conclusion of the FTA negotiations with ASEAN, Hong Kong is expected to seek to join the talks on the Regional Comprehensive Economic Partnership (RCEP), currently being negotiated between ASEAN and its six FTA partners: China, Japan, South Korea, Australia, New Zealand, and India.
While there are certainly challenges ahead for Hong Kong, especially in relation to tax transparency, BEPS, and more aggressive competition from regional and global financial and business hubs, its Government is looking to the future with confidence. And this positive outlook is largely linked to Hong Kong's unique position as China's connector to the global economy. As Leung summarized in his 2017 Policy Address:
"Hong Kong has been contributing to [China's] internationalization and connection with the world. Hong Kong serves not only as the offshore RMB center of our country, but also the special administrative region for early and pilot implementation of liberalization of trade in services through CEPA. As the most open international city of the country, Hong Kong plays the role of a 'super-connector,' helping our country go global and attract foreign investment."
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