Hong Kong Tax Newsflash

Draft legislation for the tax certainty enhancement scheme for onshore gains on disposal of equity interests¹ was gazetted on 20 October 2023. This Bill² sets out how onshore gains on disposal of equity interests satisfying certain conditions can be regarded as capital in nature and not chargeable to profits tax.

Gains on disposal of capital assets are not chargeable to profits tax. Traditionally, to determine if assets are capital in nature, the Inland Revenue Department (IRD) adopts the controversial "badges of trade"³ approach. To enhance the attractiveness of Hong Kong as an international investment hub by improving tax certainty, the government introduced a safe harbour scheme without the need for "badges of trade" analysis. Onshore disposal gains on equity interests held for at least 24 months by an investor entity that constitute not less than 15% of an investee entity's total equity interests can be regarded as capital in nature and hence not taxable. Taxpayers who do not elect for this scheme or derive ineligible disposal gains can continue to apply "badges of trade".

Key features

Covered taxpayer: Any legal person (not including a natural person) or arrangement that prepares separate financial accounts, including a corporation, a partnership, trust or fund. There is no resident or listing requirement on the investor or investee entity.

Covered income: Refers to disposal gains on equity interests (including ordinary shares, preference shares and partnership interest) arising in or derived from Hong Kong. The Bill clarifies that foreign-sourced disposal gains deemed as arising in or derived from Hong Kong under the Foreign-sourced Income Exemption regime are not eligible for the scheme.

Equity holding conditions: An investor entity (i.e., the taxpayer) must have held at least 15% of the total equity interests in an investee entity throughout a continuous period of 24 months immediately before the disposal of the interest.

• Group basis: Equity interests held by a taxpayer's closely related entities will also be considered in assessing the ownership threshold. "Closely related" is when either entity has control (i.e., more than 50% of direct or indirect beneficial interest or voting rights) over the other or both are under the control of the same entity. The entities must remain closely related throughout the continuous period of 24 months for their equity interests to be aggregated.
• Flexibility for disposal in tranches: If a taxpayer's equity interests are disposed of in tranches and fall below 15% after an earlier disposal, subsequent disposal of the remaining tranche within 24 months can still be covered by the scheme and the 24-month time limit will count from the earlier disposal date. For example, a taxpayer who has owned a 26% equity interest in an investee entity since January 2022 and disposed of this in two tranches, say 16% in August 2024 and 10% in March 2026. In this case, the second disposal gain would also be regarded as non-taxable despite the interest being less than 15% at the time. The IRD has released guidance and frequently asked questions on its website.
• First-in-first-out basis: If equity interests in the same investee entity have been acquired on different occasions, these would be taken to be disposed of in the order in which they are acquired i.e., "first-in-first-out" when determining if holding conditions are met.

Insurers excluded from the scheme: The proposed scheme would not apply to insurers⁴ because making investments for returns is normally considered as revenue in nature for an insurer's business.

Equity interests as trading stock excluded: Equity interests would be regarded as trading stock if any gain or loss (realized or unrealized) thereon has been brought into account to compute the taxpayer's assessable profits under an assessment which has become final and conclusive⁵, or a computation of losses. These equity interests would be disregarded when determining if equity holding conditions are met, and disposal gains on the remaining interests would not be eligible for safe harbour, unless there is a change of intention⁶ from trading stock to capital assets.

Equity interests in property-related entities excluded: Non-listed investee entities that engage in the following property-related activities will not be eligible for the proposed scheme:

• Property trading – The business of acquisition and sale of immovable properties in or outside Hong Kong⁷.
• Property development – Property development in or outside Hong Kong unless immovable properties are used to carry on its own trade or business, e.g., properties held for letting but not for sale. In addition, the investee entity must not undertake property development⁸ for at least 60 continuous months before the disposal.
• Property holding – If the value of its immovable properties exceeds 50% of the investee entity's total asset value (where it is not categorized as property trading or property development). This test will consider the immovable properties held directly or indirectly by the investee entity in or outside Hong Kong. If these are for its own business use (including property letting) but not for sale, their value will not be considered in determining the 50% threshold.

Disposal losses unaffected: Onshore losses on disposal of equity interests would not be affected by the scheme and would continue to be assessed based on "badges of trade".

Effective date: Upon enactment of the Bill, the proposed scheme would apply to:

- disposals on or after 1 January 2024; and

- disposal gains accrued from the year of assessment 2023/24.

Administration

Taxpayers can elect for the scheme through their annual profits tax return for the year of assessment in which the disposal occurs.

Non-election or exclusion from the scheme does not mean disposal gains must be chargeable to profits tax. This will continue to be determined based on "badges of trade".

Our observations

We are pleased the Government has adopted our suggestion to allow aggregation of equity interests held by closely related entities when determining the 15% threshold, and covered disposal in tranches, in designing the scheme. The scheme appears more competitive than those in other jurisdictions, with wider coverage of businesses and equity interests and a lower equity holding threshold.

We highlight that the considerations for the 24-month time limit under disposal in tranches contain complex details. For example, if there are three tranches of disposals, the 24-month period for the 3rd disposal will run from the last earlier disposal (say, the 2nd disposal) that met the equity holding conditions. Disposal gains of remaining equity interests would not be eligible for safe harbour if the earlier disposal that met the equity holding conditions occurred before 1 January 2024.

Equity interests previously regarded as trading stock in an assessment or loss computation would not be eligible for the safe harbour or considered in determining equity holding conditions. Given taxpayers cannot lodge an objection against a loss computation officially under the Inland Revenue Ordinance, such treatment (i.e., regarded as trading stock by the IRD) might not be agreed by the taxpayers. This would deprive them of eligibility for the safe harbour and they would need to revert to “badges of trade” to determine if the disposal gains are capital in nature.

The Bill has extensive anti-abuse rules for property-related equity interests. For example, the exclusion is not limited to immovable properties in Hong Kong, but also covers overseas properties. Nevertheless, immovable properties held for own business use and infrastructure will not be considered. The rules for determining whether the investee entity is “property-rich” could be complicated. The value of immovable properties for calculating the 50% threshold includes those indirectly held by the taxpayer. “Value" is not defined in the legislation (e.g., carrying value or market value). Further guidance will be needed from the IRD.

Taxpayers who plan to expand or restructure their businesses should seek professional advice in assessing whether the safe harbour scheme applies to the proposed transactions.

¹ Please refer to our Hong Kong Tax Newsflash Issue 176 and Issue 191 for the background and details.

² Inland Revenue (Amendment) (Disposal Gain by Holder of Qualifying Equity Interests) Bill 2023

³ Under the “badges of trade” approach, consideration is given to the facts and circumstances of the case, e.g., the frequency of similar transactions, the holding period, the shareholding ratio, and reasons for purchase or sale.

⁴ An entity is an insurer if Subdivision 1 of Division 11 of Part 4 of the Inland Revenue Ordinance applies to the ascertainment of its assessable profits.

⁵ An assessment has become final and conclusive if no valid objection or appeal has been lodged, an appeal against the assessment has been withdrawn, the Assessor and the taxpayer have agreed on the assessable profits upon an objection, or the assessable profits have been determined on objection or appeal.

⁶ The equity interests would cease to be regarded as trading stock provided that the deemed gain up to the date of change of intention has been chargeable to tax. The 24-month holding period of such interests would be counted from the date of change of intention.

⁷ Unless the acquisition and sale of immovable properties is incidental to property development by the entity

⁸ Excludes works for the renovation or refurbishment of a building with a view to maintaining its commercial value

^{Tax Newsflash is published for the clients and professionals of Deloitte Touche Tohmatsu. The contents are of a general nature only. Readers are advised to consult their tax advisors before acting on any information contained in this newsletter.}
 

If you have any questions, please contact our professionals:

Authors

Doris Chik
Tax Partner
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dchik@deloitte.com.hk

Carmen Cheung
Senior Tax Manager
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Kiwi Fung
Tax Manager
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kifung@deloitte.com.hk

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Andrew Zhu
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Raymond Tang
Tax Partner
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