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Legislative Council meeting on 16 June 2004
Resumption of Second Reading debate on the
 Inland Revenue (Amendment) Bill 2000
Speech for Dr Hon Eric LI

Madam President,

As Chairman of the Bills Committee on Inland Revenue (Amendment) Bill 2000, I wish to report on the work of the Committee.

1.     The Bill proposes amendments to the Inland Revenue Ordinance to revise or strengthen provisions for revenue protection and anti-tax avoidance purposes.  The amendments cover the deeming provisions in respect of royalty income and the anti‑avoidance provisions on deduction of interest expenses from chargeable profits.  There are other amendments in the Bill, the main purpose of which is to make remedies to a number of provisions to reflect more clearly the legislative intent.

2.     The Bills Committee started the scrutiny of the Bill in November 2000, but in view of the grave concerns expressed on the proposals in the Bill, suspended its work from December 2000 to October 2003 to allow the Administration to further consult the industry, professional bodies and the parties likely to be affected by Bill.  The Bills Committee received submissions from 13 organizations, some of which have also made oral representation to the Bills Committee.

3.     On royalty income, we note that the proposed amendments aim to remedy the current deeming provision in respect of sums received for the use of or right to use intellectual property in Hong Kong to be trading receipts, in the light of a recent ruling of the Court of Final Appeal.

4.     In 1999, the Court ruled that under the terms of the existing provision, only the royalty income attributable to the sale of goods manufactured in Hong Kong could be deemed to be profits arising from the use of the trademark concerned in Hong Kong.  The royalty payments attributable to goods manufactured elsewhere should not be taxable in Hong Kong.  According to the Administration, the implication of the Court ruling is that even if the goods are manufactured in Hong Kong, the royalty payments will not be subject to tax in Hong Kong so long as the process of applying the trademark to the goods or the packaging is done outside Hong Kong.  Tax avoidance can be easily achieved by changing the manufacturing process.  This was not the original intention in enacting the existing deeming provision.  In order to clearly reflect the policy intent in the legislation and to avoid substantial loss of revenue from profits tax, the Bill proposes to add a new section to deem receipts for the use of or right to use intellectual property outside Hong Kong to be trading receipts, so long as these trading receipts are deductible from the chargeable profits of a Hong Kong taxpayer.

5.     In this respect, some deputations have drawn our attention to the issue that the proposed new deeming provision would violate the territorial source principle of Hong Kong's tax system.  They have pointed out that the place where an intellectual property is used is a matter of fact which cannot be changed just because it has been used for producing profits chargeable to Hong Kong tax.  The principle of "symmetry" between taxability and deductibility, which is introduced explicitly by the Bill, does not currently constitute part of Hong Kong's framework of taxation.  The proposed amendment therefore represents a policy change and would create uncertainty among Hong Kong and overseas companies.

6.      In response to these concerns, the Administration has affirmed its position that it is necessary to keep the "symmetry" between the deductibility of royalty expenses and the taxability of the royalty receipts in order to avoid revenue leakage through tax planning.  The Administration stresses that the current proposed amendments merely serve to bring the legislation in line with the policy intent, and those similar approaches are widely used in other jurisdictions.  The Administration's response has failed to convince some deputations, in particular the Association of Chartered Certified Accountants Hong Kong and the Hong Kong Society of Accountants, which do not subscribe to the argument that the proposed amendments merely serve to reinstate the position that had been widely accepted by taxpayers prior to the said court case.  They also do not agree to the application of the "deductibility test", as the test hinges on the economic activities of other parties, instead of the taxpayers themselves or the location of use (in the conventional sense) of the taxpayers' assets.  Taking note of the strong views of these associations, the Bills Committee has requested the Administration to review the proposed amendments.  Nevertheless, the Administration remains of the view that the proposed amendments are consistent with the original policy intent and are in line with international practice.  It also stresses that the effective tax rate on royalty income, which is 5.25%, is highly competitive among other jurisdictions.  Hence, the proposed amendments would not have significant effect on Hong Kong's business environment.

7.      The Bills Committee has not taken a position on the proposed amendments, i.e. clause 5 of the Bill.  It will be for individual Members to decide whether the proposal should be supported.

8.      Turning to the anti-avoidance provisions on deduction of interest expenses from chargeable profits, the Bills Committee has had substantial discussions on the proposed amendments.  We have taken note of the very divergent views on the proposed amendments between the Administration and the Real Estate Developers Association of Hong Kong.  I will refer the Association as "REDA" hereafter.  Towards the later stage of our deliberation, we also received views from the Hong Kong General Chamber of Commerce on this subject.   Most of its views echo those of REDA.

9.    The Bill seeks to make specific amendments to the anti-avoidance provisions in section 16 of the Ordinance.  The Administration holds the view that interest expense must either meet the "tax symmetry" rule or the "non‑associate borrowing" rule before it may be deducted from profits tax liability.  According to the Administration, aggressive tax avoidance schemes began to emerge several years after the enactment of those provisions in section 16 on borrowings from external sources.

10.    Tax-avoidance arrangements that cannot be caught by section 16 are currently tackled by a general anti-avoidance provision under section 61A on a case-by-case basis.  According to the Administration, this general provision does not guarantee success in each individual case and is far from effective.  This is mainly because under section 61A, only those transactions which are carried out with the sole or dominant purpose of obtaining a tax benefit may be caught.

11.    At the early stage of scrutiny of the Bill, we already received representations expressing grave concerns about the proposed anti-avoidance provisions.  Among the views expressed, it was pointed out that the definition of "associate of the borrower" had too wide a scope.  It covered the relatives, partners, associated companies etc. of the borrower, as well as the directors or principal officers of the borrowing company and its associated companies.  It would be difficult and costly for the borrower to know whether any of his associates was entitled to the loan interest, or any of them was the holder of his debentures.  It was also pointed out that the proposed anti-avoidance provisions did not cater for partial deduction of interest payments.  Once the prescribed conditions were not complied with, no matter how trivial the failure might be, the whole amount of interest payment would be disallowed for tax deduction.

12.    In response to the Bills Committee's request, the Administration has undertaken two rounds of consultations with the professional and business sectors.   In light of the views received, the Administration agrees to move CSAs to provide for, among others, a more restricted "connected person" test in place of the "associate" test, and partial deduction of interest payment where only part of the interest payment flows back to the borrower or to a connected person.

13.    As the Administration has made substantial amendments to the original provisions in the Bill, the Bills Committee has further invited views from the public and interested parties.  The views received mainly focus on those proposed amendments which have the effect of disallowing interest deduction in respect of marketable debt instruments held by a connected person of the borrower.

14.    The Bills Committee shares the concern about the compliance problem arising from the proposed amendments.  In the case of large groups, it is almost inevitable that affiliates will from time to time buy debt instruments issued by their group's companies in the course of their normal trading or market-making activities.  It would be incredibly complicated for such groups to monitor the activities of all their worldwide affiliates, particularly where such debt instruments are bought and sold in the course of short-term trading activities.  These company groups would therefore face a compliance problem when they are required to apportion their interest expenses so that those paid to their affiliates would be carved out from the deduction on chargeable profits.

15.    According to the Administration, currently all major debt securities in Hong Kong are issued through financial institutions or issued by corporations who would not engage in market-making activities.  Financial institutions are excepted persons as defined in a proposed new section and are thus exempted from the application of the deduction disallowance provisions.  Therefore, the compliance problem is not a concern insofar as current market operations are concerned.  However, in light of the future development of Hong Kong's bond market, the Administration agrees to move CSAs to exempt the market-making activities of registered securities dealers from the restriction on interest deduction.

16.   On the amendments to disallow deduction of interest expenses on debt instruments held by a controlling shareholder of the issuing corporation, REDA has raised strong reservation about the need and justifiability of the amendments.  The Hong Kong General Chamber of Commerce also shares the view that the amendments would unnecessarily restrict legitimate business practices.  They point out that there are genuine commercial reasons for controlling shareholders to participate in their corporations' local debt issues.  For example, a controlling shareholder may be required to underwrite the issue.  In most instances of debt issues, the controlling shareholder's participation would show confidence to the market and increase chance of a successful launch.  Sometimes, the controlling shareholder may need to acquire convertible bonds issued by his corporation in order to avoid dilution of his percentage shareholding.

17.   The two trade associations hold the view that the proposed amendments will have the effect of discriminating against the controlling shareholder of a Hong Kong company by treating them differently from normal investors.  As such, controlling investors would be discouraged from reinvesting their funds in Hong Kong.  If the amendments are put through, Hong Kong corporation groups may be discouraged from issuing debentures.  They also consider that the existing anti-avoidance provisions are adequate in dealing with isolated abuse cases, and the Inland Revenue Department has been applying section 61A to counteract tax avoidance cases with notable success. 

18.    In response to these views, the Administration emphasizes that loans that are internal to a corporation or corporate group should be governed by the symmetry principle.  As the existing section 61A only applies where the transaction in question is carried out with the sole or dominant purpose of obtaining a tax benefit, it is far from effective in combating those tax avoidance transactions which also involve some substantive commercial elements.

19.   According to the Administration, tax avoidance cases in relation to interest expenses are far from isolated and the situation is worrying.  For the period from 1997 to March 2004, the back tax which the Government has assessed on tax avoidance schemes involving interest expenses by invoking section 61A has exceeded $6.7 billion.  Out of this amount, more than $1 billion involves debentures.

20.   As to how the tax treatment of interest income and expenses in Hong Kong compares with other major tax jurisdictions, the Administration has provided information on Singapore, the United Kingdom, Australia and Japan as suggested by the Bills Committee.  According to the Administration, all the four jurisdictions maintain a withholding tax system on interest payable to non‑residents.  In addition to the application of withholding tax system, most of the places studied impose other specific conditions such as the "thin capitalization rules".  The Administration considers that the tax treatment of interest deduction in Hong Kong is generally much more favourable than the jurisdictions studied.

21.   REDA and the Hong Kong General Chamber of Commerce however inform the Bills Committee that full tax symmetry in relation to interest is not prevalent in most overseas tax regimes.  In all the four jurisdictions studied by the Administration, the interest withholding tax rate is significantly lower than the domestic income tax rate and they are all in the taxpayers favour.  Moreover, none of the jurisdictions has sought to disallow an interest deduction simply on the basis that the recipient is an affiliate or controlling shareholder of the issuing corporation.

22.   The Administration maintains that "tax symmetry" is the prevalent rule governing deduction of interest expense in other tax jurisdictions.  Although the rates under the withholding system may be lower than the income tax rates in these jurisdictions, there is no doubt that an important purpose of the tax withholding system is to maintain "tax symmetry" in order to prevent abuse.

23.    As to whether the proposed amendments will adversely affect the development of the Hong Kong debt market, the Administration's advice is in the negative.  The Administration explains that the proposal will not change the tax treatment of debentures which are genuinely issued to the public, i.e. the interest paid on those debentures will continue to be eligible for deduction from chargeable profits.  The amendments will only disallow deduction of interest expenses on debentures held by controlling shareholders and remove the current unintended tax benefits for arranging overseas debenture issues.  

24.   In early May 2004, REDA submitted a proposal after a meeting with the Administration.  REDA suggested that in line with the relevant arrangement in Singapore, tax deductions should be allowed if a controlling shareholder does not hold more than 50% of the debentures on issue.  The Administration does not accept the proposal.  It does not find any convincing arguments in REDA's proposal which may justify an exemption from the "tax symmetry" rule or from the "non-associate borrowing" rule. 

25.   In its further submission, REDA points out that in describing the purchase by a controlling shareholder of debt securities issued by a listed company as "internal borrowings", the Administration seems to have ignored the fact that transactions between a listed company and its controlling shareholder are subject to the most stringent regulatory supervision and public scrutiny.  The Administration also seems to have ignored the fact that in an open market, the funds provided by the controlling shareholder are as genuine as the funds provided by the general public.

26.    REDA also criticises that the Administration's assertion on the prevalence of tax symmetry for interest expense in most overseas jurisdictions is simply not correct.  REDA's understanding is that tax symmetry is not prevalent in other countries, nor has it been a standard feature of Hong Kong's tax legislation.  On the other hand, many countries do recognize the commercial reality that a business could be funded by a mix of capital and debt, including debt from related parties.  Accordingly, their tax legislation would allow a commercially acceptable financial gearing to exist without resulting in a tax penalty, typically through the use of "thin capitalization rules" to regulate the debt to equity ratio.

27.    Having examined the views of the Administration and those of the trade associations, the Bills Committee has not reached a consensus view on the issue of the deductibility of interest expense on marketable debt instruments held by controlling shareholders of the issuing corporations.

28.    Some members consider that the approach adopted by the Administration may be abrasive, focusing on the need to impose the "tax symmetry" rule to protect revenue but giving no regard to the genuine commercial elements in the holding of debentures by controlling shareholders.  The proposed amendments if enacted may cause significant disincentives to local corporations in raising funds through public issue of debt instruments.  As such, the development of the local debt market may be seriously affected.  Such a possible scenario warrants particular concern when the local debt market is still at the budding stage of development. 

 29.   Some members do find that the anti-avoidance provisions presently proposed involve a change of policy.  Although the Administration has repeatedly stressed that the "tax symmetry" rule has all along been a fundamental principle of Hong Kong's taxation regime, this rule has in fact been applied to different extents at different times by the Government.  In this connection, the Bills Committee notes that in the 1986 amendment exercise when the general anti-avoidance provisions under sections 61A and 61B were introduced, the then Financial Secretary made it clear that the anti-avoidance provisions "would only be used to strike down blatant and contrived schemes where there is a clear and dominant tax avoidance purpose.  It is not the intention to use the law to penalise genuine commercial transactions."  Some members of the Bills Committee consider that the then Financial Secretary's reference to avoiding unnecessary inhibitions on genuine commercial transactions is relevant to the current amendments to section 16, which is also concerned with combating tax avoidance.

 30.    The Administration has responded that the then Financial Secretary's reference relates only to the general anti-avoidance provisions of sections 61A and 61B, and is not relevant to the current amendment to plug the loopholes in section 16, or otherwise it would be an anomaly inequitable vis-à-vis other related taxation arrangements in the Ordinance.

 31.    In view of the controversies raised and the strong concerns from the business sector, a majority of the Bills Committee members consider that instead of rushing through the proposed amendments, it would be advisable for the Administration to further discuss the issue with the business sector.  This would be conducive to working out an alternative proposal which would safeguard government revenue from deliberate tax avoidance schemes and would not cause unnecessary inhibition to genuine commercial transactions.  Nevertheless, the Administration re-affirms the need to plug the existing loophole and decides not to pursue the proposal of REDA or any modified version of the proposal because all such efforts would only enlarge existing loopholes.

 32.   The Bill also deals with a number of revisions to set out more clearly the legislative intent of certain provisions. One of it is the expansion of the scope of self-education expenses to include any examination fees, so long as the examination concerned is set by a provider of a prescribed course of education and undertaken by the taxpayer to gain or maintain qualifications for use in any employment.  The policy intent is that all employment-related self-education expenses should be deductible from the assessable income of a taxpayer.  We support this policy intent and the proposed amendment.

 33.    We also notice that under the existing provisions, the term "prescribed course of education" covers only education courses provided by an education provider or a trade, professional or business association.  Since education courses nowadays are operated in many different modes, we consider that the existing scope of "prescribed course of education" is too narrow.  The scope falls short of recognizing those education courses which are not directly provided by trade, professional and business associations but are subject to strict quality control and are recognized or accredited by these associations.

 34.   The Administration concurs with the view of the Bills Committee.  After reviewing 22 relevant ordinances, the Administration agrees to move CSAs to extend the scope of "prescribed course of education" to cover courses accredited or recognised by two types of institutions.  The first type of institutions are those having a role in the registration and recognition of professional or occupational qualifications, or the granting of permits or licenses for practicing in the professions, trades or occupations under 22 ordinances.  The second type of institutions is statutory organisations endowed with the function of establishing standards of skill to be achieved and award certificates of competence in any particular trade or industry.

 35.    We welcome the proposed extension of the scope of education courses for deduction of self-education expenses from the assessable income for salaries tax.

 36.    There are also other amendments which are mainly technical in nature.

 37.    Firstly, the Bill proposes to revise the method of computation of annual allowances and the determination of balancing allowances and charges in respect of commercial and industrial buildings and structures.  We support the amendment.

 38.    Secondly, the Bill proposes to allow deduction of the interest paid on the portion of a home loan in respect of a car parking space, if such portion of the loan has been applied for the acquisition of the car parking space.  In this respect, we notice that the retrospective application of the proposed amendment alone may not be sufficient to cater for the revision of tax assessments for some eligible taxpayers.  In response to our suggestion, the Administration agrees to move a CSA to add a saving provision stating a specified period for eligible taxpayers to apply for the deduction.

 39.    Thirdly, the Bill seeks to empower the Board of Review to extend the time for lodging notice of appeal against the assessment to additional tax.  And lastly, the Bill seeks to provide for certain costs and fees to be specified in a Schedule to the Ordinance and empower the Secretary for Financial Services and the Treasury to vary the amounts by order. We support these amendments.

 40.    Madam President, the Bill has taken almost one full term to reach resumption of second reading.  Despite our 11 meetings, the 22 minutes of my speech and the three years given to the Administration to consult the parties concerned, you will notice that consensus could not be reached on quite a number of issues.  The Bills Committee has nevertheless completed its deliberation on the Bill.  It will be for individual Members to decide which parts of the Bill should be supported.


 41.    Madam President, now that the Committee¡¦s report is out of the way, I can, at last, freely speak my mind. I shall try to keep them very short. Although I support the many principles of the Bill in general, I feel obliged as a professional to clearly point a number of seriously flawed arguments that the Administration have deployed in their attempt to try persuading members to support the Bill. These flawed arguments, if stand uncorrected, will muddle the existing foundation of tax policies and confuse serious investors both locally and overseas. It could also lead to wasteful litigations in future and mislead this Council now and in future in considering proper tax legislations.

 42.    I am particularly concerned with the fact that this Bill has breached the territorial source principles in defining our tax jurisdiction; resurrected the interest tax through the back door after its abolition in 1989 and inadvertently introduced a new tax policy of ¡¥symmetry¡¦ which is ill conceived and clearly unworkable if applied universally and fairly to the entirety of the Inland Revenue Ordinance.


 43.    I shall begin with the territorial source principle. As explained already in my Bill Committee¡¦s Report, the accounting profession is strongly opposed to Clause 5 of the Bill on the deeming provision to treat royalty¡¦s payments in respect of intellectual property used outside Hong Kong as taxable trading receipts. In their submission, they clearly pointed out that the ¡¥so-called¡¦ tax policy of ¡¥symmetry¡¦ does not currently constitute part of Hong Kong¡¦s framework of taxation. I fully agree with this view and consider this fundamental change in policy should first be serious debated in public instead of being selectively applied in a hazardous fashion. The proposed amendment if passed will create damaging uncertainties to Hong Kong¡¦s tax policy and are likely to be ineffective. There is ample judicial authority that laws can only be enacted by this Council which has sufficient nexus to the Territory of Hong Kong. In consequence, the laws cannot deem income to arise ¡¥in¡¦ Hong Kong when as a matter of fact it arises ¡¥outside¡¦ Hong Kong. I personally doubt the wisdom of this amendment which would be opened to challenges on constitutional grounds. I am therefore opposing this amendment and also urge members to consider carefully this ill conceived proposal before passing it into law.


 44.    On the even more controversial subject of interest deduction. I shall begin by clearly stating that no one is opposing the tax anti-avoidance efforts of the Administration. The issues at hand are where are the legitimate parameters of taxation and how do we define that scope for taxation. To bring in ¡¥new¡¦ sources of taxation is not anti-avoidance measures and to label existing tax-payers who are legally exempt from taxation as ¡¥tax avoiders¡¦ is clearly unjustified, unhelpful and unfair. In analyzing this issue, some reflection of history is unfortunately necessary.

 45.    In 1989, the Government of Hong Kong abolished interest tax for the express purpose of promoting Hong Kong as an international finance centre. It then clearly recognize the fact that Hong Kong must be more favourable than, not just equal to or comparable to, other jurisdictions to which the Administration has now only sought to draw a parallel. The Government then also clearly recognizes the fact that the move will involve not insignificant revenue lost. But it was a clear and good tax policy that has benefited Hong Kong¡¦s investment environment for some 15 years.

 46.    The problems of tax anti-avoidance are historically dealt with by a number of clear and specific anti-avoidance provisions such as Section 16(2) (c) and Section 16(2) (d) in 1984 and then even more conclusively by Section 61A and 61B the ¡¥general anti-avoidance provisions¡¦. Madam President, you and I might recall that at that time, I was a representative of the HKSA making submission to the then Bills Committee and you were a concerned member of the Legislature. I hope therefore that you would indulge me in quoting two short statements by the Financial Secretary which are instructive to the policy intent at the time and still highly relevant up to now.

 47.   In his Budget Speech in 1984/85, The Financial Secretary said ¡§I believe that the proposals are essential for the protection of revenue and should deter tax avoiders. At the same time they are carefully designed to leave ample scope for genuine business borrowers to obtain full deductions for interest expenses incurred¡¨.

 48.   He again replied to your question in this Council in 1986 to say that ¡§I can also confirm for Mrs. Fan¡¦s benefit that section 61A and B will only be used to strike down blatant and contrived schemes where there is a clear and dominant tax avoidance purpose. It is not the intention to use the law to penalize genuine commercial transactions.¡¨

 49.   I note that throughout the deliberations of the Bill¡¦s Committee, the Administration did not contest that many transactions now caught by the new provision could be genuine commercial transactions. For the avoidance of doubt, they have even proposed transitional provisions to ensure that the Bill will have no retroactive effects. The proposed amendments are therefore clearly bringing in an element of ¡¥new taxation¡¦, or in effect, to resurrect partially the interest tax regime that it has abolished in 1989 through the backdoor.

 50.   The problem become more confusing when the Administration insists that there is an implied policy of ¡¥Tax Symmetry¡¨ for sometime. A fact already refuted by tax professionals and the so-called policy was never expressed in any Government official records before.

 51.   It is, I submit, a very conscious decision in the past for good reasons. It is because of the fact that the concept is so difficult to apply universally and fairly to the whole of the Inland Revenue Ordinance where tax symmetry will hardly succeed. In particular, Hong Kong imposes tax only on a territorial basis and not on a worldwide basis. It distinguishes trading income from capital gain and it is not uncommon for deduction to be tax allowable but the corresponding income to be exempt from taxation. To elevate tax symmetry to the level of a ¡¥tax policy¡¦ and not simply a factor for consideration would create uncertainty and in the end be counter-productive. Unless otherwise expressed in the legislation, should tax professionals now treat all expense deductions inadmissible unless there is full tax symmetry on the income side? I wish the administration can clarify its policy intent before real confusion sets in.

 52.   Another case in point is that even in this proposed legislation, the target is only the major shareholders of large companies and that others are still exempt from the symmetry rule. It shows just how difficult, how unfair and how selective this policy can be in actual practice.

 53.   In conclusion, I understand the frustration the IRD must have in its difficult task of combating tax avoidance and the pressure of the present budget deficits. However, despite the limitations of the present Section 61 A & B, they are still very powerful and much feared weapons of the Inland Revenue Department with a track record of considerable successes. More importantly, it has struck the right balance between genuine business interests and the need to deter tax avoiders. I believe that before the Administration extend its scope of taxation and seeks additional legislative powers in the form of specific anti-avoidance provisions, it must come clean before this council on the following issues.

 54.   Where the Government stands now on taxing interest income? Is it permissible for businesses to deduct interest expenses or not? Why should deductibility of an expense depend upon the tax status of the recipient instead of the tax status of the person incurring the expense? Are we not resurrecting interest tax through the backdoor but disallowing interest deductions for selected major business groups? If so, why is that there is no proper open debate on the matter and how can the Government say that it does not affect the business environment by taking this backward steps from 1989 when interest tax was abolished?

 55.   The present legislation clearly went beyond the existing definition of ant-avoidance and will have the effect of extending the scope of tax to bring in additional revenue by including those transactions with genuine commercial substance. It is also specifically targeted at selected group of majority shareholders of large companies. Where is the equitable ground for this move and why is it disguised as an anti-avoidance measures?

 56.   Madam President, unless these stealth changes in fundamental tax policies and thinking are honestly and fairly debated, I agree with the business community of Hong Kong that the present proposals are ill conceived, poorly explained and unsafe to support. I urge members of the Council to consider these factors carefully and not to trade principles for expediency and possible additional tax revenue.

 57.   With these remarks, Madam President, I shall oppose Clauses 5, 6 together with their respective consequential amendments. Thank you.


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