The Hong Kong connection

Hong Kong fortunes are inextricably linked to China. However, the city’s role has evolved over the years.

Since the earliest days of its establishment as a British colony, Hong Kong’s fortunes have been inextricably linked to China. However, Hong Kong’s role has evolved over the years, from trading to low-cost manufacturing, shipping and logistics to a regional aviation hub, and now a leading international financial centre and regional headquarters location for many of the world’s leading companies.

As a result, Hong Kong remains an excellent choice as a gateway into China. This is, in part, due to the fact that the Hong Kong legal system provides greater flexibility, clarity and certainty than is currently possible for direct investments under People’s Republic of China (PRC) law.

Although the PRC legal system has undergone breathtaking improvements over the past 15 years, there is still a high level of PRC government involvement in most aspects of a foreign-invested enterprise in China. Government approvals are required for everything from transfers of ownership to amendment of constitutional documents and remittance of profits.

Therefore, it is often possible for investors to achieve their commercial objectives more flexibly and efficiently using a Hong Kong holding company. This will be even more so when the new PRC Enterprise Income Tax Law comes into effect on 1 January 2008, as dividends payable to Hong Kong investors will enjoy a lower rate of withholding tax.

The Hong Kong tax system is simple, transparent and fair, and offers low rates. The Hong Kong government has recently announced that the standard tax rate for individuals will be reduced to 15 per cent and the standard profits tax rate for corporations will be reduced to 16 per cent over the next three years, from the current levels of 16 per cent and 17.5 per cent, respectively.

Hong Kong only taxes profits and salaries that are generated in Hong Kong. Profits and income earned from sources outside Hong Kong by Hong Kong residents are not generally subject to any tax in Hong Kong. There is no capital gains tax and no withholding tax on dividends, interest or royalties.

In recent years, Hong Kong has also become important as a gateway out of China for major PRC companies choosing to list on the Hong Kong Stock Exchange. In the past few years, several of the largest IPOs in the world were listed on the Hong Kong Stock Exchange, for example, the $21.9bn (£10.52bn) IPO of Industrial and Commercial Bank in October 2006 and the $11.2bn (£5.38bn) IPO of the Bank of China in June 2006.

Recent changes in the PRC rules, which are intended to boost the two mainland stock exchanges in Shanghai and Shenzhen, will limit dual listings, but Hong Kong will continue to play an important role as more PRC companies expand outside China.

Traditionally, some investors were deterred by Hong Kong’s lack of a network of comprehensive double tax agreements (DTAs). As Hong Kong’s taxation system is territorial (ie generally only profits and salaries generated in Hong Kong are subject to taxation in Hong Kong) and many countries offer unilateral relief against taxation of profits which have already been taxed in Hong Kong, the risk of double taxation for Hong Kong residents and companies doing business in Hong Kong is generally low.

However, by the nature of their operations, shipping and aviation companies are potentially susceptible to double taxation, and the Hong Kong government has negotiated a comprehensive network of arrangements which provide relief from double taxation for income earned in the shipping and aviation sectors.

More recently, the Hong Kong government has concluded comprehensive double taxation agreements with mainland China, Belgium and Thailand, and recently initialled a DTA with Luxembourg. Negotiations are underway for comprehensive DTAs with a number of other countries, including the Czech Republic, Italy, Kuwait, Macao SAR, the Netherlands, Pakistan and Vietnam).

However, Hong Kong is not just about China: these reasons apply equally to regional investments. Hong Kong companies offer a number of advantages as holding companies for regional operations, especially the fact that dividends received are not taxable in Hong Kong and dividends paid by Hong Kong companies are not subject to withholding tax.

Donald Hess is a partner at Allens Arthur Robinson in Hong Kong