DIPN 24

Our web site : www.ird.gov.hkInland Revenue DepartmentHong KongDEPARTMENTAL INTERPRETATION AND PRACTICE NOTESNO. 24 (REVISED)PROFITS TAXSERVICE COMPANY “TYPE II” ARRANGEMENTSThese notes are issued for the information of taxpayers and their taxrepresentatives. They contain the Department’s interpretation and practices inrelation to the law as it stood at the date of publication. Taxpayers arereminded that their right of objection against the assessment and their right ofappeal to the Commissioner, the Board of Review or the Court are not affectedby the application of these notes.These notes replace those issued in August 1995.LAU MAK Yee-ming, AliceCommissioner of Inland RevenueJuly 2009DEPARTMENTAL INTERPRETATION AND PRACTICE NOTESNo. 24 (REVISED)CONTENTParagraphIntroduction 1Type II arrangements 4Legal principles 6Acceptable arrangements 14Arm’s length basis 15Qualifying services 17Deduction allowable 22Returns and accounting 28Application 29Annex AINTRODUCTIONThe Financial Secretary announced in his 1994-95 Budget Speechthat the Administration proposed to take steps to deal with the tax avoidanceaspects of certain “service company arrangements”. Two types ofarrangements were identified as causing particular concern. The first (Type Icases) amount to disguised employment arrangements where the remunerationfor services rendered by a person under employment-like conditions is paid notas salary to that person, but as a consultancy fee to a service company hecontrols. The second (Type II cases) typically involve deductions beingclaimed by an unincorporated business for payments, often described asmanagement fees, which are made to a company or a trust (service company)controlled by the proprietor or partners of the business.2. Following the announcement, consultations were held with a numberof practitioners and professional groups with a view to ascertaining the mostappropriate way to address the areas of concern. Having considered theadvice received, the Administration introduced section 9A to the InlandRevenue Ordinance (“the Ordinance”) to curb Type I arrangements.Departmental Interpretation and Practice Notes No. 25 discuss the applicationof the relevant provisions which were introduced following the enactment ofthe Inland Revenue (Amendment) (No. 2) Ordinance 1995.3. With regard to Type II arrangements, it was decided that in the firstinstance legislation would not be required. Rather, the Department shouldseek to discourage abuse by both explaining in a Practice Note thecircumstances under which service company claims will be challenged byplacing greater reliance on the general anti-avoidance provisions of theOrdinance. Accordingly, the purpose of this Practice Note is to set out theDepartment’s position in relation to the application of the present terms of thelaw to Type II arrangements.TYPE II ARRANGEMENTS4. As indicated at the beginning of this Practice Note, a Type IIarrangement usually involves an agreement (service company agreement)under which management fees are paid by a firm to a service company directly2or indirectly controlled by the proprietor or partners of the firm. Asconsideration for the fees paid, the agreement generally provides for the servicecompany to supply certain operating requirements to the firm.5. It has become apparent to the Department that many arrangements ofthis kind are directed at reducing the overall incidence of tax. If the amountpaid to the service company is allowed as a deduction and exceeds the cost thatwould have been incurred if it had directly obtained the requirements inquestion, the assessable profits of the firm will be reduced. The servicecompany in turn will normally seek to avoid or minimise exposure to tax on theexcess payment by claiming deductions for tax efficient remuneration providedto connected parties (e.g. the proprietor or partners of the firm or their relatives)as employees or directors of the service company.LEGAL PRINCIPLES6. It has been accepted in other tax jurisdictions that where acommercially realistic sum is paid under a service company arrangement for aservice essential to the conduct of a firm’s business, the presumption is raisedthat the expenditure was for business purposes and is a genuine cost of earningthe firm’s income (i.e. incurred in the production of its profits). However, ithas also been recognised that the converse will apply if the expenditure isexcessive, namely that the payment was not wholly for the services provided,but for some other purpose. This thinking is considered by the Department tobe equally applicable to management fee claims under the Ordinance andaccordingly it underlies the Department’s position in relation to such claims.7. It follows that it is recognised there may be valid commercial reasonsfor the owners of an unincorporated business to make use of a service companyarrangement. However, what has caused concern to the Department in recenttimes has been the increase in the number of arrangements encountered where,having regard to the services involved, the fees paid have been well in excessof commercially realistic amounts and, therefore, by implication, are notincurred wholly in the production of chargeable profits. Equally disturbinghave been the cases where agreements have not been reduced into writing;accounts have not been properly kept; or fees have been decided on an arbitrarybasis bearing little, if any, relationship to the cost of the services provided.38. It is apparent that there is a lack of appreciation on the part of somepractitioners and taxpayers of the options open to the Department to challengeservice company arrangements where they fail to operate on a propercommercial basis. In this regard it should be noted that the decisions of theBoard of Review in Case No. D19/99 14 IRBRD 209 and D153/01 17 IRBRD189, both of which involved inflated management fees, provide clearillustrations of circumstances under which, by virtue of section 16(1) of theOrdinance, a management fee can be dissected and that part which is notattributable to the production of chargeable profits disallowed. Support forthis view can be found in the observations of the Board in D19/99 -At page 218“a. Section 16Section 16 ascertains the chargeable profits by defining whichoutgoings and expenses are deductible from the chargeable profits ofa taxpayer. Section 16(1) allows to ‘be deducted all outgoings andexpenses to the extent to which they are incurred during the basisperiod ... in the production of profits in respect of which he ischargeable to tax under this Part for any period including...’Section 16(1) then sets out those expenses which are deductible.”And at page 226“20. D61/91, IRBRD, vol 6, 457 and D32/93, IRBRD, vol 8,261 cited by the Revenue did not deal with section 61 and thequestion of artificial or fictitious transaction. Nor did Case D32/94,IRBRD, vol 9, 97 in which the taxpayer, a medical practitioner,admitted that section 61 applied to his case in order to avoid the direconsequence of the board disallowing the management fee in total asthe Board was of the view that on the evidence of that case themanagement fee was indivisible. Although the Board in D110/98,IRBRD, vol 13, 553 cited to us mentioned on the side that thewording of section 61 does not allow the Revenue to disregard a partof a transaction, we are of the view that if service companyarrangement is to be disregarded in accordance with section 61, thenit is open to the Revenue to assess the chargeable profits of a4taxpayer by totally ignoring service company and the service fees.With service company and service company arrangement out of theway (in other words, after lifting the corporate veil), it is open to theRevenue to dissect the outgoing expenses of service company as ifsuch outgoing or expenses were that of a taxpayer in the light ofwhether such outgoing or expenses were deductible to the extent towhich they are incurred in the production of a taxpayer’s chargeableprofits.”9. Taxpayers should also be mindful of the view expressed by theBoard of Review in Case No. D153/01 17 IRBRD 189 and D85/02 17 IRBRD1017 to the effect that it may be appropriate to disallow entirely an excessivemanagement fee which is not capable of being split into its component parts.In D153/01, at page 205, the Board said -“53. Whether an expense is an allowable expense is governedby sections 16 and 17 of the IRO. Section 16(1) permits deductionof all outgoings and expenses which satisfy two criteria, namely (1)they must be incurred in the production of assessable profits and (2)they must be incurred during the basis period of the year ofassessment in question. Section 17 disallows deduction of certaintypes of outgoings and expenses. If a taxpayer fails to prove that anexpense was incurred for the production of his assessable profits, thewhole of that expense will be disallowed. In the present case, if theTaxpayer is unable to prove that the management fees were incurredin the production of his assessable profits, the whole of thesemanagement fees would be disallowed. But if an expense iscapable of analysis and subdivision or where section 61 or section61A applies which allows dissection of the expenses, then thatexpense can be allowed ‘to the extent’ that it was incurred to producethe taxable profits and the balance thereof be disallowed. In thepresent case, since the management fees were made up of thoseexpenses as detailed in Company B’s profit and loss accounts plus amark-up of 5%, they are thus capable of analysis and subdivision.Accordingly, only those expenses which are proved to be incurred inproduction of the Taxpayer’s assessable profits would qualify asallowable deductions.”5And at page 206“56. We were asked by Counsel for the Taxpayer to decide onthe question of whether a minute examination of Company B’sexpenses was permissible under the circumstances. We decide thatwe should allow an examination of Company B’s expenses in detail.The amounts of management fees were calculated by reference to allthe expenses and outgoings incurred by Company B in providing therequisite services plus a mark-up of 5%. Examination of thoseexpenses and outgoings is necessary as to determine whether theywere incurred in production of the Taxpayer’s assessable profits. Inso doing, we are not lifting the corporate veil nor are we saying thatthe Taxpayer is not free to decide his own affairs but the question ofwhether an expense is deductible in law when computing thechargeable profits must be answered objectively. We must lookinto the purpose of the payments and see whether the expense wasbona fide incurred in production of the chargeable profits. Theonus is on the Taxpayer to show that each of those items of expensesin Company B’s profits and loss accounts was bona fide incurred forthe production of his assessable profits. We are not persuaded byCounsel for the Taxpayer that since Company B’s tax position wasnot in dispute, the expenses in Company B’s accounts were the leastrelevant. Nor do we accept the contention that once the Taxpayercould establish that the management fees were incurred for thepurpose of acquiring professional services from Company B, themanagement fees should be allowed in full. The matter does notstop there. The Taxpayer is still required to prove that the expenseswere bona fide incurred for production of his assessable profits.”10. The view expressed by the Board on the above occasion may well beregard as reflecting the principle stated in an earlier management fee case, “It isfor the Taxpayer to prove that the money had been used in the production ofthe profits” [D96/89 6 IRBRD 372].11. The relationship, if any, of the management fee to the servicesprovided is also clearly an important consideration in relation to the question ofwhether there is a commercial rationale for a service company arrangement.In this regard, the Board observed in Case No. D110/98 13 IRBRD 553 at page558 -6“7. In conclusion, while it is clear that some of the expensesof Company X did relate to the Taxpayer’s practice, the interposingof Company X was in reality predominantly designed to be a taxvehicle whereby a lot of the Taxpayer’s personal expenses were to bemade tax deductible and, more importantly, to enable the Taxpayerto reduce his tax liability to minuscule proportions. It was hardlynecessary nor even advantageous for the Taxpayer to engageCompany X to provide services to his practice and certainly not atthe management fee that company charged. To put it another way,if Company X was not owned by the Taxpayer and not providinghim with the benefits it did (including loans on generous terms), wewould not have thought there would be much if any possibility thatthe Taxpayer would have engaged that company. It would simplynot have been commercially acceptable. Lastly, it should be notedthat Company X acted only for the Taxpayer; it had no other clients.”12. The Board in fact held in Case No. D94/99 14 IRBRD 603 that therelationship between the taxpayer and the service company was artificial andlargely, if not totally, fictitious and therefore should be disregarded under theprovisions of section 61 of the Ordinance. In reaching its conclusion theBoard emphasised the need for the parties involved to act on an arm’s lengthbasis if a service company arrangement is to be acceptable. At page 611 theBoard stated -“24. Mr B said that it was solely a matter for the Taxpayer andCompany D as to what the fair and reasonable service would be.We accept the Revenue’s submission that the matter had to beassessed objectively. That is not to say that we are lifting thecorporate veil. Nor are we saying that the Taxpayer is not free todecide its own affairs. The Taxpayer is free to give away part of itsincome as it so wishes to a related company or to a relative orindeed to any third party. The question here is whether thatpayment is a deductible expense in law when computing thechargeable profits. This question must be answered objectively.The agreement between the Taxpayer and Company D does notpreclude us from examining whether the payment is or is not adeductible expense incurred in the production of profits.725. Such expense must have been bona fide incurred in theproduction of profits. We must look at all surroundingcircumstances. For example, the relation between the payer andthe payee is a relevant circumstance. So is the purpose or thereason of the payment. The basis and the breakdown of the amountare also important. The lack of a rational basis may lead us to theconclusion that the amount is wholly arbitrary, lacking incommercial reality, and thus not bona fide incurred.26. In this case, the Taxpayer has given us very littleinformation as to how the service fee was incurred in the productionof profits. The consultancy agreement referred to ‘firstly’ a fee$12,000 every month. There is no explanation as to how this cameto be increased to $1,391,200 for the relevant period. The minutesof Company D’s board is, quite apart from the discrepancies pointedout by the Revenue, totally silent as to the reasons for the substantialincrease. We do not accept the contention in the Taxpayer’s letterof 2 July 1996 that the fee was agreed on an arm’s length basis.There is no explanation as to how the fees were determined‘periodically’ as stated in that letter. The schedule, which isannexed hereto as Appendix B and relied upon by Mr B, showsirregular payments and is again totally unexplained. There is noinformation as to how these payments relate to services provided byCompany D. It looks more like a list of sole proprietor’s drawingsfrom his own business. There is no attempt to justify any of thesums by reference to the service provided by Company D. In thecircumstances, the Taxpayer failed to discharge his onus, we haveno hesitation in dismissing the appeal.”13. It should also be noted that apart from the possibility of applyingsection 61 where a service company arrangement is not operated on acommercial basis, the Department may also turn to section 61A if it is apparentthat the sole or dominant purpose of the arrangement is to obtain a tax benefit.In such circumstances the existence of the service company could bedisregarded and the tax benefit effectively cancelled. The decision of theBoard of Review in Case No. D153/01 17 IRBRD 189 is an example where theCommissioner has applied section 61A to a Type II service companyarrangement. The Board accepted the Commissioner’s views and stated atpage 209 -8“ As to section 61A, we also accept the Commissioner’sreasons in his determination to conclude that the Service Agreementand the Employment Agreement were entered into by the Taxpayerand Company B for the sole and dominant purpose of enabling theTaxpayer to obtain a tax benefit.”ACCEPTABLE ARRANGEMENTS14. The following paragraphs set out the minimum requirements thatmust be satisfied to support a management fee claim and also spell out the basison which the quantum of the deductible amount can generally be determined.Arm’s length basis15. There may well be circumstances which warrant a person carryingon a trade, profession or business entering into an arrangement with a properlyconstituted service company to obtain certain services and facilities which arerequired in order for the person to derive chargeable profits. However, for taxpurposes, it must be emphasised that where such an arrangement is entered into,the service company has to function as a separate business operating on anarm’s length basis in its dealings with the firm. To support and be consistentwith the separate status of each party, their respective rights and obligationsand dealings with each other should be fully documented. Suchdocumentation should include -• the agreement under which the services are provided (it shouldspecify the relevant services, the basis on which fees are to bepaid, the period covered by the agreement, etc);• minutes of meetings recording approval of the terms of theservice company agreement and any subsequent amendment;• invoices and receipts in respect of transactions between theparties;• working papers in respect of the calculation of the fees chargedby the service company;9• bank records in respect of each party; and• employment contracts in respect of persons employed by eachparty.16. In the generality of cases, where a management fee is paid to aservice company on an arm’s length basis, the amount involved should reflectthe costs of the service company which are directly attributable to the relevantservices (e.g. salary paid to a typist) plus an appropriate mark-up to provide forthe operating expenses (e.g. rent of premises occupied by the service companyitself) and reasonable profit margin of the company. These matters are furtherdiscussed in the following paragraphs.Qualifying services17. In order to determine the deductible amount, if any, in respect of amanagement fee paid by a firm, the starting point must be to examine thenature of the services received from the service company. In this regard, it isnecessary to identify what might, for convenience, be called “qualifyingservices” required by the firm in order to produce chargeable profits.18. The Department’s position is that, broadly, the term “qualifyingservices” encompasses non-professional services which are required to providethe infrastructure in which the firm operates and to cater for its day-to-dayoperations. Accordingly, it can include services such as the provision ofpremises, staff (e.g. administrative, secretarial, clerical and cleaning staff),plant and equipment and miscellaneous supplies (i.e. stationery, photocopying,medical, etc). The term does not, however, extend to the provision of anyservices to a firm by its proprietor or partners as employees of a servicecompany. In the latter regard, the position of the Department reflects the viewthat such an arrangement would in substance amount to the proprietor orpartners seeking to employ themselves and therefore, on established principles,it would not be effective for taxation purposes.19. Also excluded from the term are services performed by otherprofessional “fee-earners” who have contracts of employment with a servicecompany, whether or not they also hold positions as ordinary employees orsalaried partners with the firm. It is pertinent in this regard that where10professionals are employed by the service company instead of the firm, itwould generally be possible for the parties concerned to arrange for the servicecompany to directly charge the client for the relevant services. In thesecircumstances the deduction allowed in respect of remuneration of theprofessionals against the sum received would be limited to the amount actuallypaid. Accordingly, it is not considered that any mark-up could be justified incommercial terms in respect of the portion of a management fee relating tosuch remuneration where the firm bills the client even though the servicecompany employs the professionals.20. A reference to professionals in this context should be read asapplying to persons whose day-to-day duties require them to apply expertisethey have acquired through training or experience in the profession of the partyfor whom the duties are performed. On the other hand, the term does not referto a person who has expertise in a profession but performs onlynon-fee-earning services. For example, it should not be taken as applying toan accountant who carries out administrative functions in a medical practice orto a legally qualified person acting only as an office manager or librarian in afirm of solicitors.21. It should be noted that the Department does not accept that aprofessional can “wear two hats” so that what might be called administrativeduties are isolated from professional duties for the purpose of treating theformer as qualifying services. The position of the Department in this regard isthat, irrespective of whether the person concerned is a proprietor, partner oremployee of the firm, such administrative duties are part and parcel of therequirements of a professional position and do not warrant separateconsideration.Deduction allowable22. If a deduction is to be allowed, a firm must establish that the amountclaimed in respect of each qualifying service falls within section 16 of theOrdinance and is not excluded under section 17. To establish deductibility, itmust provide the Department with a detailed statement which lists thequalifying services obtained from the service company. The statement shouldinclude in respect of each service -11• an explanation, unless the reason is self-evident, of why theservice is required by the firm in order to produce its chargeableprofits;• the amount included in the management fee claim in respect ofthe particular service (any portion applicable to non-businessuse should be excluded); and• an explanation of why the amount should be accepted as beingcommercially realistic and deductible.23. As was mentioned in paragraph 16 above, the Department acceptsthat a commercially realistic figure for a firm to pay for qualifying services canreflect not only the costs of the service company which are directly attributableto providing the relevant services (the “cost element”), but also an appropriatemargin or “mark-up” to cover the overheads and profits of the servicecompany. It follows that to establish the deductibility of a management feepaid for qualifying services, a firm will need to provide the Department withdetails of how the amount claimed has been calculated. In this regard, theDepartment will accept that for a particular year of assessment the costelement is represented by the sum of the tax deductions, including depreciationallowances, claimable by the service company in the same year of assessmentin respect of expenditure which is directly attributable to the provision of thequalifying services. As such, it should not include any amount in respect ofexpenditure which would not have qualified for a deduction or given rise to adepreciation allowance if it had been incurred by the firm itself, instead of bythe service company, in order to obtain directly the relevant services.24. As it is not accepted that qualifying services can include any functionperformed by a proprietor or partner of a firm, expenditure on anyremuneration or benefits provided by a service company to such a person (e.g.as a director’s fee) must not be reflected in the computation of the cost elementof qualifying services. Attached as Annex A is a simple example illustratingthe adjustment required where expenditure on the provision of remuneration toa connected party is involved.25. Where a service is provided which is used partly for a qualifyingpurpose and partly for some other purpose, the cost element should be reduced12to reflect the non-business application. For example, if an item of plantprovided by a service company to a firm is only used by the latter 40% forbusiness purposes, only that percentage of any depreciation allowance andrelated expenses should be included in the cost calculation. Similarly, wherefunds are borrowed by a service company in order to provide qualifyingservices to a firm and for some other purpose (e.g. to purchase a propertyoccupied by a connected party), only that part of the interest which relates tothe provision of the qualifying services should be included in the cost element.26. In relation to the question of what is an appropriate mark-up,provided that the overall claim does not exceed the expenditure actuallyincurred, a margin not exceeding 12.5% of the cost element will generally beaccepted as being commercially realistic. It is considered that a margin of thisorder provides a reasonable approximation of those applicable in arm’s lengthbusiness operations and reflects the views expressed by the Board of Review inCase No. D94/99 14 IRBRD 603.27. Where the information provided by a taxpayer is insufficient toestablish that the deduction claimed in respect of a management fee iscommercially realistic, the presumption will arise that the fee was paid at leastin part for a purpose unrelated to the production of chargeable profits. In sucha case, a deduction will be denied to the extent to the amount in excess of acommercially realistic figure, provided that it can be ascertained or reasonablyestimated. If this is not possible, consideration will be given to disallowingthe claim in toto in accordance with the view expressed by the Board ofReview in Case No. D153/01 17 IRBRD 189.Returns and accounting28. Unless there are exceptional reasons for doing otherwise, a firm andits related service company should make up their accounts to the same date.If different dates are used, a detailed explanation of the underlying reasonsshould be provided, otherwise it may be presumed that the parties are seekingto obtain a tax benefit. It will also facilitate the assessment of a managementfee claim in respect of qualifying services, if copies of the accounts of a servicecompany and its Profits Tax computation are lodged with the Profits Tax returnof the firm.13APPLICATION29. An assessment which in the absence of this Practice Note wouldhave been regarded as final and conclusive in terms of section 70 of theOrdinance will not be reopened for the purpose of adjusting a management feeclaim to reflect this Practice Note. However, where an assessment has notbeen made for any year, including a back-year, the Department will be atliberty to apply this Practice Note.30. Moreover, it must be stressed that this Practice Note only states theDepartment’s practice in determining whether or not management fee paid byan unincorporated business is deductible. It has no application to the taxationof the service company. As confirmed by the Board of Review in Case No.D62/01 16 IRBRD 537 at page 555, “…The whole tenor of DIPN No 24 is onthe question of whether or not the management fee paid or payable by anunincorporated business to a service company can be allowed as a deduction inthe unincorporated business’ tax file. It does not deal with the chargeabilityof the management fee paid or payable, to a service company in the servicecompany’s tax file…”. Whether a sum is deductible to the taxpayer does notaffect its chargeability in the hands of the recipient.Annex AProfessional FirmProfessional Fees $5,000,000Less: Management Fee for services(i.e. office accommodation and generalclerical support) provided 4,000,000Profits per accounts $1,000,000Actual cost of providing operating requirements(i.e. office accommodation and general clericalsupport) by Service Company to ProfessionalFirm -- $3,000,000Computation of Assessable Profits of Professional FirmProfits per accounts $1,000,000Add: Management Fee adjustment(deduction restricted to $3,375,000being actual cost of $3m + 12.5%) 625,000Adjusted Assessable Profits $1,625,000Note: The 12.5% mark-up is on expenditure incurred by the Service Companyin providing services to the Professional Firm (i.e. the “cost element”).For this purpose it is only accepted as including expenditure whichwould have been deductible to the Professional Firm if it had directlyincurred the relevant expenditure (see Para. 23 of the Practice Note).iiService CompanyIncome (Management Fee) $4,000,000Less: Cost of services provided toProfessional Firm -Office Accommodation,Administrative, Secretarial &General Clerical support $3,000,000Director/Employee remuneration(connected parties) 400,000Own Operating Expenses 200,000 3,600,000Assessable Profits $400,000Note: Remuneration paid to each director/employee of the Company isdeductible if it falls within section 16 of the Ordinance and is notexcluded under section 17. The Practice Note does not seek to provideany guidelines in respect of such claims

DIPN 25

Our web site : http://www.ird.gov.hkInland Revenue DepartmentHong KongDEPARTMENTAL INTERPRETATION AND PRACTICE NOTESNO. 25SERVICE COMPANY “TYPE I” ARRANGEMENTSSALARIES TAXThese notes are issued for the information and guidance of taxpayersand their authorised representatives. They have no binding force and do notaffect a person’s right of objection and appeal to the Commissioner, the Boardof Review or the Courts.Anthony AU-YEUNGCommissioner of Inland RevenueAugust 1995DEPARTMENTAL INTERPRETATION AND PRACTICE NOTESNo. 25CONTENTParagraphIntroduction 1How the amendments address the situation 5Scheme of the legislation 7Prima facie liability 8The operative provisions 11Section 9A(1)(i) 12Section 9A(1)(ii) 15Section 9A(1)(iii) 17Specified criteria 20Section 9A(3)(a) 21Section 9A(3)(b) 22Section 9A(3)(c) 23Section 9A(3)(d) 25Section 9A(3)(e) 27Section 9A(3)(f) 28The commissioner’s discretion : Section 9A(4) 32Advance rulings 39Compliance 41Commencement of the legislation 46iiPosition of the service company 50Service companies used by professionals 52AppendicesINTRODUCTIONFollowing the enactment of the Inland Revenue (Amendment) (No. 2)Ordinance 1995, it is considered necessary to explain why section 9A has beenadded to the main Ordinance and to lay down broad statements on theinterpretation and practice to be adopted by the Inland Revenue Department inrelation to the section.2. The Financial Secretary announced in his 1994-95 Budget Speechthat steps would be taken to deal with tax avoidance aspects of certain "servicecompany" arrangements. Two types of arrangements were identified as causingparticular concern. The first category was referred to as attempts to disguiseemployer/employee relationships (Type I cases), and the second (Type II cases)as arrangements involving the payment of inflated management fees.3. Departmental Interpretation & Practice Note No. 24 deals with TypeII cases, and seeks to discourage avoidance arrangement by explaining thecircumstances under which management fee claims will be challenged.4. With regard to Type I cases, they have typically involved servicesrendered by a person under employment-like conditions. Instead ofremuneration for the services being paid as salary to the individual concerned,it is paid as a consultancy fee to a company (service company) he or anassociate controls. The arrangement is structured with a view to the servicecompany paying little, if any, tax on the fee as a result of deductions claimedfor "tax efficient" employee benefits provided to the individual or his associates.Following consultations, the Administration concluded that legislation wasrequired to address avoidance involving such arrangements. This led to theAmendment Ordinance which was enacted on 6 July 1995 (Appendix A -Ordinance No. 54 of 1995) and came into operation on 18 August 1995.HOW THE AMENDMENTS ADDRESS THE SITUATION5. The amendments seek to address avoidance involving disguisedemployment arrangements by providing, in essence, that where remunerationfor services rendered by a person under employment-like conditions is paid notto the person, but to a company he (or an associate) controls, it will nonethelessbe treated as employment income of the person.26. One of the difficulties the Department faced in relation to these casesprior to the introduction of the legislation was the identification of thearrangements. The parties concerned directed their efforts at circumventingformal employer/employee relationships and accordingly did not comply withthe notification requirements imposed on employers and employees under theOrdinance. Identification should cease to be a problem under the newlegislation. The legislation makes it clear that for the purposes of the Ordinance(unless specified criteria are satisfied) the person for whom the services arerendered and the individual who renders the services are to be respectivelytreated as employer and employee. As such, the normal notification andcompliance requirements imposed by the Ordinance on employers andemployees will be applicable.SCHEME OF THE LEGISLATION7. Briefly, the legislation has three main elements which are containedin new section 9A -• The first, in effect, provides that there is a prima facie liabilityto Salaries Tax where remuneration for services rendered by a'relevant individual' is paid to a company controlled by theperson or his associate.• The second narrows the scope of the provisions by taking outcases which satisfy specified criteria, ie where particularindicators or hallmarks of an office or employment of profit arenot present under the arrangement.• The third element is another "escape clause" for the benefit oftaxpayers. It provides the Commissioner with a discretionarypower to exclude a case where, even though an indicator ofemployment might be present, he is satisfied that in carryingout the services under the agreement the relevant individual wasnot in substance holding an office or employment of profit.The three elements are further discussed below, together with related matters.3PRIMA FACIE LIABILITY8. The opening words to section 9A(1) set the scene by specifying thecircumstances under which the new provisions can have application toremuneration paid under an (service company) agreement. In this regard, anarrangement will come within the scope of the section where -(i) there is an agreement;(ii) a person ("relevant person")carrying on, or deemed under theOrdinance to be carrying on, a trade, profession or business, orprescribed activity, is a party to the agreement;(iii) services have been carried out under the agreement by anindividual ("relevant individual"), on or after the day theAmendment Ordinance came into operation(the "appointedday"), for the relevant person or any other person; and(iv) remuneration for the services has been paid or credited on orafter the appointed day to a corporation or trustee as specifiedin section 9A(1)(a), (b) or (c).9. In considering whether the circumstances referred to above arepresent in relation to a particular arrangement, the following points should bekept in mind:As regards (i), the agreement need not be in writing and can havebeen entered into before, on or after the appointed day.With regard to(ii), generally section 9A(1) will only have applicationwhere the relevant person is carrying on, or is deemed to be carryingon, a trade, profession or business. It is expected, based onexperience prior to the introduction of the Amendment Ordinance,that this will cover the vast majority of disguised employmentarrangements. However, if it is discovered that other relevant personsare entering into such arrangements, section 9A(6) provides theCommissioner with the power to bring the persons concerned withinthe ambit of the legislation by prescribing, by notice in the Gazette,an activity for the purposes of section 9A. Such a notice will involve4subsidiary legislation and will be subject to the scrutiny of theLegislative Council under section 34 of the Interpretation andGeneral Clauses Ordinance (Cap. 1).In relation to (iii), although section 9A(1) can only apply to aparticular relevant individual where he has carried out services underan agreement, it does not require that the agreement itself mustcontain any specific reference to the relevant individual or to theservice company. In other words, it cannot be claimed that section9A does not apply to a particular arrangement simply because therelevant individual is not mentioned in the agreement. Also, theapplication of the new legislation is not restricted to the situationwhere the services are carried out by the relevant individual for therelevant person. To ensure that arrangements involving third partiesare catered for (eg where the services are carried out for a subsidiaryof the relevant person), the subsection refers to services carried out"for the relevant person or any other person".As regards (iv), where a disguised employment arrangement is used,the remuneration under the agreement will clearly not be paiddirectly by the relevant person to the relevant individual. Typically,payment is made to a company controlled by the relevant individual.However, to restrict opportunities for circumvention of theprovisions, section 9A(1) caters not only for this type of situation,but also for arrangements under which payment is made to acompany controlled by an associate of the relevant individual or to atrust under which the relevant individual or an associate is abeneficiary. However, in this context, for the sake of brevity the term"service company" is used.10. The new provisions encompass arrangements which involve one ormore than one associate, together with or without the relevant individual.Relevant terms, such as "associate", "beneficiary", "control", "principal officer"and "relative" are defined in section 9A(8) and are along similar lines to thosecontained in sections 16E, 21A and 39E of the Ordinance. It should be noted,however, that the definition of "associate" used in section 9A(8) has beenworded so that where more than one relevant individual carries out servicesunder a single agreement, each will be an associate of the other.5The Operative Provisions11. Where the circumstances referred to above are present, a servicecompany arrangement is subject to what may be called the operative provisionsof section 9A(1), contained in paragraphs (i), (ii) and (iii), unless it falls outsidetheir application by virtue of the escape clauses provided in subsections (3) and(4). In essence, as indicated earlier, the effect of the operative provisions is totreat the relevant individual and the relevant person as employee and employerrespectively, and the remuneration for the services carried out by the relevantindividual as his income from an employment of profit, and thereforechargeable to Salaries Tax.Section 9A(1)(i)12. This paragraph provides that the relevant individual is to be treatedas having an employment of profit with the relevant person. Subparagraphs(A)(I) and (A)(II) set down the rules for determining the date ofcommencement of the employment. Where the relevant person is carrying on atrade, profession or business, the date of commencement is taken to be the daythe relevant individual commenced to carry out services under the agreement oron the appointed day, whichever is the later [(A)(I)]. Accordingly, for disguisedemployment arrangements which commenced prior to the introduction of thelegislation, the date of commencement is taken to be the appointed day.13. If the relevant person is carrying on a prescribed activity, rather thana trade, profession or business, the date of commencement is taken to be theday the Commissioner prescribed the activity by notice in the Gazette undersection 9A(6) or, if it is later, the day the relevant individual commenced tocarry out services under the agreement [(A)(II)].14. By virtue of paragraph(i)(B), the employment of profit is treated ascontinuing until the agreement terminates "without the relevant individualcontinuing to carry out any of these services as an employee of the relevantperson". In other words, if the relevant individual continues to serve as anemployee of the relevant person after the agreement terminates, the situationwill not be viewed as involving a cessation of employment.6Section 9A(1)(ii)15. This paragraph unequivocally states that whilst the relevantindividual is treated, under paragraph (i), as having an employment of profitwith the relevant person -(a) "the relevant individual shall be treated as an employee of therelevant person"; and(b) "the relevant person shall be treated as the employer of therelevant individual".16. It is pertinent in this regard that the closing words of section 9A(1)provide in effect that where the operative provisions are applicable "the otherprovisions of this Ordinance (including section 52) shall be construedaccordingly". It follows that if an arrangement comes within the scope of theoperative provisions the relevant person concerned is subject to the compliancerequirements imposed on employers, and in particular those under section 52concerning notification of commencement and cessation of employment etc.Persons who fail to comply with the requirements in question may be liableunder the offence provisions contained in Part XIV of the Ordinance.Section 9A(1)(iii)17. This paragraph ensures that the remuneration referred to insubsection (1) (ie the remuneration which is paid or credited on or after theappointed day to the service company for services carried out under theagreement by the relevant individual on or after that day) is treated asemployment income of the relevant individual. To cover the timing aspect forthe purposes of section 11B, the paragraph also provides that the remunerationshould be treated as being "received by and accrued to the relevant individualat the time that it is paid or credited to the corporation or trust concerned".18. Situations may arise where remuneration is paid or credited after theappointed day in respect of services which are carried out by the relevantindividual partly before and partly after that day. In such cases the Departmentaccepts that only the remuneration which is reasonably attributable to theservices carried out on or after the appointed day comes within the scope of7section 9A. The Department will generally allow apportionment on a time basis,although no hard and fast rules are laid down. Whatever basis is used it shouldbe clearly explained in the Salaries Tax Return of the relevant individual. As tothe taxation treatment of the remuneration attributable to the services carriedout prior to the appointed day, see para 48 below.19. It is also possible that a single service company agreement mayprovide for services to be carried out by more than one relevant individualand/or for payments to be made for purposes other than remuneration for suchservices. Where such an arrangement is used it is in the interests of the partiesconcerned to clearly specify, in the agreement or otherwise, exactly what eachpayment is for, including the amount of remuneration for the services carriedout by each relevant individual. Section 9A(2) is relevant in this regard. Thissubsection provides, in essence, that where an agreement does not specify theremuneration of a particular relevant individual, any sum paid or credited underthe agreement to the service company will be treated as remuneration forservices carried out by that individual unless it is established to the satisfactionof the Commissioner by the relevant individual concerned or the relevantperson that all or part of the sum should be excluded on the ground that it waspaid for some other purpose. In other words, unless the relevant particulars areprovided, each relevant individual will be potentially liable to Salaries Tax inrespect of the full amount paid or credited to the service company on or afterthe appointed day.SPECIFIED CRITERIA20. The operative provisions discussed above do not apply in relation toremuneration under an agreement where all of the specified criteria laid downin section 9A(3) are satisfied. The criteria in question represent some of thefactors which may indicate that the services carried out under an agreement donot in substance amount to holding an office or employment of profit. Passingor failing any particular criterion is not necessarily conclusive either way. Forexample, a person may be paid on a periodic basis which does not satisfysection 9A(3)(d), yet still be able to satisfy the Commissioner that he does notin substance hold an office or employment of profit. The Department accepts,however, that if the criteria are all satisfied an office or employment of profit isnot involved. Each is briefly discussed in turn below.8Section 9A(3)(a)21. This criterion will be satisfied if neither the agreement nor anyrelated undertaking provides for remuneration for the services carried out bythe relevant individual to include or to be the provision of any of the specified(or similar) employment-type benefits or any benefit (including money) inlieu thereof. It should be noted that in considering whether or not the criterionhas been satisfied, the key question is not whether the relevant individual hasdirectly received a benefit as compensation, but whether the agreement (orrelated undertaking) provides for the remuneration to include such a benefit orcompensation (ie the identity of the recipient need not be taken into account).Section 9A(3)(b)22. This criterion reflects the view that it is far more usual for anemployment relationship to require that services be performed personally by aparticular individual than it would be in the case of an independent contractor.In the latter situation it is not unusual to allow the engagement ofsub-contractors. However, it is recognized that an independent contractor maybe engaged on terms which require a certain individual to carry out servicesrequired (eg a particular architect may be nominated to prepare the plans for abuilding). Accordingly, the general position under this provision is that thecriterion will not be satisfied where the agreement (or any related undertaking)requires that the services be performed personally by the relevant individual.However, to cater for a genuine contractor who has more than one client, it willbe satisfied where the relevant individual also carries out the same or similarservices for persons other than the person for whom they are carried out underthe agreement.Section 9A(3)(c)23. This provision is concerned with the question of whether the relevantindividual in performing the services under the agreement is subject to controlor supervision of a kind which is usual under an employment relationship. Inthis regard, the criterion will be satisfied if there is not any control orsupervision "which may be commonly exercised by an employer in relation tothe performance of his employee's duties". It would be unusual for a relevantperson to exercise such control or supervision in respect of an individual9carrying out duties on behalf of an independent contractor. Whereas anemployer normally (although there can be exceptions) has the right to direct themanner in which work is performed by an employee, a contractor usually hasfreedom as to the way in which tasks are carried out, subject to compliancewith job specifications as detailed in the relevant contract. Accordingly, wheresupervision or control of the kind specified is present, it will generally providea strong indication of employment.24. In considering the position of a relevant individual in relation to thiscriterion, section 9A(3)(c)(ii) has the effect of providing that any control orsupervision exercised by the service company concerned may be disregarded.As a matter of practice the Department will also not take into account anysupervision or control which can be directly attributed to statutory requirementsand is not dependent on the existence of an employer/employee relationship.Section 9A(3)(d)25. The focus of this provision is the basis on which the remunerationis paid or credited. The criterion will be satisfied if the remuneration "is notpaid or credited periodically and calculated on a basis commonly used inrelation to the payment or crediting and calculation of remuneration under acontract of employment". As such, regard must be had not only to the questionof whether payments are made periodically, but also to the basis for calculatingthe payments for the work performed.26. It should as a rule be a relatively straightforward matter todistinguish payments of a kind made to contractors, even if made byinstalments or as progress payments, from those made on a basis used underemployment contracts. For contractor situations the payments will generally bein relation to an agreed sum for specified work under a contract, whereas foremployment cases payments are usually in respect of the time worked orposition occupied and made on a regular basis (eg weekly, fortnightly ormonthly).Section 9A(3)(e)27. This criterion is concerned with the provisions under the agreementrelating to the termination of the arrangement between the parties. It will be10satisfied if the relevant person does not have the right to cause any of theservices under the agreement "to cease to be carried out in a manner, or for areason, commonly provided for in relation to the dismissal of an employeeunder a contract of employment". In this regard, the services of an employeecan generally be terminated by providing the relevant notice and/or meetingother requirements under an award or statute. By way of contrast, under arelationship involving an independent contractor, the contract will usually bedischarged by performance, but may also specify other circumstances, such asdefault situations, under which it can be terminated.Section 9A(3)(f)28. As is stated in the provision, this criterion will be satisfied where"the relevant individual is not held out to the public to be an officer oremployee of the relevant person". The term "held out to the public" is notdefined in the Ordinance and should therefore be given its ordinary meaning.As such, if either the relevant individual or relevant person acts in a manner ordoes something that is intended to lead members of the public to believe thatthe relevant individual is an officer or employee of the relevant person, thecriterion will not have been satisfied. This could occur, for example, throughmaterial included in trade or professional directories, journals or otherpublications, the issue of name cards, statements made at public functions,information contained in press releases etc.29. It is appreciated that there may be cases where "independent" agentsworking in, for example, the real estate and insurance fields will be unable tosatisfy this criterion. However, if the persons concerned are held out to thepublic to be employees of the organizations they represent, then their cases willin any event warrant close examination before it is accepted that employment isnot involved30. Where all of the specified criteria are satisfied, a relevant individualwill not have any liability to Salaries Tax by virtue of section 9A. Likewise, thesection will not have the effect of imposing on the relevant person thecompliance requirements applicable to employers under section 52.31. Where a relevant individual is unable to meet one or more of thespecified criteria, it does not necessarily follow that the operative provisions11shall apply to remuneration under the agreement. Section 9A(4) providesanother avenue of escape for those cases where the relevant individualestablishes to the satisfaction of the Commissioner that at all relevant times thecarrying out of the services under the agreement "was not in substance theholding by him of an office or employment of profit with the relevant person".THE COMMISSIONER’S DISCRETION : SECTION 9A(4)32. Section 9A(3) may be viewed as a somewhat mechanical means ofascertaining whether the operative provisions can be disregarded. However, theapproach has been taken on the footing that where none of the indicators ofemployment covered by the specified criteria is present, it may be safelyconcluded, without examining the case in greater detail, that in substanceemployment is not involved. In short, it is intended to be a pragmatic approachfor the convenience of taxpayers and the Revenue alike.33. The situation is clearly quite different where one of the specifiedcriteria is not satisfied. In such a case there will at least be an indication of anemployment relationship. Careful consideration of all of the circumstances ofthe arrangement will be required before it can be concluded whether or not insubstance one exists.34. In considering cases under subsection(4) the Commissioner will ofcourse have regard to the substantial body of case law concerning thedistinction between a contract of service (ie one of employment) and a contractfor services (ie independent contractor). The test originally considered to bedecisive in this area focused on the issue of control : "a servant is a personsubject to the command of his master as to the manner in which he shall do hiswork" [Yewens v. Noakes (1880) 1 TC 260, CA].35. Although in many cases the control test can still be simply appliedto determine the matter, there are situations where it proves to be inadequate.For example,it is not now unusual for professional or highly skilled individualsto perform their tasks on the basis of their own judgement when engaged asemployees. It is therefore not surprising that a further test, known as theintegration test, was recognized alongside the control test. This wasintroduced by Lord Denning in Bank voor Handel en Scheepvaart NV v.Administrator of Hungarian Property [1954] 35 TC 311, HL where he said -12"In this connection I would observe the test of being a servant doesnot nowadays rest on submission to orders. It depends on whetherthe person is part and parcel of the organization."36. A further test, the economic reality test, was applied in MarketInvestigations Ltd. v. Minister of Social Security, [1969] 2 QB 173. This testhas regard to matters such as whether the individual is involved in themanagement of the work and is placed at financial risk, whether he can employothers to assist and whether he provides major equipment. However, in 1984the Court of Appeal, in Nethermere (St. Neots) Ltd. v. Gardiner 1CR 612,rejected the view that the economic reality test was "the fundamental test" andregarded it as "no more than a useful test".37. What has become clear from the cases, as Nolan J stated in the Courtof Appeal in Hall v. Lorimer [1993] STC 23 (at 28), is that -"In cases of this sort there is no single path to a correct decision. Anapproach which suits the facts and arguments of one case may beunhelpful in another."He went on to cite with approval (at 29) the views expressed by Mummery Jearlier in the case in the High Court, where he said –"The process involves painting a picture in each individual case. AsVinelott J said in Walls v. Sinnett (Inspector of Taxes) [1986] STC236 at 245 : "It is, in my judgement, impossible in a field where avery large number of factors have to be weighed to gain any realassistance by looking at the facts of another case and comparing themone by one to see what facts are common, what are different and whatparticular weight is given by another tribunal to the common facts.The facts as a whole must be looked at, and a factor which may becompelling in one case in the light of the facts of that case may not becompelling in the context of another case." ".It should therefore be clear that the Commissioner will only be able to form aview for the purposes of section 9A(4) if he is provided with comprehensivedetails of all the facts surrounding an agreement.1338. A relevant individual who wishes to have the Commissioner exercisehis discretion under the subsection may advise the Department either at thetime of lodging his or her Salaries Tax Return or by means of a separateapplication for an advance ruling which can be made at any time. Thesupporting material and information required is the same in each case and isdiscussed below.ADANCE RULINGS39. A request for an advance ruling should be in writing and beaddressed to the Commissioner. It must be signed by the relevant individual orhis authorized representative. The following material and information shouldsupport the request -(a) Copies of the agreement and any related undertaking. If anagreement or undertaking has not been reduced to writing, anexplanation of why this is the case should be provided togetherwith full details of its terms and conditions.(b) If not otherwise apparent, full details of the remunerationpayable under each agreement (or undertaking).(c) Copies of the respective organization charts of the relevantperson and the service company.(d) A statement setting out the relevant individual's :(i) duties and obligations in relation to the relevant personand the service company respectively; and(ii) previous employment history, if any, with the relevantperson or any associated party.(e) A statement listing, together with supporting details, thespecified criteria in subsection (3) which have been satisfied.14(f) An explanation of why it is considered that the relevantindividual did not in substance hold an office or employment ofprofit.To facilitate consideration of the application, answers should also be providedto the questions listed on Appendix B. If a particular question is not pertinentto the relevant individual's situation, this should be noted together with a briefexplanation of why that is the case.40. Under normal circumstances, where the information referred toabove is provided, it should be sufficient to allow a ruling to be made. In suchcases, it will be issued in letter form signed by the Commissioner or anauthorised officer, generally within 3 months of the date of application. Insome cases, however, it may be necessary for the Department to seek furtherinformation from the relevant individual or a third party. Where this occurs itmay not be possible to issue the ruling within the 3 months period. It should benoted that rulings will not be provided in respect of hypothetical, contemplatedor proposed situations.COMPLIANCE41. From the perspective of the relevant person, if an agreement hasbeen entered into which comes within section 9A(1) and is not excluded fromthe scope of the operative provisions by virtue of subsection (3) or (4), therewill be an obligation to comply with the notification requirements of section 52(ie on the basis that the relevant person is the employer of the relevantindividual - see paras. 11 to 19 above). On the other hand, if it is clear thatsubsection (3) or (4) is applicable, the provisions of section 52 will not apply.42. It is possible, however, that a relevant person may be unsure as towhether the operative provisions apply to a particular arrangement (eg it maynot be clear as to whether the relevant individual controls the service companyor whether all of the specified criteria in subsection (3) have been satisfied). Tocater for such cases, new section 80(1AA) in effect allows a relevant person topresume in certain circumstances that the reporting obligations do not apply.The section provides that it shall be a defence in any proceedings against aperson for failure to comply with the requirements of section 52(4), (5), (6) or15(7) if he shows that he relied upon a statement in writing by the relevantindividual "in the form specified" and it was reasonable for him to rely uponthat statement. In this regard, section 80(1AC) provides that the Commissionermay specify the form of statement by notice in the Gazette (see Appendix C).43. It can be seen from the specified form that a relevant individualshould only complete the statement where he is able to say that, to the best ofhis knowledge and belief, one or more of the following situations is applicablein relation to the agreement -(a) the party to which the remuneration is paid or credited is not acorporation or trustee of the kind referred to in section 9A(1)(eg if a corporation, it is not controlled in the mannerdescribed);(b) all of the specified criteria are satisfied;(c) the Commissioner has confirmed in writing that he is satisfiedthat in carrying out services under the agreement he is not insubstance holding an office or employment of profit with therelevant person.44. It goes without saying that the defence provided for in section80(1AA) will not apply if a relevant person has reason to doubt that therelevant individual is entitled to make a statement of the kind in question. Insuch a situation the relevant person should, as a matter of prudence, proceed onthe footing that the reporting requirements are applicable. The Department willnot, however, take any action in relation to a failure of the employer to complywith the requirements if during the relevant period the relevant individual wasawaiting the outcome of an application for a ruling from the Commissionerunder section 9A(4).45. As far as the relevant individual is concerned, if he has any doubt asto whether the service company is of the kind referred to in section 9A(1) orwhether all of the specified criteria are satisfied, he should obtain a ruling fromthe Commissioner before providing the relevant person with a statement inwriting. In this regard, it should be kept in mind that new section 80(1AB)provides that a person who knowingly or recklessly makes such a statement16which in a material respect is false or misleading shall be guilty of an offence.The sanctions provided for under sections 82 and 82A may also haveapplication where a relevant individual fails to comply with his obligations.COMMENCEMENT OF THE LEGISLATION46. As provided in the Amendment Ordinance, the new legislation cameinto operation on the "appointed day" (ie 18 August 1995). The legislation doesnot apply to any service company agreement entered into before the appointedday where the remuneration was paid or the services were carried out, or bothwere effected, prior to that date. The legislation will apply in relation to such anagreement where the remuneration is paid or credited and the services arecarried out on or after that date. The legislation will, of course, also apply inrespect of agreements entered into on or after the appointed day.47. The "appointed day" serves to place it beyond any doubt that wherean arrangement is in existence on or after that date and comes within the scopeof the legislation, there is a compliance obligation to provide information to theDepartment. As far as arrangements which commenced before the appointedday are concerned, the Department will not take any penalty action in respectof failure to comply with section 52 reporting requirements that may haveexisted before that date. A table setting out the Department's position inrelation to the application of sections 9A and 52 is attached as Appendix D.48. One of the purposes of the legislation is to facilitate the identificationof disguised employment arrangements. It stands to reason that where it isestablished that such an arrangement exists, income derived both before andafter the appointed day may be charged to Salaries Tax. The Department's viewis that if the provisions of the Ordinance (including sections 61 and 61A)existing prior to the introduction of section 9A had the effect of rendering theearlier income chargeable to Salaries Tax, it is only appropriate to assess theincome accordingly.49. It is pertinent to mention at this point that where an arrangement fallsoutside the scope of section 9A (ie, even if entered into after the appointed day),it may still, depending on the facts of the case, be charged to Salaries Tax byapplication of the general anti-avoidance provisions. For example, it might be17considered appropriate to apply those provisions if a "relevant person" notcarrying on a trade, profession or business or prescribed activity engaged aperson to carry out services under a disguised employment agreement. TheDepartment considers that its position in this regard is supported by thedecision of the Privy Council in CIR v. Challenge Corporation Limited [1987]2 WLR 24. This was to the effect that a general anti-avoidance provision canapply notwithstanding the existence of related specific anti-avoidanceprovisions.POSITION OF THE SERVICE COMPANY50. To prevent double taxation, section 9A(5) provides that where byvirtue of section 9A a relevant individual is chargeable to Salaries Tax onremuneration referred to in subsection (1), the corporation or trustee (ie theservice company) to whom that remuneration is paid or credited is notchargeable to tax on the remuneration. Accordingly, no deduction ordepreciation allowance will be granted to the service company in respect ofrelated expenditure.51. Subsection (5) also provides, in effect, that the relevant individual isnot chargeable to tax on any remuneration paid or credited to him by theservice company as an employee to the extent that the remuneration isattributable to services carried out under the agreement. This exemption willnot apply in respect of any remuneration which is not attributable to suchservices, e.g. services carried out by the relevant individual which are unrelatedto the agreement with the relevant person.Service Companies used by Professionals52. Reflecting the taxation principle that it is not possible for a man toemploy himself, section 9A(7) has the effect of providing that the proprietorsand partners of unincorporated businesses (eg professional firms) with servicecompanies are excluded from the application of the operative provisions ofsection 9A. Section 9A(7)(b)(i) covers the situation where a sole proprietorshipis involved and section 9A(7)(b)(ii) addresses partnership cases. TheDepartment's treatment of service company arrangements of this kind isdetailed in DIPN No. 24.

DIPN 44

Our web site : www.ird.gov.hkInland Revenue DepartmentHong KongDEPARTMENTAL INTERPRETATION AND PRACTICE NOTESNO. 44(REVISED)ARRANGEMENT BETWEEN THE MAINLAND OF CHINA ANDTHE HONG KONG SPECIAL ADMINISTRATIVE REGIONFOR THE AVOIDANCE OF DOUBLE TAXATION ANDTHE PREVENTION OF FISCAL EVASIONWITH RESPECT TO TAXES ON INCOMEThese notes are issued for the information of taxpayers and their taxrepresentatives. They contain the Department’s interpretation and practices inrelation to the law as it stood at the date of publication. Taxpayers arereminded that their right of objection against the assessment and their right ofappeal to the Commissioner, the Board of Review or the Court are not affectedby the application of these notes.These notes replace those issued in April 2007.LAU MAK Yee-ming, AliceCommissioner of Inland RevenueAugust 2008DEPARTMENTAL INTERPRETATION AND PRACTICE NOTESNo. 44(REVISED)CONTENTParagraphIntroduction 1Arrangement for the avoidance of double taxation 3Relationship between the comprehensive arrangement and theOrdinance5Effective dates and applicable text 8Article 1 Persons covered 11Article 2 Taxes covered 12Article 3 General definitions 15Article 4 Resident 19(I) Resident individual 21(II) Resident company 26(III) Resident persons other than individuals andcompanies31Certification of resident status 32Article 5 Permanent establishmentThe concept of a permanent establishment 36A building site, a construction, assembly orinstallation project38Provision of services by an enterprise 42iiThe place where preparatory or auxiliary activitiesare conducted44Business agent 47Article 6 Income from immovable property 48Article 7 Business profitsAllocation of taxing rights 55Computation of business profits 56Other methods of computing profits 62Other principles 64Article 8 Shipping, air and land transport 67Shipping transport 68Air transport 69Land transport 70Article 9 Associated enterprises 73Adjusting the profits of an enterprise of One Side 74Making an appropriate adjustment to the profits of anenterprise of the Other Side75Income from investment – Dividends, Interest and Royalties 79Article 10 Dividends 84Article 11 Interest 90Article 12 Royalties 96Article 13 Capital gains 101Article 14 Income from employment 109“Present for not exceeding 183 days” exemptioncondition110Hong Kong residents working across the Mainlandborder114iiiArticle 15 Directors’ fees 115Article 16 Artistes and sportspersons 116Article 17 Pensions 117Article 18 Government service 120Article 19 Students 125Article 20 Other income 126Article 21 Methods for elimination of double taxation 128Article 22 Non-discrimination 141Article 23 Mutual agreement procedure 144Article 24 Exchange of information 148Article 25 Miscellaneous provisions 158Article 26 Entry into force 159Article 27 Termination 160Conclusion 161INTRODUCTIONOn 11 February 1998, representatives of the Mainland of China (“theMainland”) and the Hong Kong Special Administrative Region (“Hong Kong”)signed a Memorandum that detailed an “Arrangement between the Mainland ofChina and the Hong Kong Special Administrative Region for the Avoidance ofDouble Taxation on Income” (“the Limited Arrangement”). The LimitedArrangement covers mainly business profits of an enterprise operating througha permanent establishment, shipping, air or land transport income, as well asincome from personal services. Some two years later, on 2 February 2000,the Mainland and Hong Kong signed the “Air Services Arrangement betweenthe Mainland of China and the Hong Kong Special Administrative Region”(“the Air Services Arrangement”).2. However, with China’s subsequent accession to the World TradeOrganisation and the increasingly close economic ties between the Mainlandand Hong Kong, both the Mainland and Hong Kong considered it necessary toexpand the Limited Arrangement into a comprehensive arrangement for theavoidance of double taxation, i.e. one on a par with international standards.Accordingly, on 21 August 2006, the Mainland and Hong Kong signed an“Arrangement between the Mainland of China and the Hong Kong SpecialAdministrative Region for the Avoidance of Double Taxation and thePrevention of Fiscal Evasion with respect to Taxes on Income”(“theComprehensive Arrangement”), to eliminate any situation of double taxationthat might otherwise be faced by a Mainland or Hong Kong investor in theconduct of cross-border economic activities. In the lead up to the signing,differences in the interpretation of some of the provisions of theComprehensive Arrangement were identified by both Sides during the courseof negotiations. However, neither the Mainland nor Hong Kong had anydesire to engage in prolonged discussions that could hinder the earlyimplementation of the Comprehensive Arrangement. Hence, the differenceswere put aside for further deliberation in the post implementation stage. BothSides then resumed discussions and consensus was reached on theinterpretation and implementation of the outstanding issues. The Mainlandand Hong Kong exchanged letters (“the exchange letters”) and formally signedthe “Second Protocol to the Arrangement between the Mainland of China andthe Hong Kong Special Administrative Region for the Avoidance of DoubleTaxation and the Prevention of Fiscal Evasion with respect to Taxes on2Income”(“the Second Protocol”) on 11 September 2007 and 30 January 2008respectively.ARRANGEMENT FOR THE AVOIDANCE OF DOUBLE TAXATION3. For the purpose of giving effect to the Comprehensive Arrangement,an Order (“Specification of Arrangements (the Mainland of China) (Avoidanceof Double Taxation and the Prevention of Fiscal Evasion with respect to Taxeson Income) Order”) was made by the Chief Executive in Council on 27October 2006, under section 49 of the Inland Revenue Ordinance (Cap. 112)(“the Ordinance”). The Order was published in the Gazette as Legal Notice234 of 2006. For the purpose of giving effect to the Second Protocol, anOrder (“Specification of Arrangements (the Mainland of China) (Avoidance ofDouble Taxation and the Prevention of Fiscal Evasion with respect to Taxes onIncome) (Second Protocol) Order”) was made by the Chief Executive inCouncil on 15 April 2008. The Order was published in the Gazette as LegalNotice 89 of 2008.4. The purpose of the Comprehensive Arrangement is to allocate theright to tax between the two Sides on a reasonable basis so as to avoid doubletaxation of the same item of income in both Sides. The provisions of theComprehensive Arrangement have been made by reference to those containedin the Model Tax Conventions of the Organisation for Economic Co-operationand Development (the “OECD”) and the United Nations. Appropriatemodifications have been made to cope with the particular requirements of theMainland and Hong Kong. In the interpretation and application of theprovisions of the Comprehensive Arrangement, both Sides will refer to theVienna Convention on the Law of Treaties (1969), the Commentaries on therelevant Articles of the Model Tax Conventions of the OECD and the UnitedNations, as well as to their respective principles of interpretation of taxationlaw.3RELATIONSHIP BETWEEN THE COMPREHENSIVEARRANGEMENT AND THE ORDINANCE5. The Comprehensive Arrangement has been implemented inaccordance with section 49 of the Ordinance and accordingly has legal effect.The Comprehensive Arrangement and the Ordinance (including subsidiarylegislation) are interrelated and complement each other. For matters fallingwithin its scope, the Comprehensive Arrangement performs the function ofallocating the right to tax between the two Sides. When the right to tax hasbeen allocated, both Sides will continue to refer to their respective domestictaxation legislation to resolve problems of tax administration and enforcement,such as in deciding whether certain income should be subject to tax, and in thecomputation of assessable income and tax payable.6. In handling problems arising from any inconsistency between theComprehensive Arrangement and the Ordinance, priority will be accorded tothe Comprehensive Arrangement to ensure compliance with its provisions.Hong Kong adopts the “preferential treatment” principle, i.e. where theComprehensive Arrangement and the Ordinance contain different provisionsrelating to the same matter, preference will be given to the provisions that aremost beneficial to the taxpayers. For example, if a Mainland resident rendersemployment services in Hong Kong but does not meet the exemptionconditions stipulated in Article 14 (e.g. his remuneration is paid by a HongKong employer), he will still be exempt from tax under the Ordinance if hisvisit to Hong Kong in the year of assessment concerned does not exceed a totalof 60 days.7. The Comprehensive Arrangement should not affect existingconcessional practices in Hong Kong. Take for example the case of a HongKong manufacturer who concludes a contract processing arrangement with aMainland entity. In accordance with paragraphs 13 to 19 of DepartmentalInterpretation and Practice Notes No. 21 (Revised 1998), 50% of his profitsmay be regarded as profits arising outside Hong Kong and not chargeable toprofits tax in Hong Kong. This method of apportioning profits that arise bothinside and outside Hong Kong on a 50:50 basis remains applicable.According to the provisions of the Comprehensive Arrangement, the HongKong manufacturer could be regarded as having a permanent establishment inthe Mainland and is therefore liable to tax there. However, it is noted that it is4not the present intention of the Mainland to change the way it taxes profitsderived from this type of operation. Nevertheless, the possibility that in futureprofits attributable to the permanent establishment may be taxed in accordancewith the Comprehensive Arrangement cannot be ruled out.EFFECTIVE DATES AND APPLICABLE TEXT8. The Comprehensive Arrangement entered into force on 8 December2006. In the Mainland, the provisions of the Comprehensive Arrangementshall apply to income derived in taxable years beginning on or after 1 January2007; and in Hong Kong, in years of assessment beginning on or after 1 April2007. The exchange letters became effective on 11 September 2007 that wasthe date of signature and the Second Protocol became effective on 11 June2008.9. A Hong Kong enterprise may adopt the end date of a year ofassessment as its accounting date, i.e. 31 March, or any other date fallingwithin that year of assessment. The “basis period” for the enterprise will bethe year ending on the accounting date that falls within that year of assessment.The basis period for the year of assessment 2007/08 may therefore commenceas early as 2 April 2006 (i.e. the period from 2 April 2006 to 1 April 2007 asthe basis period for the year of assessment 2007/08). Income derived duringthat basis period will be dealt with in accordance with the provisions of theComprehensive Arrangement.10. In Hong Kong, since the policy of bilingual legislation is in place,both the English and the Chinese texts of the Comprehensive Arrangement arelegally binding. It stands to reason, however, since the ComprehensiveArrangement is written in the Chinese language only, that any negotiationbetween the Mainland and Hong Kong on the implementation of theComprehensive Arrangement would be conducted with reference to theChinese text.5Article 1 PERSONS COVERED11. The stated purpose of the Comprehensive Arrangement is for theavoidance of double taxation in both Sides. The Comprehensive Arrangementonly applies to persons who are residents of One Side or both Sides. Theterms “resident of the Mainland” and “resident of Hong Kong” are defined inparagraph 1 of Article 4.Article 2 TAXES COVERED12. In contrast to the Limited Arrangement, the ComprehensiveArrangement adds property tax as one of the taxes of Hong Kong under itscoverage. More particularly, the existing taxes covered by the ComprehensiveArrangement are profits tax, salaries tax and property tax, whether or not thetax is charged under personal assessment, in Hong Kong; and individualincome tax, foreign investment enterprises income tax and foreign enterprisesincome tax in the Mainland. According to Article 1 of the Second Protocol, inthe Mainland the existing taxes covered by the Comprehensive Arrangementstarting from 2008 are individual income tax and enterprise income tax.Other taxes do not come within the scope of the Comprehensive Arrangement(except that business tax is included in the Mainland for the purposes of Article8 of the Comprehensive Arrangement, see paragraph 67 below).13. The Comprehensive Arrangement applies to all income that issubject to the abovementioned taxes, including taxes on gains from thealienation of movable and immovable property and taxes on capitalappreciation. As such, receipts of capital nature come within the scope of theComprehensive Arrangement. However, it is left to the domestic law of eachSide to decide whether receipts of capital nature should be taxed.14. The Comprehensive Arrangement will also apply to any identical orsubstantially similar taxes that are imposed after the date of signature of theComprehensive Arrangement in addition to, or in place of, the existing taxes aswell as any other taxes falling within Article 2 which may be imposed in future.6Article 3 GENERAL DEFINITIONS15. To facilitate the accurate interpretation and implementation of theComprehensive Arrangement by both Sides, definitions of some of its keyterms have been included in Article 3.16. The term “person” has been defined widely in the ComprehensiveArrangement to include an individual, a company, a trust, a partnership and anyother body of persons.17. The term “enterprise” applies to the carrying on of business activitiesof any form. The term “business” includes the performance of professionalservices and other activities of an independent character. The terms“enterprise of One Side” and “enterprise of the Other Side” mean respectively“an enterprise carried on by a resident of One Side”, and “an enterprise carriedon by a resident of the Other Side”. An enterprise carried on by a residentincludes an enterprise carried on by a resident company, a resident individual, aresident partnership, or a resident body of persons.18. Paragraph 3 of Article 3 expressly states that as regards theapplication of the Comprehensive Arrangement by One Side (e.g. tax isimposed in accordance with the Comprehensive Arrangement), any term notdefined therein shall, unless the context otherwise requires, have the meaningwhich it has at the time of the application under the laws of that Sideconcerning the relevant taxes.Article 4 RESIDENT19. In view of the differences between the taxation systems in theMainland and Hong Kong, both Sides define the term “resident of One Side”differently.720. The Mainland basically follows the Model Tax Convention of theOECD with its definition of the term “resident of the Mainland”1. Since HongKong adopts a territoriality concept of taxation, tax is only imposed uponincome derived from Hong Kong. No one is liable to tax in Hong Kongmerely because of his resident status. As such, Hong Kong is not in a positionto adopt the definition provided in the OECD Model Tax Convention. Instead,a detailed definition of “resident of Hong Kong” has been included in theComprehensive Arrangement to enable taxpayers to ascertain whether they areentitled to the benefits of the Comprehensive Arrangement. It should be noted,however, that the definition of “resident of Hong Kong”(香港居民) in theComprehensive Arrangement is different from the meaning given to “a residentperson”(居港者) in section 20AB of the Ordinance. With regard to the latter,the Ordinance makes it clear that the meaning applies only to the interpretationof provisions relating to offshore funds.(I) Resident individual21. In Hong Kong, a resident individual means:(1) an individual who ordinarily resides in Hong Kong;(2) an individual who stays in Hong Kong for more than 180 daysduring the relevant year of assessment or for more than 300days in two consecutive years of assessment (one of which isthe relevant year of assessment).22. It is generally considered that an individual “ordinarily resides” inHong Kong if he has a permanent home in Hong Kong where he or his familylives. Other relevant factors include the duration of his stay in Hong Kong,whether he has a permanent place of residence in Hong Kong, whether he ownsany property overseas for residential purposes, and whether he is primarilyresident in Hong Kong or overseas.1 According to Article 4(1) of the Comprehensive Arrangement and the amendment in Article 2 ofthe Second Protocol, in the Mainland “resident of One Side” refers to any person who, under thelaws of the Mainland, is liable to tax therein by reason of his/its domicile, residence, place ofestablishment, place of effective management or any other criterion of a similar nature. This term,however, does not include any person who is liable to tax in the Mainland in respect of incomefrom sources in the Mainland.823. In calculating the 180 or 300 days of stay in Hong Kong, anindividual will be considered to be a Hong Kong resident if he stays in HongKong for a period or a number of periods amounting to more than 180 days inthe relevant year of assessment, or for a period or periods amounting to morethan 300 days in two consecutive years of assessment (one of which is therelevant year of assessment). However, where the individual concerned isalso a permanent resident of a third State and makes investment or carries onbusiness in the Mainland, it is known that the Mainland will apply any treatysigned between China and the State of which that individual is a permanentresident. If there is no such treaty, the Mainland would consider to apply itsrelevant domestic laws.24. Where, under the Comprehensive Arrangement, an individual is aresident of both Sides, his status will be determined in accordance with theorder of priority set out in paragraph 2 of Article 4:(1) he shall be deemed to be a resident only of the Side in whichhe has a permanent home available to him; if he has apermanent home available to him in both Sides, he shall bedeemed to be a resident only of the Side with which hispersonal and economic relations are closer (“centre of vitalinterests”);(2) if the Side in which he has his centre of vital interests cannotbe determined, or if he does not have a permanent homeavailable to him in either Side, he shall be deemed to be aresident only of the Side in which he has an habitual abode;(3) if he has an habitual abode in both Sides or in neither of them,the competent authorities of both Sides shall resolve the issueby mutual agreement.25. If an individual who is a resident of both Sides, but deemed inaccordance with the abovementioned provisions to be a resident of Hong Kong,the tax authorities will treat him as a resident of Hong Kong when applying theprovisions of the Comprehensive Arrangement. The term “permanent home”in paragraphs 22 and 24 above refers to a home owned or possessed by anindividual that is permanent in nature. In other words, this home must be9retained for permanent use as opposed to being for temporary stays. If theindividual has a permanent home in both Sides concurrently, it is necessary toascertain with which of the two Sides his personal and economic relations arecloser. Regard will be had to his family and social relations; his occupations;his political, cultural and other activities; his place of business; and the placefrom which he administers his property, etc. The circumstances must beexamined as a whole, but it is nevertheless obvious that considerations basedon the personal acts of the individual must receive special attention.(II) Resident company26. Where a company is incorporated in Hong Kong, or if incorporatedoutside Hong Kong is normally managed or controlled in Hong Kong, it will beconsidered to be a resident of Hong Kong under paragraph 1(2)(iii) of Article 4.A company incorporated in Hong Kong includes a company that isincorporated as a legal entity in accordance with the Companies Ordinance(Cap. 32) of Hong Kong.27. The concept of “normally managed or controlled in Hong Kong”, ascompared to that of “central management and control” established in commonlaw, has a broader meaning as it does not require that both management andcontrol be exercised in Hong Kong. “Management”, in this context, refers tomanagement of daily business operations, or implementation of the decisionsmade by top management, etc. “Control”, on the other hand, refers to controlof the whole business at the top level, including formulating the central policyof the business, making strategic policies of the company, choosing businessfinancing, evaluating business performance, etc. The board of directorsusually exercises “control”. In other words, if the business of the company isnormally managed or controlled in Hong Kong, including the management ofits daily business operations, or the implementation of the decisions made bytop management, or the making of top-level policies, in Hong Kong, thecompany will be considered to be a resident of Hong Kong. The“management” or “control” of a company may, of course, be conducted inmore than one place. However, so long as a company is normally managed orcontrolled in Hong Kong, it will be considered to be a resident of Hong Kong.If the Hong Kong branch of an overseas bank is managed in Hong Kong, thebank will be regarded as a resident of Hong Kong. The Mainland, however,takes the view that in deciding whether an overseas bank is “normally managed10or controlled in Hong Kong”; one should consider the management or controlof the bank instead of that of the branch in Hong Kong only. Hong Kong willcontinue to discuss with the Mainland on this point with a view to reaching aconsensus.28. While the term “normally managed or controlled” has a broadermeaning than that of “central management and control”, in principle, acompany will only be a resident of the place in which it actually exercises itsbusiness operations or control. The conclusion is wholly one of fact.Regard will be had to factors such as the nature of business operated by thecompany, mode of operation, whether it has a permanent office or employsstaff in Hong Kong, and whether Hong Kong is the place where its board ofdirectors meets to formulate policy.29. Where by reason of the definitions adopted by both Sides, acompany is a resident of both Sides, its resident status will be determined inaccordance with paragraph 3 of Article 4, that is, the company shall be deemedto be a resident only of the Side in which its place of effective management issituated.30. The term “place of effective management” refers to the place wherekey management and strategic decisions that are necessary for the conduct ofthe company’s business are in substance made. Under normal circumstances,it is the place where the most senior persons of a company formulate thedirection and work plans of the company. A company can have only oneplace of effective management at any one time.(III) Resident persons other than individuals and companies31. It is stated in paragraph 1(2)(iv) of Article 4 that any other personconstituted under the laws of Hong Kong, or if constituted outside Hong Kong,being normally managed or controlled in Hong Kong, will be considered to bea resident of Hong Kong. In Hong Kong, partnerships are the mode mostlikely to be encountered. In determining whether a trust, partnership or anyother body of persons is normally managed or controlled in Hong Kong, thecriteria are the same as those adopted in determining the resident status of acompany.11Certification of resident status32. In applying the Comprehensive Arrangement, the tax authority of theMainland may require an individual, a company, or a body of persons toproduce a certificate from the Hong Kong Inland Revenue Departmentcertifying that the person is a “resident” of Hong Kong. This would generallyonly be required where there is a possibility that the person is a resident of bothSides, or there is a need to verify the resident status of the person. Therelevant application forms and procedures are published on the Inland RevenueDepartment website (www.ird.gov.hk).33. Upon receipt of an application, the Inland Revenue Department willexamine the information supplied by the person, and if it is sufficient, issue aCertificate of Hong Kong Resident Status for the purposes of theComprehensive Arrangement and the processing time normally requires 21working days. Where the evidence available is insufficient, the Departmentwill request the applicant to supply the additional information required.34. In general, for a company that is incorporated in Hong Kong, aCertified Extract of Information on the Business Register or a copy of theCertificate of Incorporation of the company is sufficient evidence. Anapplication for a Certified Extract of Information on the Business Register maybe made online or in person.35. On the other hand, where the Inland Revenue Department is unableto ascertain that a person is a resident of the Mainland from the availableinformation, it will issue a letter referring the person to the Mainland taxauthorities to issue a certificate of resident status for him. If the person isunable to produce proof of his status, he will not be entitled to the benefits ofthe Comprehensive Arrangement.Article 5 PERMANENT ESTABLISHMENTThe concept of a permanent establishment36. Three criteria, namely, space (a fixed place of business), time(continuous or aggregate periods), and function (activities of a preparatory or12auxiliary character), are used to ascertain whether the activities of an enterpriseof One Side constitute a permanent establishment in the Other Side.Paragraph 1 of Article 5 generally explains that a permanent establishment is afixed place of business through which the business activities of the enterpriseare carried on. There is no qualification on the scale or the form of the placeof business. A permanent establishment will normally have the followingfeatures:(1) It must be a place of business. This may include a house, asite, equipment or facilities (such as machinery andequipment), a warehouse, and a stall used for carrying on thebusiness of the enterprise, whether owned or rented by theenterprise.(2) It must be a fixed place of business with a certain degree ofpermanence. The temporary interruption or suspension ofbusiness activities conducted at a fixed place of business willnot affect the existence of a permanent establishment.(3) The enterprise must carry on the whole or a part of itsbusiness through this fixed place of business.37. Paragraph 2 of Article 5 provides that the term “permanentestablishment” includes especially “a place of management; a branch; an office;a factory; a workshop; a mine, an oil or gas well, a quarry or any other place ofextraction of natural resources”. It is clear from the words “includesespecially” that the paragraph does not preclude the determination of any otherplace of business as a permanent establishment in accordance with the generaldefinition of the term. It should be noted that the “place of management”mentioned in the list refers to a place of work or an office where some of thesupervisory activities for an enterprise may be exercised. This is in contrast tothe criteria in Article 4, i.e. the “normally managed or controlled in HongKong” criterion used for determining whether a person is a Hong Kong resident;the “head office” criterion used for determining whether a person is a residentof the Mainland prior to the effective date of the Second Protocol; and the“place of effective management” criterion used for resolving the issue of dualresidence of both Sides. Paragraph 7 of Article 5 is also pertinent, providingthat the fact that a company which is a resident of One Side controls or is13controlled by a company which is a resident of the Other Side, or which carrieson business in that Other Side, will not of itself constitute either company apermanent establishment of the other.A building site, a construction, assembly or installation project38. The term “permanent establishment” also includes “a building site, aconstruction, assembly or installation project or supervisory activities inconnection therewith, but only if such site, project or activities last more than 6months”. The Ordinance imposes tax on income derived from contractingwork carried out in Hong Kong in accordance with the territoriality principle.The duration of the work is not a relevant factor. However, pursuant to theComprehensive Arrangement, chargeability of profits in respect of contractingwork carried out in Hong Kong by an enterprise of the Mainland will begoverned by the duration of the work. An enterprise of the Mainland will bedeemed to have a permanent establishment in Hong Kong only if thecontracting work carried out in Hong Kong lasts more than six months.Profits attributed to that permanent establishment will be subject to tax in HongKong in accordance with the provisions of Article 7 (Business Profits) (seeparagraphs 55 to 66 below). Profits in respect of contracting work of a shorterduration will not be subject to tax in Hong Kong. Similarly, an enterprise ofHong Kong will not be regarded as having a permanent establishment in theMainland if contracting work carried out in the Mainland does not last morethan six months and accordingly will not be subject to tax there.39. The period for which a project is carried out is counted from the datethe contractor commences work (including any preparatory activities) up untilthe date on which the work is totally completed and handed over to the user.If the period covers two years, the period is counted on a continuous basisstraddling over the years in question. In a case where two or moresub-projects are contracted for by a person at the same site or for the sameproject, the period is counted from the date of commencement of the firstsub-project to the date of completion of the last sub-project of that person. Inother words, the respective sub-projects would not be counted separately.“Two or more sub-projects contracted for at the same site or for the sameproject” refers to sub-projects that would form a coherent whole commerciallyand geographically. Where sub-projects are situated at different localities andare contracted for in relation to different projects, the respective periods would14be counted separately. In such a case a permanent establishment would not beconsidered to exist in relation to a particular sub-project if it does not last morethan 6 months. A project that does not last more than 6 months would not beregarded as a permanent establishment even if another project of the enterpriseconstitutes a permanent establishment.40. Where, after the commencement of work, a project is suspended (butnot terminated or ended) pending, for example, the arrival of equipment andmaterials or because of bad weather, and the persons, equipment and facilitiesas well as materials involved have not been completely moved out, the durationof the project will, in such a case, be counted continuously without anydeduction for the days on which the project is suspended.41. If the enterprise subcontracts part of a project to a subcontractor whocommences work earlier than the contractor, then in accordance with paragraph39 above, the duration of the entire project would be counted from the date thesubcontractor commences work up to the date on which the work is totallycompleted and handed over to the user. This method of counting the projectperiod does not affect the separate and independent calculation of the durationof continuous work by the subcontractor. Where a subcontractor is anenterprise of the Mainland, its subcontracted work in Hong Kong will notconstitute a permanent establishment if it does not last more than six months.In such a case, exemption from profits tax in Hong Kong would be grantedunder the Comprehensive Arrangement to the subcontractor. On the otherhand, if the subcontractor is a resident of Hong Kong operating in the Mainland,exemption from tax in the Mainland would likewise be granted under theComprehensive Arrangement.Provision of services by an enterprise42. A permanent establishment also includes “the furnishing of services,including consultancy services, by an enterprise of One Side in the Other Side,directly or through employees or other personnel engaged by the enterprise, butonly if such services continue (for the same or a connected project) for a periodor periods aggregating more than 6 months within any 12-month period”. Thescope of consultancy services includes:15(1) improvement of existing production facilities and products,selection of technical know-how, or enhancement ofsupervisory and management skills, etc.;(2) feasibility studies of investment projects and selection ofdesign plans.43. The counting of “a period or periods aggregating more than 6months within any 12-month period” may commence with any month duringthe course of a service contract. Where services have been furnished by anenterprise directly or through employees or other personnel in the Other Sidefor a continuous or cumulative period of more than 6 months within any12-month period, the enterprise will be considered to have a permanentestablishment in the Other Side. Profits attributed to that permanentestablishment will be subject to tax in the Other Side in accordance with theprovisions of Article 7 (Business Profits) (see paragraphs 55 to 66 below). Inthe determination of whether a Mainland enterprise furnishing services shouldbe regarded as having a permanent establishment in Hong Kong, the criterion iswhether services are furnished by the enterprise directly (e.g. a sole-proprietor)or through employees or other personnel in Hong Kong for a continuous orcumulative period of more than 6 months (within any 12-month period).There is no definition of the term “month” in the Comprehensive Arrangement.The Commentary of the United Nations Model has not given furtherexplanations of the relevant provision and has not specified clearly how the 6months are to be counted. Hence the Mainland and Hong Kong have adopteddifferent counting methods. The Mainland considers that since only “month”is provided as a counting unit under the Comprehensive Arrangement, she isentitled not to consider the number of days in its implementation. TheMainland adopts the following method of counting the months: the Mainlandwill take the period from the month in which an employee of a Hong Kongenterprise arrived in the Mainland for furnishing services up until the month inwhich the project was completed and the employee left the Mainland as therelevant period. If during this relevant period, no service was provided by theemployee in the Mainland for a period of 30 consecutive days, 1 month can bededucted. If it results in more than 6 months by using this counting method,the Hong Kong enterprise will be considered to have a permanentestablishment in the Mainland. For a project that lasts for more than 12months, any 12-month period commencing from the month the employee16arriving in the Mainland or ending in the month leaving the Mainland duringthe course of the project shall be adopted for the purposes of applying thecounting method. In Hong Kong, the term “month” is defined in theInterpretation and General Clauses Ordinance (Cap. 1) as “calendar month”.In its ordinary meaning, month (calendar month) means a period of timebetween the same dates in successive calendar months; a period of around 30days (365 days divided by 12); a period of 28 days or a period of 4 weeks.For the purposes of paragraph 3(2) of Article 5, Hong Kong considers that theterm “month” to be a period of 30 days. In counting whether a Mainlandenterprise has furnished services in Hong Kong “for a period or periodsaggregating more than 6 months within any 12-month period”, Hong Kong willadd together each time period that services have been provided in Hong Kongby the Mainland enterprise directly or through its employees (irrespective ofthe length of the time period) within any 12-month period. If the cumulativenumber of days during the time period or time periods during which serviceshave been provided in Hong Kong within that 12-month period exceeds 180days, Hong Kong would consider that the Mainland enterprise has a permanentestablishment in Hong Kong. With effect from 11 June 2008, the term “6months” was repealed and substituted by “183 days” under Article 3 of theSecond Protocol. In other words, if within any 12-month period thecumulative number of days during which services have been provided by anenterprise of One Side in the Other Side exceeds 183 days, that enterprise willbe regarded as having a permanent establishment in the Other Side. For thetransitional arrangement, Hong Kong agreed with the Mainland that the new“183 days” rule will only apply to those services which commenced after, andfor which the employees rendering such services arrived at Hong Kong after,the effective date of the Second Protocol. For those enterprises which havecommenced to provide services in Hong Kong prior to the effective date of theSecond Protocol, the original “6 months” rule will still be adopted indetermining whether they have a permanent establishment in Hong Kong.Whilst the method of counting the “183 days” was not stated in the SecondProtocol, both Sides will in practice use the “days of physical presence”method. The day when one is in the Other Side, and the day of arrival ordeparture, irrespective of the duration and the purpose of the stay, will becounted as one day. This is because it is difficult if not impossible for the taxauthority to ascertain, and for the taxpayers to prove, whether services wererendered on any particular day of presence in the jurisdictions concerned.17The place where preparatory or auxiliary activities are conducted44. In defining a permanent establishment, the ComprehensiveArrangement excludes a fixed place of business whose activities, for theenterprise, are purely of a preparatory or auxiliary character. This is becausesuch activities, even if carried on through a fixed place of business, are of apreparatory or auxiliary character and do not themselves directly generateprofits.45. Paragraph 4 of Article 5 lists various activities of a preparatory orauxiliary character that may be carried out for the enterprise withoutconstituting a permanent establishment. They include:(1) the use of facilities solely for the purpose of storage, displayor delivery of goods or merchandise belonging to theenterprise;(2) the maintenance of a stock of goods or merchandise belongingto the enterprise solely for the purpose of storage, display ordelivery;(3) the maintenance of a stock of goods or merchandise belongingto the enterprise solely for the purpose of processing byanother enterprise;(4) the maintenance of a fixed place of business solely for thepurpose of purchasing goods or merchandise, or of collectinginformation, for the enterprise;(5) the maintenance of a fixed place of business solely for thepurpose of carrying on, for the enterprise, any other activity ofa preparatory or auxiliary character;(6) the maintenance of a fixed place of business solely for anycombination of the activities mentioned in subparagraphs (1)to (5) above, provided that the overall activity of the fixedplace of business resulting from this combination is of apreparatory or auxiliary character.1846. The purpose of paragraph 4 of Article 5 is to clarify what areaccepted as genuine “representative offices” and not regarded as permanentestablishments subject to tax. However, attention should be drawn to thefollowing:(1) the activities should be for the enterprise itself;(2) the activities should not directly generate profits; and(3) the function of the place of business should only be of asupportive nature. If the place of business conducts certainsupervisory management functions for the enterprise ormanages certain business operations, its activities would notbe regarded as being of the required character. In this event,the place of business would be regarded as a place ofmanagement and would therefore constitute a permanentestablishment.Where the activities carried out in the Other Side by a representative office gobeyond the exceptions set out in paragraph 4 of Article 5, the representativeoffice would be regarded as a permanent establishment. Profits attributed tothat permanent establishment would be taxed in the Other Side in accordancewith the provisions of Article 7 (Business Profits) (see paragraphs 55 to 66below).Business agent47. Paragraph 5 of Article 5 of the Comprehensive Arrangementexpressly points out that a dependent agent (i.e. an agent acting under thecontrol and leadership of an enterprise of One Side), who regularly acts onbehalf of that enterprise in the Other Side and has, and habitually exercises, anauthority to conclude contracts in the name of that enterprise, that enterprisewill be deemed to have a permanent establishment in the Other Side. In HongKong, if a dependent agent is not a final signatory to a contract but participatesin detailed negotiations and formulates the contract provisions on behalf of therelevant Mainland enterprise, that Mainland enterprise will still be deemed tohave a permanent establishment in Hong Kong. Paragraph 6 of Article 5states that an enterprise of One Side will not be deemed to have a permanent19establishment in the Other Side if its activities in that Other Side are conductedthrough an independent agent who is acting in the ordinary course of itsbusiness. However, when the activities of such an agent are wholly or almostwholly performed on behalf of that enterprise, he would not be regarded as anindependent agent. The scope of his duties and responsibilities and whetherhe has the right to conclude contracts on behalf of the enterprise woulddetermine whether or not that enterprise has a permanent establishment in thatOther Side.Article 6 INCOME FROM IMMOVABLE PROPERTY48. “Income from immovable property” means the income derived fromthe use of immovable property without transfer of ownership. Income derivedfrom alienation of immovable property will be dealt with in accordance withthe provisions of Article 13 (Capital Gains).49. It is specifically provided in paragraph 1 of Article 6 that incomederived by a resident of One Side from immovable property (including incomefrom agriculture or forestry) situated in the Other Side may be taxed in thatOther Side.50. According to the elaboration in paragraph 3 of Article 6, incomederived from immovable property may be income derived from the direct useof immovable property by the owner, such as running a farm or carrying onanimal husbandry, or income derived from letting or use in any other form ofimmovable property.51. To avoid possible disputes over differences in interpretation, the term“immovable property” is given the meaning which it has under the laws of theSide in which the property in question is situated. In Hong Kong, under theInterpretation and General Clauses Ordinance (Cap. 1), “immovable property”means:(1) land, whether covered by water or not;(2) any estate, right, interest or easement in or over any land; and20(3) things attached to land or permanently fastened to anythingattached to land.52. Apart from defining the meaning of immovable property accordingto the respective laws of each Side, it is specifically provided in paragraph 2 ofArticle 6 that certain assets and rights must always be regarded as immovableproperty. These assets and rights include property accessory to immovableproperty, livestock and equipment used in agriculture and forestry, and rights towhich the provisions of general laws in respect of real estate apply. However,ships and aircraft shall never be regarded as immovable property.53. The term “property accessory to immovable property” does not meana simple storage in or in connection with immovable property, but refers to acomponent part of an essential function of the immovable property, such as anair-conditioning system or elevator of a building.54. Paragraphs 1 and 3 of Article 6 also apply to income derived by anenterprise from immovable property. According to the rules set out above,income derived by an enterprise of One Side from immovable property situatedin the Other Side may be taxed in that Other Side, regardless of whether it has apermanent establishment in that Other Side, whether the immovable property ispart of that permanent establishment, or whether the income is derived throughthat permanent establishment.Article 7 BUSINESS PROFITSAllocation of taxing rights55. Business profits refer to profits derived by an enterprise from itsbusiness activities. Under the provisions of paragraph 1 of Article 7, theprofits of an enterprise of One Side shall be taxable only in that Side (i.e. theOther Side has no right to tax) unless the enterprise carries on business in theOther Side through a permanent establishment situated therein, in which caseits profits may be taxed in that Other Side, but only so much of them as isattributable to that permanent establishment.21Computation of business profits56. The Comprehensive Arrangement does not expressly specify themethod for computing business profits, but instead sets out some principleswhich must be followed. Both Sides may compute profits in accordance withtheir own relevant domestic law, provided that such principles are followed.In Hong Kong, assessable profits are based on profits computed by enterprisesin accordance with the prevailing generally accepted principles of commercialaccounting as adjusted in conformity with the provisions of the Ordinance.57. The principles stipulated in the Comprehensive Arrangement are setout in paragraphs 2 and 3 of Article 7. Paragraph 2 stipulates that a permanentestablishment will be considered as a distinct and separate enterprise, whileparagraph 3 contains provisions in relation to the deduction of expenses and thetreatment of income.58. Where a permanent establishment situated in the Other Side carrieson business with the head office or other offices of the enterprise of which it isa permanent establishment, it should do so in accordance with the arm’s lengthprinciple as between two entirely independent enterprises engaged in the sameor similar activities. There will in each Side be attributed to that permanentestablishment the profits which it might be expected to make under suchconditions. For information concerning transfer pricing and the arm’s lengthprinciple, see the relevant Departmental Interpretation and Practice Notesissued by the Inland Revenue Department.59. In computing the profits of a permanent establishment, there will beallowed as deductions expenses (wherever incurred) that are incurred for thepurposes of producing the relevant profits, including executive and generaladministrative expenses so incurred (including a reasonable share of theadministrative expenses of the head office). Relevant expenses which can beclearly attributed to that permanent establishment can be deducted. Otherwise,an allocation of the relevant expenses should be made. The allocation can bebased on the proportion of the business turnover or gross profit of thepermanent establishment to that of the enterprise. The resultant expenses willbe considered as the expenses actually incurred by the permanent establishment,though possibly not the amount actually paid by it.2260. A permanent establishment and its head office are one and the samelegal entity. Therefore, a permanent establishment should not pay any amountto the head office for its investments or services. Paragraph 3 of Article 7specifically sets out three categories of amounts which will not be deducted indetermining the profits of a permanent establishment, whether they are paid tothe head office of the enterprise or any of its other offices (other thanreimbursement of actual expenses):(1) by way of royalties, remuneration, fees or any other similarpayments in return for the use of patents or other rights; or(2) by way of commission for specific services performed or formanagement; or(3) by way of interest on moneys lent to the permanentestablishment, except in the case of a banking enterprise, i.e.relevant interest is deductible in such a case.61. Likewise, the above provisions will also apply to the income of apermanent establishment, i.e. the amounts falling within the above threecategories (other than reimbursement of actual expenses) charged by thepermanent establishment to the head office of the enterprise or any of its otheroffices would not be included in determining its profits, except that in the caseof a banking enterprise the relevant interest income would be included indetermining the profits of the permanent establishment.Other methods of computing profits62. If the financial statements prepared by an enterprise can give a trueview of the state of affairs of the permanent establishment, they should be usedto determine the profits attributed to that permanent establishment. However,insofar as it has been customary in One Side to determine the profits to beattributed to a permanent establishment by apportioning the total profits of theenterprise to its various units or by any other methods provided for in the lawsof the Side concerned, the enterprise may continue using that method.However, the result of using such a method must be in accordance with theprinciples contained in Article 7.2363. For banks and other persons whose head offices are situated outsideHong Kong, Rules 3 and 5 of the Inland Revenue Rules provide methods fordetermining the profits of their branches and permanent establishments2 inHong Kong. Those methods are, however, only applicable where thefinancial statements of the branches and permanent establishments in HongKong do not disclose their true profits arising in or derived from Hong Kong.(1) Under Rule 3, the same proportion of the total profits of thebank as the assets of the Hong Kong branch bear to the totalassets of the bank would be treated as profits of the HongKong branch. For the purposes of determining the totalprofits of the bank, similar adjustments for tax purposeswould be made in the accounts of the bank as would havebeen necessary had the whole of those profits been liable totax under the Ordinance. If the assessor is of the opinionthat the above method would be inappropriate, he mayestimate the amount of the profits of the Hong Kong branch.(2) Under Rule 5, the same proportion of the total profits of theenterprise as the turnover in Hong Kong bears to the totalturnover of the enterprise would be treated as profits of thepermanent establishment in Hong Kong. For the purposes ofdetermining the total profits of the enterprise, similaradjustments for tax purposes would be made in the accountsof the enterprise as would have been necessary had the wholeof those profits been liable to tax under the Ordinance. If theassessor is of the opinion that the above method would beinappropriate, he may compute the amount of the profitsderived from Hong Kong on a fair percentage of the turnoverin Hong Kong.Other principles64. Paragraph 5 of Article 7 of the Comprehensive Arrangement stipulatesthat no profits will be attributed to a permanent establishment by reason of the2 “Permanent establishment” for the purposes of Rule 5 is defined to mean a “branch, managementor other place of business, but does not include an agency unless the agent has, and habituallyexercises, a general authority to negotiate and conclude contracts on behalf of his principal or has astock of merchandise from which he regularly fills orders on his behalf”.24mere purchase by that permanent establishment of goods or merchandise forthe enterprise. This is because purchasing activities do not directly generateprofits in the overall business activities. In fact, it is very difficult to computethe part of the total business profits that is attributable to such purchasingactivities.65. The profits to be attributed to the permanent establishment must bedetermined by the same method year by year unless there is good and sufficientreason for a change. More particularly, the method should not be changedmerely because some other method would produce more favourable results.66. “Business profits” may include, apart from profits derived frombusiness activities, income such as that from immovable property, dividendsand interest. The taxation of these categories of income is governed by otherArticles of the Comprehensive Arrangement. To clarify the application ofArticle 7 in relation to other Articles, paragraph 7 of Article 7 provides thatwhere profits include items of income which are dealt with separately in otherArticles of the Comprehensive Arrangement, then the provisions of thoseArticles will not be affected by the provisions of Article 7. It should be noted,however, that some Articles contain provisions stating that the provisions ofArticle 7 shall apply if the relevant property in respect of which the income ispaid is effectively connected with a permanent establishment. Thoseprovisions are paragraph 4 of Article 10, paragraph 5 of Article 11, paragraph 4of Article 12, and paragraph 2 of Article 20.Article 8 SHIPPING, AIR AND LAND TRANSPORT67. Article 8 provides that revenue and profits derived by an enterpriseof One Side (i.e. an enterprise of the Mainland or an enterprise of Hong Kong)from the operation of ships, aircraft or land transport vehicles in shipping, airand land transport businesses (except when the ship, aircraft or land transportvehicle is operated solely between places in the Other Side) shall be exemptfrom tax in the Other Side. The taxes exempted in the Mainland includeenterprise income tax and business tax. Enterprise income tax is calculated byreference to profits whereas business tax is calculated by reference to revenue.Accordingly, the Article specifically includes revenue and profits in the scopeof the exemption. Revenue and profits refer to revenue and profits derived by25an enterprise from cross-border shipping, air and land transport businesses.Revenue and profits of an enterprise derived from services provided in theOther Side (other than those from cross-border shipping, air and land transport)will not be exempt in that Other Side if such services are provided through apermanent establishment situated in that Other Side. This Article also appliesto revenue and profits derived from participation in a partnership business, jointventure business or international business agency.Shipping transport68. Under Article 8, profits derived by a Hong Kong shipping enterprisefrom its shipping business will be taxed in Hong Kong alone. In this regard,the exercise of the taxing rights is subject to the provisions of section 23B ofthe Ordinance. For example, where an enterprise is deemed to be carrying ona business in Hong Kong as an owner of ships, “relevant sums” (as defined insection 23B(12)) does not include any sums derived from any relevant carriageshipped aboard a “registered ship” (as defined in section 23B(12)) at anylocation within the waters of Hong Kong and proceeding to sea therefrom.The ratio of the relevant sums to the total shipping revenue is used to apportionthe worldwide shipping profits of the Hong Kong ship-owner and calculate theassessable shipping profits derived from Hong Kong. Accordingly any sumsfrom relevant carriage shipped aboard a registered ship at any location withinthe waters of Hong Kong and proceeding to sea therefrom by a Hong Kongshipping enterprise will continue to be exempt from tax in Hong Kong.Air transport69. Likewise, profits derived by a Hong Kong air transport enterprisefrom its air transport business will be taxed in Hong Kong alone. Accordingto section 23C of the Ordinance, “relevant sums” (as defined in section 23C (5))includes any sums derived from any relevant carriage shipped in Hong Kongand any relevant charter hire. The proportion of the relevant sums to the totalrevenue is used to apportion worldwide aircraft profits and calculate assessableaircraft profits derived from Hong Kong. By virtue of section 23C(2A), sumsfrom relevant carriage and charter hire from the Mainland derived by a HongKong air transport enterprise, that are exempt from tax in the Mainland underthe Comprehensive Arrangement, are included as relevant sums in calculatingprofits chargeable to profits tax in Hong Kong.26Land transport70. Article 8 is regarded as having application to a Hong Kongenterprise that carries on a business of land transport. A land transportbusiness is subject to tax under section 14 of the Ordinance. That is, anyperson who carries on a land transport business in Hong Kong is chargeable totax on the profits arising in or derived from Hong Kong.71. According to Article 8, a Hong Kong land transport enterprise willonly be subject to tax in Hong Kong and will be exempt from enterpriseincome tax and business tax in the Mainland. Similarly, revenue earned by aMainland land transport enterprise from Hong Kong uplifts to the Mainlandwill be exempt from profits tax in Hong Kong.72. A cross-border land transport business between the Mainland andHong Kong usually takes the form of a cooperative enterprise. Typically theHong Kong participant would make his investment in the form of vehicles andcapital. The Mainland participant would be responsible for obtaining permitsand licences, tax compliance and other management services. The HongKong participant would be responsible for Hong Kong uplifts and the Mainlandparticipant for uplifts in the Mainland. Occasionally, the Hong Kongparticipant could enter into a contract with the customer for the return trip.This kind of cooperative enterprise is regarded as a joint business ofcross-border transport operated by residents of both Sides. It follows,pursuant to paragraph 2 of Article 8, that the respective shares of profitsderived by each participant from the joint business operation would be exemptfrom tax by the Other Side and would be taxed in the Side of which theparticipant is a resident in accordance with its taxation laws.Article 9 ASSOCIATED ENTERPRISES73. For the purpose of relieving its total tax burden, a cross-border groupmay, by means of altering the pricing or business charges (i.e., the transferpricing method), attempt to transfer the profits derived by an enterprise of thegroup from cross-border business activities to an associated enterprise.Article 9 provides that taxation authorities may make adjustments to profitswhere transactions between associated enterprises have not been entered intoon an arm’s length basis.27Adjusting the profits of an enterprise of One Side74. Paragraph 1 of Article 9 provides that in the following two differentsituations, if the commercial or financial relations between the two enterprisesare different from those between independent enterprises, any profits whichwould have accrued to one of the enterprises but have not done so by reason ofthose relations, may be included in the profits of that enterprise and taxed assuch. The two situations are:(1) an enterprise of One Side participates directly or indirectly inthe management, control or capital of an enterprise of theOther Side; or(2) the same person participates directly or indirectly in themanagement, control or capital of an enterprise of One Sideand an enterprise of the Other Side.Making an appropriate adjustment to the profits of an enterprise of the OtherSide75. Under the provisions of paragraph 1 of Article 9, where One Sideincludes in the profits of an enterprise of that Side profits of an enterprise thathave been charged to tax in the Other Side, the Other Side shall make anappropriate adjustment to the amount of the tax charged on those profits inaccordance with the provisions of paragraph 2.76. Insofar as Hong Kong is concerned, “appropriate adjustment” meanswhere the Inland Revenue Department agrees fully with the calculation of theMainland, the Hong Kong enterprise can get an adjustment of the full amount;where the Department agrees with an amount less than that worked out by theMainland, the Hong Kong enterprise can get an adjustment of that smalleramount; where the Department disagrees with the Mainland on the adjustment,no adjustment will be made. The competent authorities of both Sides will, ifnecessary, consult each other in determining such adjustment.77. The Hong Kong enterprise can present its case to the Inland RevenueDepartment under Article 23 (Mutual Agreement Procedure) if its taxationtreatment is not in accordance with the provisions of the Comprehensive28Arrangement. The competent authorities of both Sides would endeavour toresolve the case by mutual agreement. However, such a case must bepresented within 3 years from the first notification of the action resulting intaxation not in accordance with the provisions of the ComprehensiveArrangement.78. As the issue of transfer pricing arising from the provisions on“associated enterprises” is complicated, the Inland Revenue Departmentintends to publish a Departmental Interpretation and Practice Note on thesubject. The Note will provide information and guidance on the time limit forclaims, factors to be taken into consideration in relation to appropriateadjustments, the tax adjustment methods, etc.INCOME FROM INVESTMENT – DIVIDENDS, INTEREST ANDROYALTIES79. Income derived from investment activities is indirect or passiveincome, and is different from profits from business activities. The taxation ofsuch income (including dividends, interest and royalties) is governed byspecific Articles of the Comprehensive Arrangement.80. Under the Comprehensive Arrangement, the key principle in relationto business profits is that an enterprise of One Side will not be taxed in theOther Side unless it carries on business in that Other Side through a permanentestablishment situated therein. On the other hand, if the enterprise does carryon business in the latter manner, the profits attributable to that permanentestablishment may be taxed in that Other Side. However, for investmentincome, the Side where the income arises has the taxing rights even if there isno permanent establishment situated therein.81. Although the Side of the source of investment income has the taxingrights, this does not mean that the Side of which the recipient is a resident hasno taxing rights. In other words, both the Side of source and the Side ofresidence are given the right to tax the same item of investment income (theSide of residence is required to give double taxation relief to its residents forany income doubly taxed, see paragraphs 128 to 140 below). It is specificallystipulated in the relevant provisions of the Comprehensive Arrangement that29the investment income should be taxed in the Side of source according to itslaws. Thus, where the domestic laws of the Side of source provide tax reliefor special tax treatment, the Comprehensive Arrangement does not affect theapplication of such laws. In addition, the relevant provisions of theComprehensive Arrangement set limits on the tax rates that the Side of sourcemay impose. More particularly, notwithstanding the provisions of anydomestic laws of the Side of source, the tax imposed on investment incomederived by a resident of the Other Side (“beneficial owner” that satisfies thefollowing conditions) should not exceed the amount provided for in theComprehensive Arrangement.82. The Side of source will only limit its right to tax if a condition is met:the beneficial owner of the investment income must be a resident of the OtherSide. “Beneficial owner” may be an individual, a company or a trust, and isthe person who actually receives the benefit and fully controls the income.For example, if the investment income is received by a unit trust, the beneficialowner is the unit trust itself, and is not the individual beneficiary of the unittrust. Where the recipient of the investment income does not actually receivethe economic benefit of the income concerned, but only collects it in thecapacity of an agent or a nominee and will subsequently transfer the income tothe actual owner in accordance with a contract or law, such an agent or anominee will not be deemed to be the beneficial owner of the income. Inother words, even though an agent or a nominee is a resident of the Other Side,the Side of source need not apply the tax limitation if the beneficial owner isnot a resident of the Other Side.83. On the other hand, as long as the “beneficial owner” is a resident ofthe Other Side, the limitation of tax on the income in the Side of sourceremains applicable, regardless of whether the agent or nominee is a resident ofthe Other Side at the time of the receipt of the relevant income.Article 10 DIVIDENDS84. Paragraph 1 of Article 10 provides that dividends paid by a companywhich is a resident of One Side to a resident of the Other Side, may be taxed inthat Other Side, that is, the Side of residence has the right to tax the dividends.The meaning of the term “pay” is not limited to actual payment but will include30the fulfillment of the obligation to put funds at the disposal of the shareholderin the manner required by contract or by custom.85. Paragraph 2 of Article 10 provides that such dividends may also betaxed in the Side of which the company paying the dividends is a resident (i.e.the Side of source) and according to the laws of that Side. The tax so charged,in 2 tiers, shall not exceed:(1) where the beneficial owner is a company directly owning atleast 25% of the capital of the company which pays thedividends, 5% of the gross amount of the dividends;(2) in any other case, 10% of the gross amount of the dividends.86. As dividends are not chargeable to tax in Hong Kong, the limitationof tax rates has no practical application in Hong Kong. It is also stipulated inparagraph 2 of Article 10 that the limitation of tax rates on dividends will notaffect the taxation of the company in respect of the profits out of which thedividends are paid.87. Paragraph 3 of Article 10 defines the term “dividends” to mean“income from shares or other rights, not being debt-claims, participating inprofits” and “income from other corporate rights which is subjected to the sametaxation treatment as income from shares under the laws of the Side of whichthe company making the distribution is a resident”. The first part of themeaning makes it clear that the relevant income must be derived fromshareholding rather than debt-claims. The second part links the definition tothe laws of the Side of which the company paying the dividends is a resident.88. The provisions of Article 7 (Business Profits) shall apply if thebeneficial owner of the dividends, being a resident of One Side, carries onbusiness in the Other Side (of which the company paying the dividends is aresident) through a permanent establishment situated therein, and theshareholding in respect of which the dividends are paid is effectively connectedwith that permanent establishment.89. In respect of the taxation on dividends, paragraph 5 of Article 10further provides that dividends paid by, or undistributed profits of, a company31which is a resident of One Side may not be taxed by the Other Side even if thedividends paid or the undistributed profits consist of profits or income arisingin that Other Side. For example, where a Hong Kong resident companycarries on business through a permanent establishment situated in the Mainlandand makes profits, the relevant profits may be taxed in the Mainland under theprovisions of Article 7 (Business Profits). When the Hong Kong residentcompany pays dividends out of its profits, the Mainland may not impose anytax on the dividends, except insofar as such dividends are paid to a resident ofthe Mainland, or insofar as the shareholding in respect of which the dividendsare paid is effectively connected with a permanent establishment situated in theMainland.Article 11 INTEREST90. The taxation principles laid down in paragraphs 1 and 2 of Article 11are the same as those in paragraphs 1 and 2 of Article 10. What differs is thatthe source of interest is “the Side in which the interest arises”. Under theprovisions of paragraph 6 of Article 11, interest will be deemed to arise in aSide when the payer is the Government of that Side, a local authority thereof ora resident of that Side. However, where the person paying the interest has in aSide a permanent establishment in connection with which the indebtedness onwhich the interest is paid was incurred, and such interest is borne by thatpermanent establishment, then such interest will be deemed to arise in the Sidein which the permanent establishment is situated. In other words, the sourceof interest is the Side in which the payer who effectively bears the interest issituated.91. The limitations of tax rates in the Side in which the interest arises arein 2 tiers as follows:(1) the tax charged will not exceed 7% of the gross amount of theinterest, except in the following situation;(2) interest is exempt from tax in the Side of source if it isreceived by the Government of the Other Side or any otherinstitutions mutually recognized by the competent authoritiesof both Sides. (Currently, the institutions mutually32recognized by the competent authorities of both Sides are: inthe case of the Mainland, China Development Bank, TheExport-Import Bank of China and Agricultural DevelopmentBank of China, and with effect from 11 September 2007 theNational Council for Social Security Fund and China Export& Credit Insurance Corporation; and in the case of HongKong, the Hong Kong Monetary Authority.)92. The term “interest”, as defined in paragraph 4 of Article 11, means“income from debt-claims of every kind, whether or not it is secured bymortgage or whether or not it carries a right to participate in the debtor’sprofits” (i.e. interest is limited to income derived from debt-claims). Inaddition, “income from bonds, debentures and Government securities,including premiums and prizes attaching to such bonds, debentures orsecurities” are interest within the meaning of the definition. Generallyspeaking, the difference between the amount paid to and received from anissuing institution by a subscriber is the interest on debentures. Penaltycharges for late payment will not be regarded as interest.93. The provisions of paragraphs 1, 2 and 3 of Article 11 will not applyif the beneficial owner of the interest, being the Government of One Side, alocal authority thereof or a resident of that Side, carries on business in theOther Side in which the interest arises through a permanent establishmentsituated therein and the debt-claim in respect of which the interest is paid iseffectively connected with that permanent establishment. In such a case, theprovisions of Article 7 (Business Profits) will apply.94. In a situation of the kind provided for in paragraph 7 of Article 11,the provisions of Article 11 will have limited application. Such a situation isone where, by reason of a special relation between the payer and the beneficialowner of the interest or between both of them and some other person, theamount of interest paid exceeds, for whatever reasons, the amount which wouldhave been agreed upon in the absence of such relation. In such a case, theprovisions of Article 11 will apply only to the last-mentioned amount. Theexcess part of the payments will remain taxable according to the laws of eachSide, but due regard will still be had to the other provisions of theComprehensive Arrangement.3395. As Hong Kong only taxes interest arising in Hong Kong frombusiness carried on in Hong Kong, the limitation of tax rates does not have anypractical application in Hong Kong.Article 12 ROYALTIES96. The provisions of Article 12 and the criteria for determining thelocality of the source are the same as those for Article 11. Regarding thelimitation of the tax rate, it is 7% of the gross amount of the royalties in allcases.97. The definition of “royalties” as provided for in paragraph 3 of Article12 is wide enough to cover the provisions of paragraphs (a), (b), (ba) and (d) ofsection 15(1) of the Ordinance.98. Where a resident of the Mainland receives royalties which aredeemed to be chargeable to tax under paragraphs (a), (b) and (ba) of section15(1) of the Ordinance, the Mainland resident is taxed at the following rates byvirtue of section 21A (1)(b):(1) corporations – at a tax rate of 17.5% (the tax rate for the year2007/08 is 17.5%) on 30% of the gross amount, i.e. 5.25% ofthe gross amount;(2) persons other than corporations – at a tax rate of 16% (the taxrate for the year 2007/08 is 16%) on 30% of the gross amount,i.e. 4.8% of the gross amount.Since the Comprehensive Arrangement has entered into force, as the applicabletax rate is 7% which is higher than the rates mentioned above, royalties arisingin Hong Kong and paid to a resident of the Mainland will be taxed at theeffective rate (i.e. 5.25% or 4.8%) instead of the rate as provided for in theComprehensive Arrangement. However, if royalties arising in Hong Kongand paid to a resident of the Mainland are part of a scheme directed atexploiting section 21A of the Ordinance, the Comprehensive Arrangement willnot prejudice the right of Hong Kong to apply its laws and measuresconcerning tax avoidance (see paragraph 158 below).3499. Where a resident of the Mainland receives royalties which aredeemed to be chargeable to tax under section 15(1)(d) of the Ordinance (forexample, hire charges for the use of or the right to use industrial, commercialand scientific equipment in Hong Kong), such a resident will be taxed subjectto the provisions of the Comprehensive Arrangement as follows:Example 1Company A, a resident of the Mainland, derives from Hong Kongroyalties of $900,000 during the year from 1 April 2007 to 31 March2008. After deduction of allowable expenses and depreciationallowances in respect of the relevant equipment, the amount ofassessable profits of Company A is $500,000 and the tax payablethereon is $87,500 (i.e. 9.7% of the gross amount), calculated at therate of 17.5% (the tax rate for the year 2007/08 is 17.5%).As the tax rate provided for in the Comprehensive Arrangement is7% of the gross amount of royalties (i.e. $900,000 x 7%), the taxpayable by Company A will be reduced to $63,000.Example 2Same as Example 1 except that the amount of assessable profits ofCompany A is $300,000 and the tax payable thereon is $52,500 (i.e.5.8% of the gross amount), calculated at the rate of 17.5% (the taxrate for the year 2007/08 is 17.5%).As the tax rate provided for in the Comprehensive Arrangement is7% of the gross amount of royalties, the tax payable remains as$52,500, unaffected by the Comprehensive Arrangement.100. The provisions of Article 12 will not apply if the beneficial owner ofthe royalties, being the Government of One Side, a local authority thereof or aresident of that Side, carries on business in the Other Side in which theroyalties arise through a permanent establishment situated therein, and the rightor property in respect of which the royalties are paid is effectively connectedwith that permanent establishment. In such a case, the provisions of Article 7(Business Profits) will apply. In other words, if the abovementioned35Mainland residents have a permanent establishment situated in Hong Kong,and the right in respect of which the royalties are paid is effectively connectedwith that permanent establishment, the royalties concerned will be included inthe computation of the profits of that permanent establishment. The profits ofthat permanent establishment will be taxed in accordance with the provisions ofArticle 7 (Business Profits). The limitation of tax rate as provided for inArticle 12 would have no application.Article 13 CAPITAL GAINS101. Article 13 allocates the right of tax on the gains from the alienationof property. It should be noted that Article 13 does not distinguish as to thenature of the capital gains. Accordingly, “capital gains” may include gains ofa capital nature and gains of a revenue nature (speculative gains).102. Paragraph 1 of Article 13 deals with gains derived by a resident ofOne Side from the alienation of immovable property situated in the Other Side.Paragraph 2 of Article 13 deals with gains derived from the alienation ofmovable property forming part of the business property of a permanentestablishment which an enterprise of One Side has in the Other Side, includinggains from the alienation of such a permanent establishment. Both paragraphsallow the Other Side to impose tax. This is consistent with the principle onthe allocation of taxing rights as provided for in Article 6 (Income fromImmovable Property) and Article 7 (Business Profits). The term “movableproperty” means all property other than immovable property, includingintangible assets such as goodwill.103. Gains derived by an enterprise of One Side from the alienation ofships or aircraft or land transport vehicles operated in shipping, air and landtransport or movable property pertaining to the operation of such ships, aircraftor land transport vehicles, shall be taxable only in that Side under theprovisions of paragraph 3 of Article 13. This is consistent with the principleon the allocation of taxing rights as provided for in Article 8 (Shipping, Air andLand Transport).104. Paragraphs 4 and 5 of Article 13 deal with gains derived from thealienation of shares in a company.36105. Under the provisions of paragraph 4 of Article 13, gains derivedfrom the alienation of shares in a company the assets of which are comprised,directly or indirectly, mainly of immovable property situated in One Side maybe taxed in that Side. Both Sides, pursuant to paragraph 2 of the Protocol,take 50% as the benchmark in determining whether the assets of a company arecomprised “mainly” of immovable property. Where the value of immovableproperty is not less than 50% of the value of the total assets of a company, theassets of that company will be deemed to be comprised mainly of immovableproperty. In calculating the value of the total assets of a company, debts ofthat company (including liabilities secured by mortgages on the relevantimmovable property) must not be deducted. Both Sides hold different viewsas to the relevant point in time for deciding whether the value of immovableproperty equals or exceeds 50% of the value of the total assets of the company.Hong Kong holds the view that it means the time of the alienation of shares,whereas the Mainland holds the view that it means any time in the periodduring which the alienator held any shares in the company. The StateAdministration of Taxation has discussion with the Hong Kong Inland RevenueDepartment and then concluded the Second Protocol. Both Sides agreed toset a time frame of “3 years” for the purposes of deciding whether the value ofimmovable property equaled or exceeded 50% of the value of the total assets.Though the State Administration of Taxation has not adopted Hong Kong’sinterpretation, the specification of a time frame has already provided morecertainty in the interpretation of this provision. Hong Kong would continue todiscuss with the Mainland on this issue.106. Before the Second Protocol became effective, Hong Kong willcalculate the value of assets on the basis of market value as at the time of thealienation of the shares concerned; whereas the Mainland will calculate thevalue on the basis of historical cost. In general, Hong Kong Inland RevenueDepartment will accept the last available audited financial statements of thecompany whose shares are alienated, supplemented by its managementaccounts up to the date of alienation of the shares (the latter may be unaudited),for the purposes of calculating the value of assets. In the Mainland, the valueof assets is calculated at present on the basis of historical cost. The StateAdministration of Taxation has, however, agreed that notwithstanding thedifferent bases adopted by the two Sides for their respective calculations, wherethe calculation satisfies the taxing conditions and tax is imposed in both Sides,the Side of residence should give credit to its resident for income doubly taxed.37For the alienation of shares on or after 11 June 2008 (effective date of theSecond Protocol), both Sides will calculate the value of assets by reference tothe book value at the end of any of the 3 taxable years prior to the alienation.The calculation will base on generally accepted accounting standards whichinclude normal depreciation and revaluation provisions. The followingexample shows how the new calculation method is applied:Example 3On 1 May 2004, a Mainland resident Mr. Wong bought shares inCompany B, which closed its accounts annually on 31 December.Company B held immovable properties in Hong Kong, with theproperties representing, as per the accounts at the end of the taxableyear, the following percentages of total company assets:(a) for 2004, 60%;(b) for 2005, 40%;(c) for 2006, 40%;(d) for 2007, 40%.Mr. Wong sold the shares of Company B on 23 June 2008 and madea profit.The new rule will apply as the Second Protocol has become effectiveat the time of alienation, 23 June 2008. The book value at the endof the 3 taxable years prior to the alienation will be used indetermining whether the assets of Company B are comprised“mainly” of immovable property. According to the year-endaccounts for 2005 to 2007, the immovable properties only accountedfor 40% of the total assets of Company B. Hence, the assets ofCompany B were not at any time comprised “mainly” of immovableproperty. According to paragraph 4 of Article 13 of theComprehensive Arrangement, Hong Kong does not have the taxingrights on the gains on alienation received by Mr. Wong.In Hong Kong, the taxable year refers to the period from 1 April to31 March of the next year. Hence, strictly speaking the Departmentshould require Company B to provide annual accounts as at 31March for each year from 2005 to 2007. In general, the Departmentwould adopt a more flexible approach and would accept the relevant38company’s accounting year-end accounts (with the exception of taxplanning cases).107. Before the Second Protocol became effective, gains derived from thealienation of “shares”, other than shares referred to in paragraph 4 of Article 13,of not less than 25% of the entire shareholding of a company which is aresident of One Side may be taxed in that Side under the provisions ofparagraph 5 of Article 13. Hong Kong interprets the word “shares” asreferring to shares sold at the time of alienation, rather than the total shares in acompany held or once held by the alienator. In other words, it is only whenshares alienated are not less than 25% of the entire shareholding of a companymay gains derived from the alienation be taxed in that Side. It is understoodthat the Mainland interprets “25%” as referring to 25% or more of the shares ina company once held by the alienator. That is, if shares representing 25% ormore of the entire shareholding of a Mainland company were once held by aHong Kong resident, gains derived by the Hong Kong resident from thealienation of all or part of his/its shareholding may be taxed in the Mainland.After negotiation, the State Administration of Taxation and the Hong KongInland Revenue Department reached a consensus that the “25%” applied to theshares held by the alienator. Under the Second Protocol, both Sides agreed toset a time frame of 12 months for the purpose of deciding whether the alienatorhas “once held” at least 25% of the shareholding. However, the alienation ofshares prior to the effective date of the Second Protocol (i.e. 11 June 2008)would not be affected by this new provision. According to Article 5 of theSecond Protocol, gains derived by a resident of One Side from the alienation ofshares in the capital of a company which is a resident of the Other Side may betaxed in that Other Side if, at any time within the 12 months before thealienation, the recipient of the gains had a participation, directly or indirectly,of not less than 25% of the capital of the company.Example 4On 1 April 2006, a Mainland resident, Mr. Cheung, acquired 35%of the entire shareholding of a Hong Kong company, Company C.Mr. Cheung made a profit in selling 25% and 10% shares ofCompany C on 1 May 2007 and 23 June 2008 respectively.39Paragraphs 1 to 4 of Article 13 of the Comprehensive Arrangementwill not apply. However, Hong Kong has the taxing rights on Mr.Cheung’s gains received from the alienation of 25% shares ofCompany C on 1 May 2007 (i.e. before the effective date of theSecond Protocol), according to paragraph 5 of Article 13. Eventhough Hong Kong has the taxing rights, whether the gains wouldbe taxed still depends on other factors, like whether the gains werecapital or revenue in nature.By the time Mr. Cheung sold the 10% shares of Company C on 23June 2008 the Second Protocol has come into effect. As Mr.Cheung only had a participation of less than 25% of the capital ofCompany C during the 12 months prior to the alienation, his gainsfrom the second sale of shares will not be subject to tax in HongKong according to the new rule under paragraph 5.108. Gains derived from the alienation of any property, other than thatreferred to in paragraphs 1 to 5 of Article 13, shall be taxable only in the Sideof which the alienator is a resident.Article 14 INCOME FROM EMPLOYMENT109. Paragraph 1 of Article 14 provides that salaries, wages and othersimilar remuneration derived by a resident of One Side in respect of anemployment shall be taxable only in that Side unless the employment isexercised in the Other Side. If the employment is exercised in the Other Side,such remuneration as is derived therefrom may be taxed in that Other Side.However, remuneration derived by a resident of One Side in respect of anemployment exercised in the Other Side will be exempt from tax in that OtherSide if all the following three conditions are satisfied:(1) the recipient is present in the Other Side for a period orperiods not exceeding in the aggregate 183 days in any12-month period commencing or ending in the taxable periodconcerned;40(2) the remuneration is paid by, or on behalf of, an employer whois not a resident of the Other Side;(3) the remuneration is not borne by a permanent establishmentwhich the employer has in the Other Side.In addition, it is provided in paragraph 3 of Article 14 that remunerationderived in respect of an employment exercised aboard a ship, an aircraft or aland transport vehicle operated in shipping, air and land transport by anenterprise of One Side shall be taxable only in that Side.“Present for not exceeding 183 days” exemption condition110. Under the provisions of paragraph 2(1) of Article 14, where anemployment is exercised by a resident of One Side in the Other Side, one of theconditions for tax exemption is satisfied only when he is present in the OtherSide for a period or periods not exceeding in the aggregate 183 days in any12-month period commencing or ending in the taxable period concerned.“Any 12-month period commencing or ending in the taxable period concerned”denotes two concepts, namely, that the number of days of presence maystraddle over 2 years, i.e. the days of presence can be calculated continuouslyor in the aggregate irrespective of the year; and that a floating calculationmethod may be adopted. The 12-month period can commence or end at anyday within the taxable period concerned. The taxable period in the Mainlandis the calendar year, whereas the taxable period (i.e. the year of assessment) inHong Kong is the period from 1 April to 31 March of the next year.111. Take the year of assessment 2008/09 as an example, the time periodthat should be taken into account, based on the two concepts mentioned above,is between 2 April 2007 and 30 March 2010. If a Mainland resident is notpresent in Hong Kong for more than 183 days in any 12-month period in thetime period identified above, he has met the “present for not exceeding 183days” exemption condition for the year of assessment 2008/09. However, ifthe Mainland resident is present in Hong Kong for more than 183 days in any12-month period in the time period identified above, remuneration derived byhim in respect of the employment exercised in Hong Kong is chargeable toHong Kong salaries tax for the year of assessment 2008/09.41112. In the year when Article 14 of the Comprehensive Arrangementbecame effective (the year 2007 for the Mainland and the year of assessment2007/08 for Hong Kong), the Mainland adopts 1 January 2007 as thecommencement date for the purposes of ascertaining the number of days aHong Kong resident is present in the Mainland; whilst Hong Kong adopts 1April 2007 as the commencement date for the purposes of ascertaining thenumber of days a Mainland resident is present in Hong Kong. In other words,in the first year of Article 14’s application, the Mainland regards any 12-monthperiod to be any 12-month period commencing in the period from 1 January2007 to 31 December 2007; and Hong Kong regards any 12-month period to beany 12-month period commencing in the period from 1 April 2007 to 31 March2008.113. The “days of physical presence” method is adopted in decidingwhether a resident is present in the Other Side for a period or periods exceeding183 days. Under this method, the day of arrival or departure and each day inthe period during which he stays in the Other Side, however brief and forwhatever reasons, will be counted as one day respectively.Hong Kong residents working across the Mainland border114. If a resident of Hong Kong provides services both in the Mainlandand in Hong Kong, the tax treatment in both Sides is as follows:(1) Tax liabilities in Hong Kong- the income derived from his Hong Kong employment willbe wholly assessable irrespective of whether it has beenpaid by the Hong Kong employer or a Mainlandestablishment. However, if the Hong Kong resident haspaid individual income tax in respect of the incomeattributable to services rendered by him in the Mainland,he may apply for tax exemption for that part of the incomeunder section 8(1A)(c) of the Ordinance, or for a tax creditunder the provisions of Article 21 of the ComprehensiveArrangement. Application may be made on his tax returnfor the year of assessment concerned, and supported withevidence of the Mainland tax payment. In general, tax42exemption provides greater tax relief than that provided bytax credit. A Hong Kong resident who has declared andpaid salaries tax on his employment income, and who hassubsequently paid individual income tax on all or part ofhis employment income in the Mainland because he hasrendered services there, can apply, under section 70A ofthe Ordinance, to have his assessment revised inaccordance with the provisions of section 8(1A)(c).- the income derived from his non-Hong Kong employmentwill be assessed according to the number of days in HongKong irrespective of whether it has been paid by anoverseas employer or a Mainland establishment, providedthat his visit(s) to Hong Kong exceed 60 days and duringwhich he renders services.(2) Tax liabilities in the Mainland- If, under his employment, a Hong Kong resident rendersservices in the Mainland only (i.e. services are notrendered whilst in Hong Kong), all his income from thatemployment will be regarded as attributable to servicesrendered in the Mainland. Such income is whollychargeable to Mainland tax, irrespective of whether it ispaid by a Mainland establishment or an overseas employer(including a Hong Kong employer) unless he satisfies thethree conditions mentioned in paragraph 109 above.- If, under his employment, a Hong Kong resident rendersservices both in the Mainland and in Hong Kong, and hisaggregated periods of stay in the Mainland do not exceed183 days, income paid or borne by the Mainlandestablishment will be chargeable to individual income tax.Tax will be calculated on the chargeable income and thenapportioned on time basis. Income paid by an overseasemployer (including a Hong Kong employer) is notchargeable.43- If, under his employment, a Hong Kong resident rendersservices both in the Mainland and in Hong Kong, and hisaggregated periods of stay in the Mainland exceed 183days, the total income received from the Mainlandestablishment and the overseas employer (including HongKong employer) will be chargeable to individual incometax. Tax will be calculated on the total income and thenapportioned on time basis.(3) Counting of days of stay for calculating tax liabilities- For tax computation purposes, the aggregated periods ofstay in a year of assessment is the aggregate of the days ineach period of stay where the number of days is countedunder the rule of the “days of physical presence” minusone day.- The Mainland and Hong Kong are geographically so closeto each other that a taxpayer may travel between theMainland and Hong Kong on a particular day and providesservices in both Sides. As such, it is not appropriate toapply the rule of the “days of physical presence” minusone day. However, serious double taxation could occur ifboth Sides apply the rule of “days of physical presence”.To address such cases, the State Administration ofTaxation and the Hong Kong Inland Revenue Departmenthave reached consensus. If a taxpayer travels betweenthe Mainland and Hong Kong on a particular day andprovides services in both Sides, he would be counted aspresent in the Mainland for half a day and in Hong Kongfor half a day. However, if he only provides serviceseither in the Mainland or Hong Kong on that day, hewould be counted as having been present for one day inthe Mainland or Hong Kong, as the case may be.44Article 15 DIRECTORS’ FEES115. Article 15 provides that directors’ fees and other similar paymentsderived by a resident of One Side in his capacity as a member of the board ofdirectors of a company which is a resident of the Other Side may be taxed inthat Other Side. In other words, directors’ fees received by a resident of eitherSide in his capacity as a director of a company may be taxed in the Side ofwhich the company is a resident, irrespective of the period of his stay in eitherSide or the place where the services are actually rendered. Therefore,directors’ fees derived by a Hong Kong resident in his capacity as a director ofa Mainland company will all be subject to the individual income tax in theMainland. Likewise, directors’ fees derived by a Mainland resident in hiscapacity as a director of a Hong Kong company will all be subject to salariestax in Hong Kong. “Directors’ fees and other similar payments” includebenefits in kind (such as share options, the use of a residence or car, health orlife insurance coverage and club memberships). “Directors’ fees and othersimilar payments” do not include wages, salaries and other remunerations paidto a director on account of his other functions with the company (e.g. as anemployee or consultant). Such wages, salaries and other remunerations willbe dealt with in accordance with Article 14 (in the case of income fromemployment) and Article 7 (in the case of business profits).Article 16 ARTISTES AND SPORTSPERSONS116. Paragraph 1 of Article 16 provides that income derived by a residentof One Side as an entertainer, a musician or a sportsperson, from his personalactivities as such exercised in the Other Side, may be taxed in that Other Side.A theatre artiste, a musician or a sportsperson who performs in the Other Sidemay derive substantial amounts of income, yet his stay may only be for a shortperiod of time, usually not exceeding 183 days. Therefore, paragraph 1 ofArticle 16 provides that the relevant income may be taxed in the Side where hisactivities are exercised. In addition, paragraph 2 of Article 16 stipulates thatincome in respect of personal activities exercised by an artiste or a sportspersonmay be taxed in the Side in which the activities are exercised, irrespective ofwhether the income accrues ultimately to the artiste or sportsperson himself orto another person (including a company or any other legal entity). This is toensure that all income derived by an entertainer or a sportsperson in respect of45his personal activities may be taxed in the Side in which the activities areexercised.Article 17 PENSIONS117. Regarding pensions and other similar remuneration paid to a residentof One Side in consideration of past employment, Article 17 stipulates ataxation principle that is different from that on which income from employmentis taxed. The term “pensions and other similar remuneration” includes annuitiespaid in respect of past employment, lump sum payments in lieu of pensionsreceived at the time of or after leaving services, sums received by way ofcommutation of pensions and pensions received by widows and orphans.However, Article 17 does not apply to a lump sum payment made uponcessation of an employment or termination of a contract. Such a paymentfalls within the meaning of income from employment and therefore will betaxed in accordance with the provisions of Article 14.118. According to the provisions of paragraph 1 of Article 17, pensionsreceived by an individual shall be taxable only in the Side of which theindividual is a resident, except that government pensions will be taxed inaccordance with paragraph 2 of Article 18. Paragraph 2 of Article 17 alsostipulates that notwithstanding the provisions of paragraph 1, pensions andother payments made under the following pension schemes shall be taxableonly in the Side in which the schemes are implemented:(1) a public scheme which is part of the social security systemimplemented by the Government of One Side or a localauthority thereof;(2) an arrangement in which individuals may participate to secureretirement benefits and which is recognized for tax purposesin One Side.119. According to the provisions of paragraph 2 of Article 17, pensionsand other similar payments made under a public scheme which is part of thesocial security system implemented in the Mainland shall be taxable only in theMainland; whilst pensions and other similar payments made under a46“recognized retirement scheme” in Hong Kong shall be taxable only in HongKong. In Hong Kong, a “recognized retirement scheme” means a “recognizedoccupational retirement scheme” and a “mandatory provident fund scheme”.Article 18 GOVERNMENT SERVICE120. According to the principle of Article 18, remuneration and pensionspaid by the Government of One Side to an individual (other than an individualwho is a resident of the Other Side and renders services in that Other Side) inrespect of services rendered to that Government, in the discharge ofgovernment functions shall be taxable only in that Side.121. There are three paragraphs in Article 18. Paragraph 1 applies toremuneration other than pensions. Sub-paragraph (1) states that salaries andwages paid by the Government of One Side or a local authority thereof to anindividual in respect of services rendered to that Government or authority, inthe discharge of government functions, shall be taxable only in that Side.Sub-paragraph (2) applies to cases which are exceptions to those covered bysub-paragraph (1). Sub-paragraph (2) stipulates that salaries and wages paidby the Government of One Side or a local authority thereof to an individual inrespect of services rendered to that Government or authority, in the discharge ofgovernment functions shall be taxable only in the Other Side if the services arerendered in that Other Side and the individual is a resident of that Other Sidewho did not become a resident of that Other Side by reason only of therendering of such services. The expression “a resident of that Other Side whodid not become a resident of that Other Side by reason only of the rendering ofsuch services” in sub-paragraph (2) refers to an individual who is originally aresident of that Other Side and does not become the resident of that Other Sideonly because he is employed by the Government of One Side or a localauthority thereof to render services in that Other Side.122. For example, the income of a Hong Kong resident employed by theHong Kong Government to work in its office in Beijing shall be taxable only inHong Kong. On the other hand, the income of a Mainland resident employedby the Hong Kong Government to work in the Beijing office shall be taxableonly in the Mainland. The income of a Mainland resident employed by theCentral People’s Government to work in the Hong Kong office shall be taxable47only in the Mainland. If a Hong Kong resident is employed by the CentralPeople’s Government to work in the Hong Kong office, his income shall betaxable only in Hong Kong.123. Paragraph 2 of Article 18 applies to pensions and its taxationprinciple is the same as that laid in paragraph 1. The expression “or paid outof funds created or contributed as employer” in sub-paragraph (1) makes itclear that pensions include the pensions directly paid by the Government ofOne Side or a local authority thereof and the pensions paid out of funds createdor contributed as employer by the Government of One Side or a local authoritythereof. Sub-paragraph (2) provides for cases which are exceptions to thosecovered by sub-paragraph (1), which is the situation covered in sub-paragraph(2) of paragraph 1, as stated in the foregoing paragraph 121 above.124. Paragraph 3 of Article 18 states clearly that paragraphs 1 and 2 donot apply if the services are rendered in connection with a business carried onby the Government of One Side or a local authority thereof. In such cases theordinary rules apply: Article 14 (Income from Employment) for salaries andwages; Article 15 (Directors’ Fees) for directors’ fees and other similarpayments; Article 16 (Artistes and Sportspersons) for income derived byartistes and sportspersons; and Article 17 (Pensions) for pensions and othersimilar remuneration.Article 19 STUDENTS125. Article 19 gives limited tax exemption to students so as to assist andnurture talents as well as to take care of students’ living expenses. The Articleprovides that “payments which a student who is or was immediately beforevisiting One Side a resident of the Other Side and who is present in the OneSide solely for the purpose of his education receives for the purpose of hismaintenance and education shall not be taxed in that One Side, provided thatsuch payments arise from sources outside that One Side.” Qualifyingpayments include tuition fees, student grants and scholarships from sourcesoutside that One Side.48Article 20 OTHER INCOME126. Article 20 is written by reference to the United Nations Model. Itprovides that items of income of a resident of One Side, wherever arising, notdealt with in the Articles of the Comprehensive Arrangement shall be taxableonly in that Side. However, the abovementioned income, if arising in theOther Side, may also be taxed in that Other Side.127. Article 20 also provides that the provisions of Article 7 (BusinessProfits) shall apply to income, other than income from immovable property asdefined in paragraph 2 of Article 6, if the recipient of such income, being aresident of One Side, carries on business in the Other Side through a permanentestablishment situated therein and a right or property in respect of which theincome is paid is effectively connected with such permanent establishment.Article 21 METHODS FOR ELIMINATION OF DOUBLE TAXATION128. Under the Comprehensive Arrangement, both Sides eliminate doubletaxation by the allowance of a tax credit. In accordance with the provisions ofthe Comprehensive Arrangement, Mainland tax paid in the Mainland in respectof any item of income derived by a resident of Hong Kong will be allowed as acredit against the Hong Kong tax payable on that income by that resident.However, the amount of tax credit will not exceed the amount of tax payable inrespect of that item of income, computed in accordance with the provisions ofthe Ordinance.129. In processing an application for tax credit, One Side will considerwhether the relevant tax is imposed by the Other Side under the laws of thatOther Side (and such laws being in accordance with the provisions of theComprehensive Arrangement). A tax credit will be granted only if the answeris in the affirmative.130. The Comprehensive Arrangement provides that the method forelimination of double taxation adopted in Hong Kong will be subject to theprovisions of the Ordinance relating to the allowance of a deduction and acredit. Section 50 of the Ordinance provides for the allowance of a tax creditin respect of arrangements having effect under section 49. This section49provides the basis for the granting of a tax credit in relation to an item ofincome stipulated in the Comprehensive Arrangement and in respect of whichtax has been paid in the Mainland. Only tax paid in the Mainland can beallowed as a credit under the Comprehensive Arrangement against Hong Kongtax. In accordance with section 50(2), an applicant for a tax credit must beresident in Hong Kong during the year of assessment in which the income isearned. However, if income derived by a Hong Kong resident from theMainland does not arise in Hong Kong, it will not be chargeable to tax in HongKong. The tax paid in the Mainland in respect of that item of income cannotbe allowed as a credit because the question of double taxation does not arise.In the case of a Hong Kong manufacturer whose profits are apportioned on a50:50 basis, only half of the profits will be taxed in Hong Kong. The otherhalf is regarded as having been derived from the Mainland and is thus notchargeable to tax in Hong Kong. Under such circumstances, where tax hasbeen paid in the Mainland in respect of half or less than half of the profits, suchtax will not be allowed as a credit against the Hong Kong tax payable. Ifmore than one half of the profits are regarded by the Mainland as profitsderived therefrom according to the Comprehensive Arrangement, then the taxpaid in the Mainland in respect of such profits, in excess of one half of the totalprofits, will be allowed as a credit against the tax payable in Hong Kong.131. According to the abovementioned tax credit method, the tax credit inrespect of tax paid in the Mainland allowable for set off in Hong Kong iscomputed in accordance with sections 50(3) and 50(5) of the Ordinance asfollows:Example 5HongKongTheMainland$ $Total assessable income (Gross) 1,500Including income in respect of which taxhas been paid in the Mainland inaccordance with the ComprehensiveArrangement500Tax rate (Partnership business) 16% 33%50Tax payableHong Kong : $1,500 x 16% 240The Mainland : $500 x 33% 165Total tax liabilities of the two Sides before allowance of tax credit$240 + $165 = $405Less : Tax credit- Tax paid in the Mainland $165 )or )- The tax credit limit (Note 1) )$500 x 16% = $80 )(whichever is smaller) (80) (Note 2)Total tax liabilities of the two $325 160 + 165Sides after allowance of tax credit(Note 1) In accordance with section 50(5), the amount of tax paid in theMainland not allowed as a tax credit, i.e. $102 ($165 – $63), can beallowed as a deduction as shown in the detailed computation below:$ $Mainland tax paid 165Net income from the Mainland after tax(grossed up at effective Hong Kong tax rate)100%$335 x100% – 16%398Less: Net Income from the Mainlandafter tax $(500 – 165) (335)Less: Tax credit limit for tax paid in the Mainland (63)Tax paid in the Mainland not allowed as a tax credit 102Hong Kong tax payable before tax credit$[1,000 + (500 – 102)] x 16%=$(1,000 + 398) x 16% 223Less: Tax credit limit for tax paid in the Mainland (63)Hong Kong tax payable after allowance of tax credit 16051(Note 2) The formula of the credit limit is based on sections 50(3) and 50(5)of the Ordinance. If the tax payable by a taxpayer is computed atflat rate, the following simplified formula can be used to compute thecredit limit:Tax payable in Hong KongTax credit limitfor tax paid in theMainland=Taxable incomefrom the MainlandxTotal assessable income$Taxable income in the Mainland 500Tax payable in Hong Kong before allowance oftax credit240Total assessable income 1,500Tax credit limit for tax paid in 240the Mainland= $500 x1,500= $80132. In the case of an individual taxpayer whose tax is computed atprogressive tax rates, the tax credit is computed as follows:Example 6$Total Hong Kong assessable income 200,000Including gross income from the Mainland before tax 120,000Tax paid in the Mainland 10,000Tax rate in the Mainland 8.33%Net income after tax from the Mainland 110,000The effective tax rate in Hong Kong and the tax credit are computedas follows:$Total Hong Kong assessable income 200,000Less: Deductible items (12,000)Net assessable income 188,000Less: Personal allowance (100,000)Net chargeable income 88,00052Tax payable on:The first $30,000 x 2% 600The second $30,000 x 7% 2,100The remaining $28,000 x 13% 3,640$88,000 6,340Tax payableThe effective tax rate in Hong Kong =Net assessable incomex 100%6,340=188,000x 100%= 3.37%Net income from the Mainland after tax(grossed up at the effective tax rate in Hong Kong) (Note 1)$100%$110,000 x(100% – 3.37%)113,836Less: Net income from the Mainland after tax (110,000)Tax credit limit for tax paid in the Mainland 3,836Under section 50(5), the actual tax payable in Hong Kong iscomputed as follows:$ $Assessable income (Hong Kong) 80,000Assessable income (the Mainland)after deduction of tax110,000Add: tax deducted in the Mainland 10,000Gross income from the Mainland before tax 120,000Total Hong Kong assessable income 200,000Less: amount not allowed as a tax credit (Note 1) (6,164)193,836Less: Deductible items (12,000)181,836Less: Personal allowance (100,000)Net chargeable income 81,83653Tax payable on:The first $30,000 x 2% 600The second $30,000 x 7% 2,100The remaining $21,836 x 13% 2,838$81,836 5,538Less: tax credit allowed (3,836)Hong Kong tax payable 1,702(Note 1) Under section 50(5), tax paid in the Mainland which is not allowed as atax credit can be deducted from the incomeAmount not allowed as a tax credit $10,000 – $3,836 = $6,164Net income from the Mainland after tax(grossed up at effective tax rate in Hong Kong)$120,000 – $6,164= $113,836133. The computation of tax credits where profits are attributed to apermanent establishment situated in the Mainland:Example 7Hong Kong Resident Company $Total business receipts 15,000,000(from the Mainland and Hong Kong)Assessable profit 1,000,000Profits tax rate (company) 17.5%Tax payable $1,000,000 x 17.5% = 175,000Mainland ContractSales of machinery and equipment including installation (whichtakes more than 6 months to complete) to the Special EconomicZone of the Mainland (Tax rate : 15%)Total price $2,000,000Profits attributed to the permanent establishment = $10,000Enterprise income tax in the Mainland = $10,000 x 15%= $1,50054Tax credit in respect of profits attributed to the permanentestablishment in the Mainland= Tax payableProfits attributed to the permanentestablishment in the MainlandxAssessable profits175,000= $10,000 x1,000,000= $1,750Actual tax credit allowed is to be restricted to the actual tax paid inthe Mainland, i.e. $1,500134. The computation of tax credit for royalties received by Hong Kongresidents:Example 8Hong Kong resident Company D prepares its accounts annually forthe year ending 31 December. For the year ended 31 December2007, Company D receives royalties of $90,000 from the Mainlandand the tax withheld in the Mainland is $6,300 (i.e. $90,000 x 7%).Such royalties are income arising in Hong Kong. The amount ofexpenses allowable for deduction under the Ordinance (excludingthe tax withheld) is $70,000. Company D does not have any otherincome or expenses during the relevant year.$Assessable income for the year of assessment 2007/08$(90,000 – 70,000) 20,000Tax payable before allowance of tax credit(the tax rate for the year 2007/08 is 17.5%) 3,500Less: Tax credit- Tax paid in the Mainland $6,300 )or )55- The tax credit limit (Note 1) )$20,000 x 17.5% = $3,500 )(whichever is smaller) (3,500)(Note 2)Tax payable after allowance of tax credit 0(Note 1) In accordance with section 50(5), tax paid in the Mainland which isnot allowed as a tax credit, i.e. $3,394 ($6,300 – $2,906), can beallowed as a deduction as shown in the detailed computation below:$ $Mainland tax paid 6,300Net income from the Mainland after tax(grossed up at effective Hong Kong tax rate)100%$13,700 x100% – 17.5%16,606Less: Net income from the Mainland after deduction of tax$(20,000 – 6,300) (13,700)Less: Tax credit limit for tax paid in the Mainland (2,906)Tax paid in the Mainland not allowed asa tax credit3,394Hong Kong tax payable before tax credit 2,906$(20,000 – 3,394) x 17.5%Less: Tax credit limit for tax paid in the Mainland (2,906)Hong Kong tax payable after allowance of tax credit 0(Note 2) The formula of the credit limit is based on sections 50(3) and 50(5)of the Ordinance. As the tax payable by Company D is computedat flat rate, the following simplified formula can be used to computethe credit limit:Tax payable in Hong KongTax credit limitfor tax paid in theMainland=Taxable incomefrom the Mainland xTotal assessable income56$Taxable income from the Mainland 20,000Tax payable in Hong Kong beforeallowance of tax credit3,500Total assessable income 20,000Tax credit limit for tax paid $3,500in the Mainland= $20,000 x$20,000= $3,500Example 9Following Example 8, assume Company D, in addition to theroyalties from the Mainland, receives royalties of $80,000 fromThailand and the tax withheld in Thailand is $8,000 (i.e. $80,000 x10%). Company D incurs expenses of $20,000 (excluding the taxwithheld in the Thailand) in the production of royalties fromThailand and such expenses are allowable for deduction under theOrdinance. Company D does not have other income or expensesduring the relevant year.$Assessable income for the year of assessment 2007/08$(90,000 + 80,000 – 70,000 – 20,000) 80,000Tax payable before allowance of tax credit(the tax rate for the year 2007/08 is 17.5%) 14,000Less: Tax credit- Tax credit limit for tax paid in the Mainland,see Example 8 above (3,500)- Tax paid in Thailand $8,000 )or )- The tax credit limit $10,500 )[$(80,000 – 20,000) x 17.5%] )(whichever is smaller) (8,000)Tax payable after allowance of tax credit 2,500Since the Comprehensive Arrangement applies to years of assessmentbeginning on or after 1 April 2007 in Hong Kong, the tax withheld in theMainland in respect of the royalties received by Hong Kong resident Company57D from 1 January 2007 to 31 March 2007 will be allowed as a credit against itsHong Kong tax payable, see paragraph 9 above.135. Section 50(4) of the Ordinance provides that the total tax credit to beallowed to a Hong Kong resident for a year of assessment in respect of foreigntax paid shall not exceed the total tax payable in Hong Kong for that year ofassessment. Therefore, if a Hong Kong resident suffers a loss in a year ofassessment and does not pay any Hong Kong tax (i.e. tax credit allowed iszero), the tax paid by him in the Mainland will not be allowed as a credit.136. Under section 50(5), the amount of tax paid in the Mainland isincluded in computing profits or income subject to tax in Hong Kong.However, due to the differences in tax rates between the Mainland and HongKong, the tax paid in the Mainland may exceed the amount of the credit limit.In such circumstances, the excess is allowed as a deduction. Any tax paid inthe Mainland that is not allowed as a credit is not available to be carriedforward to subsequent years of assessment.137. A claim for a tax credit is required, in accordance with section 50(9)of the Ordinance, to be made within 2 years after the end of the relevant year ofassessment. The claim can be submitted with the tax return for the relevantyear of assessment or made separately in writing. Any dispute over theallowance of a tax credit is to be dealt with in accordance with the objectionand appeal provisions of the Ordinance.138. Under the provisions of section 50(10) of the Ordinance, a HongKong resident who considers that the tax credit allowed for a year ofassessment is excessive or insufficient because of a subsequent adjustment tothe amount of tax payable by either Side can make a claim within 2 years fromthe time when the assessment, adjustment or other determination by either Sidehas been made. The period for lodging the claim will not be limited by thetime for raising an assessment or for lodgement of any other claim under theOrdinance. The relevant assessment, adjustment or determination must bematerial in determining whether and to what extent a tax credit is allowable.It should be noted that those provisions do not apply to any new claim for a taxcredit, as the application for such claim should be made in accordance withsection 50(9).58139. Paragraph 3 of Article 21 provides that where dividends received bya resident company of One Side which controls not less than 10% of the sharesof a resident company of the Other Side, the credit that the resident company ofthat One Side is entitled to will include the tax paid by the company whichpays the dividends in respect of the profits from which such dividends arederived. As dividends are not chargeable to tax in Hong Kong, this provisionwill have no practical application to Hong Kong resident companies.140. Before a tax credit is allowed, it will need to be established to thesatisfaction of the Inland Revenue Department that the tax has been paid by theperson in the Mainland. The person will need to submit the tax computationissued by the tax authority of the Mainland (showing details of the relevantincome and tax paid thereon) together with documentary evidence to the effectthat the tax has been paid and is not subject to any further adjustment.Article 22 NON-DISCRIMINATION141. Paragraph 1 of Article 22 establishes the principle that, for purposesof taxation, discrimination based on the actual situs of an enterprise isforbidden. This paragraph provides that the taxation on a permanentestablishment which an enterprise of One Side has in the Other Side shall notbe less favourably levied in that Other Side than the taxation levied onenterprises of that Other Side carrying on the same activities.142. Paragraph 2 of Article 22 aims at eliminating discrimination on thegrounds of the resident status of the persons receiving payments. Thisparagraph provides that interest, royalties and other disbursements paid by anenterprise of One Side to a resident of the Other Side shall, for the purpose ofdetermining the taxable profits of such enterprise, be deductible under the sameconditions as if they had been paid to a resident of that One Side, except underspecified circumstances.143. Paragraph 3 of Article 22 forbids One Side to give less favourabletreatment to enterprises of that Side where the capital of the enterprise iswholly or partly owned or controlled, directly or indirectly, by one or moreresidents of the Other Side. This paragraph provides that enterprises of OneSide shall not, by reason of their capital being owned or controlled by residents59of the Other Side, be subjected in the One Side to any taxation or anyrequirement connected therewith which is other or more burdensome than thetaxation and connected requirements to which other similar enterprises of theOne Side are or may be subjected.Article 23 MUTUAL AGREEMENT PROCEDURE144. The Comprehensive Arrangement is a bilateral arrangement madebetween the State Administration of Taxation and the Hong Kong InlandRevenue Department after consultation which allocates the right to tax betweenthe two jurisdictions. It sets out mainly matters of principle. In the course ofapplying the Comprehensive Arrangement, it is possible that problems relatingto the specific interpretation of the provisions and uncertainties may arise andneed to be addressed. For this reason, Article 23 provides that the competentauthorities of both Sides shall endeavour to resolve by mutual agreement anydifficulties or doubts arising as to the interpretation or application of theComprehensive Arrangement, and may also consult together for the eliminationof double taxation in cases not provided for in the Comprehensive Arrangement.For the purposes of reaching an agreement, representatives of the competentauthorities of both Sides may meet and exchange their opinions verbally.Consultation in respect of the Comprehensive Arrangement shall be dealt withcentrally between the State Administration of Taxation and the Hong KongInland Revenue Department, and not be conducted separately between theHong Kong Inland Revenue Department and different local taxation authoritiesof the Mainland.145. Paragraph 1 of Article 23 states clearly that where a person considersthat the actions of One Side or both Sides result or will result for him intaxation not in accordance with the provisions of the ComprehensiveArrangement, he may present his case to the competent authority of the Side ofwhich he is a resident. The case must be presented within 3 years from thefirst notification of the action resulting in taxation not in accordance with theprovisions of the Comprehensive Arrangement.146. The competent authority receiving the claim shall endeavour, if theobjection appears to it to be justified, and if it is not itself able to arrive at asatisfactory solution, to resolve the case by mutual agreement with the60competent authority of the Other Side, with a view to the avoidance of taxationwhich is not in accordance with the Comprehensive Arrangement. Anyagreement reached shall be implemented notwithstanding any time limits in therespective domestic laws of both Sides.147. Hong Kong residents presenting to the Commissioner of InlandRevenue a case which satisfies the requirements set out in paragraph 145 above,should also provide all information relevant to the case (e.g. details of activitiesthat give rise to taxation carried out in the Mainland or in Hong Kong, detailsof negotiations with the competent authority of the Mainland including copiesof documents, letters, notices of assessment and demand notes), so that theInland Revenue Department may examine the case and consult with thecompetent authority of the Mainland.Article 24 EXCHANGE OF INFORMATION148. In line with international practice, the Comprehensive Arrangementcontains provisions on the exchange of information. Paragraph 1 of Article 24states that the competent authorities of both Sides shall exchange suchinformation as is necessary for carrying out the provisions of theComprehensive Arrangement or of the domestic laws of both Sides concerningtaxes covered by the Comprehensive Arrangement. Paragraph 1 also makes itclear that the exchange of information is not restricted by Article 1 (PersonsCovered), i.e. information relating to persons who are not residents of One Sideor both Sides may be exchanged, provided that the exchange of information isfor purposes compatible with this Article.149. In order to ensure that information relating to taxpayers will not bemisused, the Comprehensive Arrangement provides that any informationreceived by One Side from the Other Side shall be treated as secret in the samemanner as information obtained under the domestic laws of that Side. In otherwords, both the Mainland and Hong Kong shall keep information obtainedfrom the other party confidential and such information shall be disclosed onlyto persons or authorities concerned with the assessment or collection of, theenforcement or prosecution in respect of, or the determination of appeals inrelation to, the taxes covered by the Comprehensive Arrangement. Suchpersons or authorities shall use the information only for such purposes. They61may disclose the information in public court proceedings or in judicialdecisions, including, in case of Hong Kong, the decisions of the Board ofReview. Both Sides also specify in the Protocol to the ComprehensiveArrangement that information may not be disclosed to any other jurisdictionwithout the consent of the Side which furnished the information in the firstplace.150. Information received by the Mainland from the competent authorityof Hong Kong will not be used by the Mainland to impose taxes which are nottaxes covered by the Comprehensive Arrangement, such as custom duties andvalue-added taxes.151. Paragraph 2 of Article 24 specifies that in no case shall theprovisions of paragraph 1 in relation to the exchange of information beconstrued so as to impose on One Side the obligation to carry outadministrative measures at variance with the laws and the administrativepractice of either Side; to supply information which is not obtainable under thelaws or in the normal course of the administration of either Side; or to supplyinformation which would disclose any trade, business, industrial, commercialor professional secret or trade process, or information, the disclosure of whichwould be contrary to public policy.152. The power conferred on the Inland Revenue Department by virtue ofthe provisions of the Ordinance in relation to the seeking of information isrestricted to cases where any matter relating to any liability or obligation of anyperson under the Ordinance is at issue.153. Currently the Department would, in general, not provide automaticexchange of information, such as supply of bank interest information on aperiodic basis. Nor would the Department spontaneously provide informationwhich it supposes to be of interest to the Mainland. The Department will onlysupply information upon specific requests received from the competentauthority of the Mainland in justifiable cases, and only where such requests arein compliance with the conditions as laid down in the ComprehensiveArrangement. These general rules will also be adopted by the Mainland. Itis understood that the means of seeking information available under the internaltaxation procedures should be exhausted in the first place before any requestfor information would be made to the Other Side.62154. Article 24 provides that the exchange of information shall beconducted by the competent authorities of both Sides. Paragraph 1(8) ofArticle 3 of the Comprehensive Arrangement provides that “competentauthority” means, in the case of the Mainland, the State Administration ofTaxation or its authorized representatives; and in the case of Hong Kong, theCommissioner of Inland Revenue or his authorized representative. Therefore,all requests for exchange of information should be put forward by the StateAdministration of Taxation (unless the State Administration of Taxation hasauthorized a representative). The Hong Kong Inland Revenue Departmentwill not exchange information with unauthorized local tax authorities of theMainland.155. Section 49(5) of the Ordinance stipulates that “where anyarrangements have effect by virtue of this section, the obligation as to secrecyimposed by section 4 shall not prevent the disclosure to any authorized officerof the government with which the arrangements are made of such informationas is required to be disclosed under the arrangements”. In addition, accordingto paragraph (c) of section 58(1) of the Personal Data (Privacy) Ordinance(Chapter 486), disclosure of relevant information to the competent authority ofthe Mainland by the Commissioner of Inland Revenue or his authorizedrepresentative for the purposes of implementing the ComprehensiveArrangement does not violate the information protection principles of thePersonal Data (Privacy) Ordinance.156. The Commissioner of Inland Revenue has obtained legal advice onthe Exchange of Information Article of the Comprehensive Arrangement.Provided that the Inland Revenue Department complies with the rules as laiddown in the Comprehensive Arrangement when carrying out the relevantprovisions, there would be no contravention of the Basic Law or theInternational Covenant on Civil and Political Rights. Hong Kong’s existinglegislation (including the Personal Data (Privacy) Ordinance) does not providethat the Inland Revenue Department should inform the taxpayer concerned if ithas passed on information relating to him to the competent authority of theMainland. Accordingly, the Department would not provide taxpayers withdetails of any such exchanges.157. Information exchange is carried out only after the ComprehensiveArrangement is in force. Where information that existed prior to the entry63into force of the Comprehensive Arrangement is exchanged, such informationshould not be used in the assessment or collection of, the enforcement orprosecution in respect of, or the determination of appeals in relation to, thetaxes for the following years:(1) In the Mainland: any taxable years before 1 January 2007;(2) In Hong Kong: any years of assessment before 1 April 2007.Article 25 MISCELLANEOUS PROVISIONS158. Article 25 states clearly that nothing in the ComprehensiveArrangement shall prejudice the right of either Side to apply its domestic lawsand measures to prevent tax avoidance. “To prevent tax avoidance” shall beconstrued as including the prevention of the abusive use of the ComprehensiveArrangement. In the case of Hong Kong, the laws and measures concerningtax avoidance include sections 5B, 9(1A), 9A, 15(1)(j), 15(1)(k), 15(1)(l), 16(2),16(2A), 16(2B), 16(2C), 16(2D), 16(2E), 16(2F), 16E(2A), 16E(2B), 18D(2A),20, 20AE, 21A(1)(a), 22B, 38B, 39E, 61, 61A and 61B of the Ordinance.Article 26 ENTRY INTO FORCE159. In Hong Kong, the provisions of the Comprehensive Arrangementshall apply to income derived in the years of assessment beginning on or after 1April 2007; and in the Mainland, in the taxable years beginning on or after 1January 2007. The relevant provisions of the Air Services Arrangement(paragraph 6 of Article 11) signed between the Mainland and Hong Kong andthe Limited Arrangement (see paragraph 1 above) shall cease to have effect onthe date on which the Comprehensive Arrangement applies to the relevanttypes of tax. The provisions of the Comprehensive Arrangement shall applyin the Shenzhen Bay Port Hong Kong Port Area from its commencement ofoperation on 1 July 2007.64Article 27 TERMINATION160. The Comprehensive Arrangement shall remain in force indefinitely,but One Side may give the Other Side written notice of termination on orbefore 30 June in any calendar year beginning after the expiration of a periodof 5 years from the date of its entry into force. In such event, theComprehensive Arrangement shall cease to have effect from:(1) in the Mainland: the taxable year beginning on or after 1January in the calendar year next following the year in whichthe notice is given;(2) in Hong Kong: the year of assessment beginning on or after 1April in the calendar year next following the year in which thenotice is given.CONCLUSION161. The Comprehensive Arrangement is intended to effectively resolveproblems of double taxation faced by residents of the Mainland and HongKong and to promote commercial and trading activities between the two Sides.The explanations concerning Mainland taxation treatment mentioned in thisNote (in the Chinese version) have been vetted by the International TaxationDepartment of the State Administration of Taxation. This would contribute tothe effective implementation of the Comprehensive Arrangement.