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In my role as an intern at Ravenscroft & Schmierer, I had a chance to deepen my insights into the complexities of international tax regulations and their impact on multinational enterprises (MNEs). Base Erosion and Profit Shifting (BEPS) 2.0 represents a significant overhaul of global tax rules aimed at addressing tax avoidance by MNEs. These changes are particularly relevant for Hong Kong, a major financial hub with many MNEs.
Author: Ashley Xiaowei Zhu, former intern, now Part-time Paralegal
The Hong Kong Financial Secretary announced in the 2023-24 Budget that starting in 2025, Hong Kong will implement a global minimum effective tax rate of 15% on MNE groups that meet specific criteria. This move reflects Hong Kong's commitment to aligning with international standards and maintaining its competitive edge as a global business centre. Please also see an earlier article we wrote on this topic here.
Understanding BEPS 2.0 Pillars and Their Impact on Tax Jurisdiction
BEPS 2.0 is a major initiative aimed at ensuring that MNEs pay taxes where they operate and generate profits. This framework consists of two pillars:
Pillar One changes how profits are allocated by focusing less on physical presence and more on where economic activities occur. It targets MNEs with global revenues exceeding €20 billion and profits greater than 10% of their revenue.
Pillar Two introduces the Global Anti-Base Erosion (GloBE) rules, mandating a minimum tax rate of 15% for MNE groups with revenues of at least €750 million in two of the last four fiscal years. This pillar has a broader scope, impacting more MNEs.
Our focus is on Pillar Two, particularly the question of tax rights: which jurisdiction collects the additional tax to meet the 15% minimum rate? The rules prioritize different jurisdictions as follows:
Qualified Domestic Minimum Top-up Tax (QDMTT): MNE subsidiary’s domicile Jurisdictions implementing this tax can impose a top-up tax on MNEs to reach the minimum rate.
Income Inclusion Rule (IIR): This rule allows the parent company's jurisdiction to tax additional profits from subsidiaries to meet the minimum rate.
Under-taxed Payments Rule (UTPR): This rule applies when payments between related entities are taxed below the minimum rate, allowing the jurisdiction of the source of the profit to deny deductions or impose taxes.
Subject to Tax Rule (STTR): This allows jurisdictions to tax financial flows within a group if they are taxed below a 9% rate, giving the payer's jurisdiction the right to tax.
In response to these developments, the Hong Kong government initiated the domestic enactment of the Pillar Two global minimum tax—specifically, the GloBE Rules and the proposed introduction of a Domestic Minimum Top-up Tax in Hong Kong (HKMTT).
HKMTT was contemplated to preserve Hong Kong’s primary tax right over profits derived from Hong Kong while honouring its international commitments. Hong Kong's ambition is to configure the HKMTT in alignment with the principles of a QDMTT, embracing certain degrees of flexibility accorded to jurisdictions in administering their respective Domestic Minimum Top-up Taxes. This levy is designed to redress instances where covered MNE operational within Hong Kong are taxed at rates falling below the 15% threshold.
In a broad sense, for Hong Kong, Pillar Two has significant implications. Historically, Hong Kong's low tax rates have attracted MNEs. However, the introduction of the global minimum tax rate means that Hong Kong's tax advantages may diminish unless it adapts its tax policies. Even if Hong Kong does not implement the GloBE rules, MNEs will still be subject to a 15% effective tax rate elsewhere, eliminating tax benefits under the current system.
Hong Kong’s corporate tax rate of 16.5% is slightly above the minimum rate, but due to exemptions and incentives, many businesses have an ETR below 15%. This situation makes it crucial for MNEs operating in Hong Kong to understand how the new rules will affect their tax strategies and obligations. While offshore income exemptions and the absence of capital gains tax remain attractive, these benefits may no longer apply to entities under the minimum tax threshold.
Economic Substance Requirements: Aligning MNE Strategies with Global Tax Standards
The introduction of BEPS 1.0 and 2.0 brings heightened focuses on economic substance requirements, which are critical in ensuring that MNEs pay taxes in jurisdictions where they have substantial activities. The essence of these requirements is to prevent companies from using shell entities in low-tax jurisdictions merely to avoid paying taxes.
According to the Inland Revenue Department, economic substance refers to the "management and control" of a business. "Management" involves overseeing daily operations and implementing top management decisions, while "control" encompasses high-level strategic decisions, such as formulating business policies, making financial choices, and evaluating performance.
Under the GloBE rules, companies can benefit from the economic substance exemption if they have tangible assets and labour costs in a jurisdiction. Specifically, they can exclude 5% of the net value of fixed assets and 5% of labour costs from the profits used to calculate their effective tax rate. This exemption effectively reduces the global minimum tax, incentivizing companies to establish substantial operations where they claim tax benefits.
Significantly, the OECD recognizes independent contractors as eligible employees under economic substance guidelines. This inclusion broadens the definition of economic activity, accommodating modern business practices where traditional employment may not be the norm.
As meeting economic substance requirements is crucial for MNEs striving to legally minimize compliance costs, Hong Kong remains a strategic hub for Chinese companies expanding internationally due to its geographic proximity and cultural alignment with Mainland China. Establishing substantial operations in Hong Kong is straightforward and often perceived by tax authorities as motivated by legitimate business needs, rather than solely for tax benefits. This perception is strengthened by Hong Kong's developed infrastructure and business-friendly environment, making it a favourable jurisdiction for international expansion under evolving global tax standards.
In conclusion, economic substance is a vital component of the global tax landscape. MNEs face increasing challenges in aligning with these requirements, but doing so enhances their strategic position in Hong Kong, reinforcing the region's appeal as a compliant and competitive base for international business. By focusing on substantial economic activities, companies can navigate the complexities of BEPS 2.0 while leveraging Hong Kong's unique advantages.
Hong Kong's implementation of BEPS 2.0: balancing compliance and competitiveness
The introduction of BEPS 2.0 marks a significant shift in the international tax landscape, with profound implications for multinational enterprises (MNEs) operating through Hong Kong. As a leading financial hub, Hong Kong is uniquely positioned to adapt to these changes, leveraging its strategic advantages to remain a key player in global business.
BEPS 2.0 emphasizes the need for MNEs to demonstrate substantial economic activities in jurisdictions where they seek tax benefits. For Hong Kong, this presents both challenges and opportunities. The region's well-developed infrastructure, robust legal framework, and strategic location make it an ideal base for MNEs aiming to align their operations with new international standards.
Hong Kong's response to BEPS 2.0, including the planned implementation of a global minimum tax rate, underscores its commitment to maintaining its competitiveness while adhering to global tax norms. MNEs must now focus on establishing genuine economic substance in their Hong Kong operations, ensuring compliance with evolving regulations and maximizing the benefits of the city's unique advantages.
In conclusion, BEPS 2.0 is not just about compliance; it is an opportunity for Hong Kong to reinforce its position as a premier international business hub. By embracing these changes and fostering an environment of transparency and integrity, Hong Kong can continue to serve as a vital bridge between East and West, driving international trade and investment while upholding the highest standards of fiscal responsibility. For MNEs, this means a renewed focus on aligning their operations with global standards, ensuring long-term success in an increasingly complex tax landscape.
Disclaimer: This publication is general in nature and is not intended to constitute legal advice. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.
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