This article was first published in the July 2011 China edition of Accounting and Business magazine.
Hong Kong has achieved phenomenal growth in its tax treaty network over the last couple of years. While investors have been hoping to enjoy the benefits of double taxation agreements (DTAs), there are in fact a few hiccups in the treaty application process.
However, the problems are not necessarily caused by the treaty clauses themselves. Very often it is the domestic anti-avoidance regulations imposed by governments that prevent the residents of the other contracting party [foreign investors] from obtaining the treaty benefits.
There are a growing number of governments that impose local anti-avoidance mechanisms so as to combat tax treaty abuses, and there is a genuine need to put them in place.
However, if these domestic anti-avoidance regulations have not had due deliberations, and consideration is not given to possible incompatibility with the taxation system of the counterparty, the potential DTA benefits remain ‘on paper’. One of the examples is the DTA between Hong Kong and Indonesia (the HK-Indo Treaty), which was signed in March 2010, but at the time of going to press was not yet effective.
The ‘paper’ treaty benefit
In an article in AB China in October 2010, some of our colleagues at Deloitte gave an account of the essential features of the HK-Indo Treaty. When compared with other DTAs that Indonesia has entered into with other jurisdictions like China, the Netherlands and Singapore, the key provisions are more advantageous, particularly in terms of the dividend and royalty withholding tax rate of 5% (given that the dividend and royalty withholding tax rates under the DTAs between Indonesia and the above countries range from 10% to 15%).
These apparent treaty benefits coupled with other advantages have been perceived as catalysts for using Hong Kong as a prime regional service centre, an ideal location for goods and services under turnkey projects and a platform for foreign enterprises to set up their holding companies.
Obstacles in application
However, the Indonesian Directorate General of Taxation (IDGT) issued two regulations on 5 November 2009 and they became effective from 1 January 2010 onwards. The two regulations are the Procedures for the Application of Double Taxation Agreements – PER-61/PJ/2009 (Regulation 61) and the Prevention of Tax Treaty Abuse – PER-62/PJ/2009 (Regulation 62).
On 30 April 2010, with the aim of providing certainty in the application of these two regulations, the IDGT issued PER-24/PJ/2010 (Regulation 24) as the amendment to Regulation 61; and PER-25/PJ/2010 (Regulation 25) as the amendment to Regulation 62.
These regulations and the respective amendments provide administrative guidance on the implementation and prevention of abuse of tax treaties concluded between Indonesia and its counterparts.
Regulations 61 and 24 need to be read in conjunction with Regulations 62 and 25. The former set of regulations basically set out the requirements to treaty partners for obtaining tax treaty benefits.
The requirements are that the recipient of the income is not a domestic Indonesian tax subject and second, the administrative requirements to apply the provisions stipulated in the DTA have been met and lastly, there is no misuse of the DTA by the foreign recipient as stipulated in the provisions of the latter set.
If any of the above requirements are not satisfied, tax is withheld in accordance with the prevailing domestic income tax law in Indonesia, and a foreign taxpayer that is abusing the DTA is not allowed to ask for a refund of overpaid tax, even though it is a resident of the other contracting party under the respective DTA with Indonesia.
Regulations 62 and 25 stipulate and clarify that ‘abuse’ of a DTA occurs in the following situations:
- A transaction that has no economic substance is carried out using a structure or scheme that is solely arranged to obtain the DTA benefits.
- A transaction has a structure or scheme having its legal form that is different from the economic substance, with a sole purpose to obtain benefits from a DTA.
- The recipient of the income is not the actual owner of the economic benefit of the income; in other words, when the income recipient is acting as an agent, a nominee or a conduit company. It will be applied only in respect of income for which the relevant treaty article contains a beneficial owner requirement.
Also, they state that the following individuals or entities will not be deemed to have committed tax treaty abuse:
- An individual who does not act as an agent or nominee.
- An institution expressly identified in the treaty or one that has been jointly approved by the competent authorities of Indonesia and the treaty partner country.
- A foreign taxpayer (apart from the one acting as an agent or nominee) which receives income (other than interest and dividends) through a custodian in connection with transfers of shares or bonds that are traded or reported in a capital market in Indonesia.
- A company whose shares are listed in a capital market and regularly traded.
- A bank.
- A company that fulfils all of the following requirements, ie, the ‘six conditions safe harbour’:
(a) Purpose: the establishment of the company or the arrangement of the transaction structure or scheme is not aimed solely at utilising the treaty.
(b) Management: the company’s business activities are managed by its own management which has sufficient authority to perform transactions.
(c) Employees: the company has employees.
(d) Active business/activities: the company has an active business or activities.
(e) Income subject to tax: the company’s income derived from Indonesia is subject to tax in the treaty country, even if ultimately the non-resident is not taxed because of zero rate or exemption from tax by complying with certain requirements etc.
(f) Fifty per cent limit on base erosion: the company does not use more than 50% of its total income to fulfil obligations to other parties, for example, in the form of interest, royalties, or other compensation.
We use dividends as an example to illustrate how the above regulations impact the HK-Indo Treaty. Based on the above domestic anti-avoidance regulations imposed by the Indonesian government, a Hong Kong resident holding company that receives dividends from its subsidiary in Indonesia might be prevented from obtaining the preferred dividends withholding tax rates of 5%, even though it acts in good faith.
The holding company is not able to meet all the ‘six conditions safe harbour’. Specifically, it cannot meet the ‘income subject to tax’ condition (e) since dividends received by the resident Hong Kong holding company are not subject to tax in Hong Kong.
The situation elsewhere
Other jurisdictions that have DTAs with Indonesia, for instance, China and the Netherlands, impose taxes on dividends received by their resident companies. Similar to the taxation system of Hong Kong, Singapore’s tax system is also territorial but foreign source income is taxed if it is remitted into Singapore. In this manner, dividends received in Singapore by resident companies are taxable with credit allowed for foreign tax paid, or are exempt if certain conditions are met.
It seems that Hong Kong is one of the few treaty partners of Indonesia that has problems in achieving the DTA benefits. Even though the HK-Indo Treaty mentions it shall not prejudice the right of local government to implement anti-avoidance measures (article 27), it will hurt the interests of both parties if the problem cannot be solved.
Is there a way out?
Since the HK-Indo Treaty is not yet effective and there is no precedent case to demonstrate how these regulations will be enforced by the Indonesian government, it is a potential problem yet to be solved. Under the regulations mentioned above, if not all the ‘six conditions safe harbour’ are met, an Indonesian dividend payer has to withhold tax at the non-treaty rate of 20%.
Nevertheless, Hong Kong resident companies which have no intent to abuse the HK-Indo Treaty, theoretically, may attempt to apply for a refund of the excess (being 20% less 5%) and get back the tax benefits that they should have obtained under the DTA. It is uncertain whether the excess amount of tax withheld would be refunded and when, even though Regulation 25 specifies that if a non-resident taxpayer does not abuse a treaty, it will be entitled to treaty benefits.
Alternatively, Article 24, Mutual Agreement Procedure (MAP), of the HK-Indo Treaty allows competent authorities from the governments of the contracting parties to negotiate with the intent to resolve the disputes. In reality, however, the MAP article does not compel competent authorities to reach an agreement and resolve the tax disputes. They are only obliged to exert their best efforts to reach an agreement. This is time-consuming and the outcome is uncertain.
We certainly appreciate the efforts of the Inland Revenue Department (IRD) to build up the DTA network of Hong Kong. We expect there will be more DTAs concluded and put into force this year. The expansion of the DTA network is essential to consolidate the strength of Hong Kong and shape it as an international hub for global businesses.
However, it is equally important for the IRD to stand up for the interests of the Hong Kong resident entities when they are having disputes or problems dealing with the foreign governments in the course of DTA interpretations or applications. In the case of the HK-Indo Treaty, it would be constructive if the governments of Hong Kong and Indonesia could discuss and enter into a protocol to the HK-Indo Treaty.
An example is the DTA between Singapore and Ireland. Under the tax law in Singapore, there is a ‘15% headline tax rate’ condition that exempts foreign-sourced dividends received in Singapore from tax, if the highest corporate tax rate levied under the law of the dividend paying entity’s country is not less than 15%. Singapore resident companies receiving dividends from Ireland will not meet the ‘15% headline tax rate’ condition since the standard rate on trading income is 12.5% in Ireland.
However, the governments of Singapore and Ireland effectively addressed the problem by entering into a protocol to the DTA between Singapore and Ireland, stating that the ‘15% headline tax rate’ condition shall be considered fulfilled.
In the case of the HK-Indo Treaty, a possible protocol could state that the ‘income subject to tax’ condition shall be considered fulfilled for the purposes of the domestic tax laws in Indonesia. Such rectification will benefit not only Hong Kong but Indonesia as well.
Unless the issue is addressed, Hong Kong risks losing its competitive edge to neighbouring countries like Singapore, in attracting foreign investors to establish their regional headquarters in Hong Kong. Also, Indonesia will lose potential investments from or via Hong Kong.
Davy Yun is a tax partner and Kelvin Mak is senior tax manager at Deloitte Hong Kong