In 2023, the international business community is going to see some of the most profound changes made to the global tax system since the 1920s, which is when the current set of global tax rules were agreed and established between countries. The obvious question to ask is – how will these changes affect Hong Kong businesses?
The answer might be surprising – not at all for small and medium businesses. Larger businesses in the “big multinational” category though will need to study the changes and seek advice about how they will be affected.
There are two legs to the proposed changes which have been instigated by the Organisation for Economic Co-operation and Development (OECD) and the G20, and which are typically referred to as “Pillar 1” and “Pillar 2.” A total of 139 jurisdictions, including Hong Kong, are participating in the final negotiations concerning points of detail, and 130 have so far endorsed the broad thrust of what is being proposed. It is almost certain that Hong Kong will implement the final proposals, because the effect of not doing so would be to expose Hong Kong to various tax-related sanctions on an international level.
So, what are the two “Pillars” about?
Pillar 1 – giving taxing rights to more countries
Pillar 1 is aimed at a very small group of the world’s largest multinational groups – those that have consolidated revenue exceeding €20 billion per year and whose profit margin exceeds 10%, thus giving rise to “excess profits.” There are, on some accounts, only about 80 groups in this category worldwide. (There is a small handful of Hong Kong-based groups that exceed the €20 billion threshold, but presumably not all of them meet the profit margin threshold.)
Needless to say, most Hong Kong businesses will not be affected by Pillar 1. However, the €20 billion revenue threshold is expected to be reduced to €10 billion after seven years, and this will bring more groups within the scope of Pillar 1.
The original proposal was to apply Pillar 1 only to digital and technology businesses, but now it will apply to all sectors except financial services and extractive industries.
For those who are caught by Pillar 1, the result is that between 20-30% of their “excess profits” will be allocated to the various market jurisdictions where the group has ultimate customers or users, even if the group has no physical presence or subsidiaries in those jurisdictions. The allocation criteria are yet to be finalised. The amounts allocated to each such jurisdiction can be taxed in those jurisdictions. This will give to market jurisdictions a new right to tax some of the profits of multinationals who derive revenues from their markets.
Pillar 1 will not result in additional tax costs to the group because – to the extent that Hong Kong currently taxes those profits – the amount of Hong Kong tax payable will be reduced accordingly through a tax credit. (If no Hong Kong tax is paid because, eg, such profits are currently treated as offshore sourced, then there will likely be an additional tax cost to the group.)
The annual revenue and the profit margin thresholds mean that Pillar 1 is unlikely to apply to more than a small handful of Hong Kong-based groups. One benefit to Hong Kong is that the “excess profits” of many foreign-based groups may be allocated to Hong Kong as one of their market jurisdictions, and these profits can be taxed in Hong Kong. But, the total amounts of taxable income to be reallocated to Hong Kong is likely to be small in the total scheme of things.
The high thresholds have led many countries to criticise Pillar 1 for not going far enough in allocating to market jurisdictions a “fair share” of the profits earned by foreign multinationals who earn revenue from their markets, but who currently pay no tax there because of the way the global tax rules currently work.
Pillar 2 – minimum tax rate
Pillar 2 will have more impact. It applies to groups who have consolidated revenue exceeding €750 million per year (compared to the much higher €20 billion for Pillar 1). There is no profit margin threshold. Groups affected by Pillar 2 will be subjected to a minimum global tax rate of at least 15% (and possibly higher, depending on the final rules – indeed, 20% still remains a possibility). This will have an impact on a much wider range of Hong Kong-based groups, and on an even wider range of foreign-based groups that have subsidiaries and branches in Hong Kong.
One could say that Hong Kong already has a tax rate of 16.5%, so why the concern? This is because Hong Kong’s 16.5% tax rate is typically not applied to all of a group’s profits. Hong Kong exempts from tax such things as capital gains and offshore sourced income, and also taxes certain other types of profits at one-half of the 16.5% rate. The result is that most groups in Hong Kong have an effective tax rate which is far less than 16.5% (realistically, maybe 6-7%).
The new global tax rate will be applied to financial reporting income and will include all income which is currently exempted or taxed concessionally. This means that, unlike Pillar 1, the Pillar 2 tax will increase the effective tax rates of those groups which are above the €750 million revenue threshold, and which currently pay less than 15% tax (or maybe higher) on their financially reported income.
Both listed and private groups are in the scope of Pillar 2. Also, whether the 15% minimum tax rate is met is not calculated on a global base, but for each jurisdiction where the group operates. So, if a group pays 20% tax globally overall but only 10% in Hong Kong, then the tax rate on the Hong Kong profits will be increased to 15%.
Timing and implementation
According to the OECD, the final details of both Pillars are due to be announced in October this year, implementation will proceed globally during 2022, and the new rules will apply in 2023. This is a very optimistic time-frame. As a practical matter, implementation will vary from jurisdiction to jurisdiction. Nevertheless, the OECD in the past has been very effective in operating within very tight deadlines where global tax reform is concerned.
What could stop this?
Could anything prevent this happening? Possibly. Many countries are unhappy about the design features of the rules. Less developed countries are dismayed that most of the fiscal benefits of these two Pillars will flow to developed countries and not to them. They argue the thresholds are too high and they would like to see them reduced. Many assert that the proposed 15% minimum tax rate is too low and insufficient to put an end to global tax planning.
And of course, countries that have offered preferential tax rates and tax exemptions to attract foreign investors, and to encourage domestic investment, will find that such incentives will no longer be meaningful if the investors are going to be taxed elsewhere to make up for these tax savings. But of course, at the global negotiating table, the lesser developed countries have less political power than the developed countries that control the OECD.
Another major impediment might be the politically divided United States, because it is not clear whether the U.S. will implement these proposals (even though the Biden administration supports them). The U.S. already has another version of a minimum tax regime, so that is less contentious. However, Pillar 1 will disproportionately permit countries to tax the profits of larger U.S. multinationals, and this might be a stumbling block in the U.S. legislature. Of course, these proposals could proceed even if the U.S. itself does not agree to implement them.
It’s also possible that only one of the two Pillars will proceed to implementation.
What you need to do
Obviously, for both Pillars 1 and 2, there are many details still to be resolved and globally agreed, and there are many nuances to what is simplistically described above. The main point to note is that, if your organization is in the scope of either Pillar 1 or Pillar 2, you need to take advice and start planning now if you have not already done so.
There will be compliance issues if your group is in scope of either or both Pillars. There will be implications for any subsidiaries your group has in low or zero tax jurisdictions (e.g. BVI) where tax rates are obviously below the new global minimum. There might be additional withholding taxes on payment your group receives from other countries, including Mainland China. All in all, there is a lot of attention that must be directed to these new initiatives.
Michael Olesnicky, Senior Consultant, Tax & Wealth Management at Baker & McKenzie