The IRD Releases Practice Notes on the Concessionary Tax Regime for Aircraft Leasing in Hong Kong
In July 2017, the Hong Kong Government enacted the Inland Revenue (Amendment) (No. 3) Ordinance 2017, introducing a concessionary tax regime to promote the Hong Kong aircraft leasing industry. The Inland Revenue Department (IRD) has since released the Departmental Interpretation and Practice Notes No. 54 – Taxation of Aircraft Leasing Activities (DIPN 54), which provides guidance on the IRD’s interpretation of the legislative regime. This briefing highlights several clarifications provided in DIPN 54 around the operation of the regime.
Overview of the Regime
Under the regime, an 8.25% tax rate (i.e., half of the prevailing corporate tax rate) applies to the assessable profits of (i) qualifying aircraft lessors, and (ii) qualifying managers providing leasing management services (including aircraft financing activities) to qualifying aircraft lessors. Additionally, in lieu of tax depreciation allowances, the assessable amount of leasing income of a qualifying aircraft lessor is deemed to be 20% of the gross leasing income less deductible expenditure (excluding depreciation allowances).
The tax concessions can apply to profits derived on or after 1 April 2017. In respect of aircraft lessors, DIPN 54 confirms that the concession applies not only to leasing income, but also any incidental income such as interest income, exchange gains, or hedging gains, as long as the transactions are ancillary to the qualifying leasing activities.
The regime extends to leasing activities with both offshore and Hong Kong aircraft operators. You can read our Client Alert of 12 July 2017 for further details regarding the key features of the regime here. There are a couple of aspects of the issues discussed in DIPN 54 that are worth highlighting.
Notable Issues Discussed in DIPN 54
Central management and control (CMC)
To qualify for the regime, lessors and managers must have their CMC in Hong Kong. DIPN 54 clarifies that this requires the executive officers and senior management employees of the lessors and managers to primarily (if not solely) exercise their day-to-day responsibility of any strategic, financial and operational policy decision making in Hong Kong. This may be the location where board meetings are held if this is the place where actual decision making is made.
Another critical qualifying criterion is that the lessors and managers must also carry on substantial activities that produce the qualifying profits in Hong Kong. DIPN 54 specifies that this may include activities such as fund-raising, negotiation and execution of key documents, soliciting lessees, and maintenance of documents. These activities would ordinarily be supported by 2 Baker McKenzie December 2017 full-time employees with necessary qualifications, and would entail incurring a reasonable level of operating expenditures by the lessor or manager in Hong Kong. It is worth noting that DIPN 54 clarifies that the use of a third party or a group entity to carry out the core income generating activities should not necessarily impact on fulfilling this condition provided that these activities are arranged by the employees of the lessor or manager in Hong Kong and are not attributable to a non-Hong Kong permanent establishment. Whether there are substantial activities in Hong Kong will depend on the facts and circumstances of each case.
A realistic business plan will need to be submitted to the IRD in the year in which the aircraft leasing or management business commences, to allow the IRD to make an assessment as to whether the
substantial activity requirement has been fulfilled. This protocol is a new practice adopted by the IRD and was not mentioned as a requirement under the corporate treasury center regime (which was introduced back in 2016) which also has the substantial activity requirement.
Certificate of resident status
DIPN 54 also indicates that, as a rule of thumb, the IRD will not issue a Hong Kong tax residency certificate to an aircraft lessor or leasing manager for tax treaty purposes unless the entity satisfies both the CMC and substantial activity requirements. This would be particularly relevant for lessors looking to manage their offshore withholding tax exposure in relation to rental payments from offshore aircraft operators.
The leasing activity must be in respect of a "dry lease" (i.e., a bare lease that exceeds one year) under which the lessor must substantially assume the risks and be entitled to the rewards incidental to the economic ownership of the aircraft. As such, certain types of finance leases (also referred to as "funding leases" under the regime) would not come within the scope of the qualifying leasing regime.
To help to clarify the scope of permissible leasing structures that could fall within the regime, DIPN 54 considers a number of common leasing transaction structures, including sale and lease back, lease-in-lease-out, guaranteed financing, and securitization arrangements. All of these arrangements can qualify under the regime if the economic ownership of the aircraft rests with the lessor.
Option to acquire
A lease would be treated as a "funding lease" (and therefore not qualify for the regime) if the ownership of the aircraft will or may pass to the lessee at the end of the lease. Any separate arrangement or agreement such as a purchase option agreement or rental rebate agreement may be deemed to be part of a lease (so that they are considered as a single arrangement for this determination). In general, if the lessor provides to the lessee in a separate agreement an option to purchase the aircraft at market value at the end of the lease, this option would not by itself cause the lease to become a funding lease.
In order for a leasing manager to qualify under the regime, the manager must operate within the safe harbor rules which require that at least 75% of the profits of the manager, and 75% of the assets of the manager, must be attributable to the aircraft leasing management business of the manager. As it is not unusual for the leasing manager to be the holding company for the leasing group, DIPN 54 confirms that the IRD will permit the equity investment and profits arising thereof, to be excluded in determining whether the manager meets the safe harbor threshold.
Disposal of aircraft
A specific rule (section 14H(8) of the Inland Revenue Ordinance) has been included to deem that any gain arising from the disposal of an aircraft used for carrying on a qualifying aircraft leasing activity for a continuous period of at least 3 years immediately prior to the disposal would be treated as a capital gain not chargeable to tax. DIPN 54 clarifies that a disposal of aircraft that falls outside this (e.g. an aircraft which has been leased for less than 3 years) would not necessarily be treated as revenue account property and the general common law principles would apply in determining whether such gain is of a capital nature.
As noted in our Client Alert of 12 July 2017, a tax arbitrage rule has been included to ensure that any amount paid to a qualifying lessor or leasing manager will not generate a tax deduction at the full tax rate to the payer (the deduction will be adjusted by the level of tax reduction enjoyed by the qualifying lessor or leasing manager). DIPN 54 clarifies that this tax arbitrage rule will only apply where the payer is subject to the full tax rate and will not apply where both the payer and the recipient are subject to the concessionary tax regime.
It is evident that the IRD has made a significant effort to produce a helpful guidance on the operation of the aircraft tax concessionary regime. DIPN 54 appears more thorough than the practice notes that have been issued in relation to other concessionary regimes such as the corporate treasury center regime (which shares similar qualifying criteria with the aircraft leasing regime). This is an encouraging sign for aircraft leasing groups that are considering a move to Hong Kong.