HK’s proposed dedicated tax regime for offshore aircraft leasing

The Hong Kong Government has put forward a proposal to amend its tax laws to establish a dedicated tax regime for aircraft owners/lessors based in Hong Kong and leasing to offshore (including PRC) lessees/airlines (see Timeline / References below) (“Proposed Regime”).

Assuming there are no surprises or drafting issues in the implementing legislation, once implemented, the Proposed Regime is expected to make Hong Kong an attractive jurisdiction for existing lessors to set up or expand operations and for new debt and equity investors to enter the aircraft financing market, particularly as cross border leasing into the PRC is concerned.

Draft legislation is expected to be available in April. KWM will provide further updates as they are available.

Proposed Regime

1. In summary:

• Only 20% of the tax base (gross rentals minus deductible expenses (but excluding depreciation)) of “qualifying aircraft lessors” will be subject to profits tax; and
• “Qualifying profits” derived from such reduced tax base for “qualifying aircraft lessors” (and for “qualifying aircraft leasing managers” (noting aircraft lessors are usually special purpose companies managed by contracted lease managers)) will be subject to a 50% discount on the prevailing company tax rate of 16.5%.

This would result in a net tax rate of 1.65% (that is, 20% x 8.25%), and an estimated effective maximum tax rate of 4% once adjusted to take into account the inability for aircraft lessors in Hong Kong to claim depreciation allowances when leasing to offshore lessees (see Timeline / References below).

This effective tax rate compares favourably to Ireland’s concessionary rate of 12.5%, and Singapore’s concessionary rate under its Aircraft Leasing Scheme of either 5% or 10% (noting that most Singapore based leasing companies would be paying the higher rate).

The Proposed Regime will be subject to anti-abuse provisions, such as:

• excluding from the tax concessions any rentals which may be tax deducted by the lessee in Hong Kong;
• ensuring that the “qualifying aircraft lessors” and “qualifying aircraft leasing managers” are standalone corporate entities, and deal with their associated entities on arm’s length terms;
• requiring central management and control of the “qualifying lessors” and their profit generating activities to be located in Hong Kong so as to ensure that the relevant businesses will invest in having commercial substance in Hong Kong. Merely incorporating or registering the business in Hong Kong of itself will be insufficient, and holding board meetings in Hong Kong is not necessarily conclusive.

The anti-abuse measures are expected to be modelled on recent similar concessionary tax regimes introduced in Hong Kong, encouraged by the “One Belt One Road Initiative”, such as the dedicated Corporate Treasury Centre regime implemented last year. It is suggested that, in order to unleash the full potential of the Proposed Regime, the implementing legislation should be clear, uniform for all participants, uncomplicated and easy to adopt.

It is also suggested that the implementing legislation should take into account, and, as appropriate, address any unintended consequences of, existing restrictive policies around denial of depreciation allowances for offshore aircraft leasing activity, aircraft ownership and aircraft income tax relief arrangements, denial of certain interest costs and the desirability of establishing new policies in a way which is seen to be compliant with OECD’s Base Erosion and Profit Shifting (BEPS) initiatives.

2. Objectives

The Proposed Regime is designed to:

capitalise on the vast leasing opportunities with respect to the Mainland specifically and Asia Pacific more generally, supplementing the existing aircraft leasing hubs in the US, Ireland, Singapore and the Chinese Free Trade Zones.

When putting forward the Proposed Regime, the Government cited estimates that in the 20 years to 2032, Mainland airlines will need nearly 6000 aircraft at a value of HK$6,100 billion, and that around 40% of all new aircraft will be destined for Asia Pacific (with 45% of that amount going to the Mainland), thereby further incentivising the need for a hub in Asia and particularly Hong Kong.

Combined with an uptick in the global leasing market, the dedicated tax regime is expected to attract around 18% of the global leasing market to Hong Kong, resulting in, over a period of 20 years, financing opportunities for over 3200 aircraft at a value of HK$707 billion, HK$2 billion in compensation associated with 1640 new jobs (without taking into account the knock on effect on jobs in related and unrelated service industries, and more than HK$10 billion in additional government revenue).

generate new investment opportunities and economic activity in Hong Kong, complementing the “Belt and Road Initiative” and existing dedicated concessionary tax regimes including in the areas of asset management, PE/funds investment and Corporate Treasury Centres.

negate the unintended impediment to growth in aircraft leasing in Hong Kong largely due to the operation of Section 39E of the Inland Revenue Ordinance which denies Hong Kong lessors who are leasing aircraft to offshore lessees the ability to claim depreciation allowances (see Timeline / References below). This anti-abuse provision was introduced to the tax law in 1992 to target tax planning schemes in the 1980s which caused a significant drain on the public revenue, but it was drafted so broadly that it discouraged all aircraft leasing in Hong Kong. The impact of the tax planning schemes still plays large in the minds of the Government that it makes it difficult for the Government to revisit the operation of Section 39E of the Inland Revenue Ordinance.

Commentary

1. Why Hong Kong?

Hong Kong already boasts a conducive environment for financial services industry businesses and their investors. Hong Kong has the advantage of being one of the world’s leading financial centres with a well-established legal system that is based on the common law system and yet having the benefit of a mutual enforcement treaty with the Mainland (pursuant to the bespoke enforcement agreement, the “Arrangement Concerning Mutual Enforcement of Arbitral Awards Between the Mainland and Hong Kong (June 1999)).

Furthermore, consistent with its free-market philosophy, there are generally no restrictions on foreign investment, no special licensing or authorisation requirements to conduct a leasing business and no generally applicable withholding or capital gains tax nor general tax on the sale of goods or services or value-added tax.

2. Withholding tax treaty network may hold it back

Aircraft lessors and investors will continue their activities through the current hubs (Ireland (which reportedly housed around 55% or 6000 of all leased aircraft in 2015), Singapore, US and the Chinese free trade zones (primarily Tianjin)). If they are not already looking closely at establishing or expanding their presence in Hong Kong, particularly to service the rapidly expanding PRC market, the Proposed Regime would certainly provide them the impetus to do so.

Ireland, Singapore and Hong Kong approximately have in place double taxation treaties with 70, 85 and 36 countries, making the former two jurisdictions more compatible for a global aviation hub.

PRC focus

There is no doubt the Proposed Regime is intended solely to capitalise on the opportunities being generated in the PRC market. As a precursor, Hong Kong and the Mainland amended their double tax treaty to ensure that Hong Kong has a more favourable treaty with the Mainland as compared to Ireland and Singapore (see Timeline / References below).

That said, Hong Kong’s tax treaties with nearby airline jurisdictions in Asia Pacific may also play an important part in its development as an aviation hub.

Furthermore, PRC lessors and airlines will look upon Hong Kong more favourably from a pre-existing presence, familiarity and proximity perspective, and may particularly look to Hong Kong to channel foreign investment for their onshore PRC aircraft financing requirements.

With the backdrop of the changes to the accounting standards under IFRS 16 in 2019, perhaps yet another factor in the mix is the potential advantage for Hong Kong over Ireland and Singapore in being able to provide the requisite environment for funding aircraft residuals and lease receivables in USD and RMB respectively.

Where aircraft leases are structured from or through Hong Kong to the PRC through the Chinese free trade zones, Hong Kong will complement the use of the PRC free trade zone leasing platforms, thereby creating investment opportunities and driving economic activity in Hong Kong even where the eventual bottom leg of the leasing chain sits within the PRC.

Timeline / References

1986 – Section 39E of the Inland Revenue Ordinance enacts anti-avoidance measure to target Hong Kong lessors using “sale and lease back” and “leveraged leasing” arrangements.

1990 – Hong Kong Government laments drain on public purse through misuse of depreciation allowances (particularly accelerated depreciation arrangement, loss sharing partnership arrangements, tax deferral arrangements and other tax sheltering schemes).

1992 – Section 39E of the Inland Revenue Ordinance amended to deny depreciation allowances to lessors where their lessee does not operate a Hong Kong registered aircraft, that is, restricting depreciation only where the operator holds a Hong Kong air operator’s certificate. Results in discouraging any aircraft leasing business based in Hong Kong.

1 July 1997 – Hong Kong is handed back to the PRC. The Basic Law of the Hong Kong Special Administration Region of the People’s Republic of China comes into effect. Article 128 provides that the Government will provide conditions and take measures for the maintenance of the status of Hong Kong as a centre of international and regional aviation.

16 January 2013 – Government cites the PRC 12th Five-Year Plan regarding Hong Kong’s development as an international asset management centre. Announces establishment of the Economic Development Commission (including, a Working Group on Transportation, with the purpose of examining the feasibility of developing Hong Kong into an international centre for aircraft financing).

19 December 2013 – Opinions of the General Office of the State Council on Acceleration of the Development of Aircraft Leasing Industry Guo Ban Fa No. [2013] 108 (“Circular No. 108”) is released. Recognising that it is the “golden period for the development of the aircraft leasing industry in China”, presents a “three step” strategy (prior to 2015: create favourable policy environment; 2015-2020: cultivate leading enterprises including through consolidation and expansion; 2020-2030: create leasing industry clusters) and puts forward seven policy measures (improving management of purchasing and leasing aircraft; supporting financing initiatives; improving fiscal and taxation policies; tapping into international market opportunities; assisting with risk prevention and control; developing professional support services and building on the pilot programs set-up in the Chinese free trade zones). See link: http://www.szqh.com.cn/What_is_Qianhai/Revolutionary_Policy_Support/201410/P020141031526123762411.pdf

1 April 2015 (with effect from 29 December 2015) – Hong Kong and the Mainland amend the 2008 Double Taxation Arrangement to reduce the withholding tax rate for payments from the Mainland to Hong Kong from 7% to 5%. This had the effect of the withholding tax rate being more competitive than the withholding tax rate for payment from the Mainland to Ireland (6%) and from the Mainland to Singapore (6%).

13 January 2016 – 2016 Policy Address contains announcement that the Government is formulating measures to develop Hong Kong into an aviation financing centre.

26 February 2016 – Citing the Irish and Singapore experience, the Financial Secretary indicates in the 2016-2017 Budget that the Government will explore the feasibility of using tax concessions to boost aircraft leasing activity.

18 January 2017 – 2017 Policy Address contains announcement that tax concessions to be offered to attract aircraft leasing businesses. See link: http://www.legco.gov.hk/yr16-17/english/panels/1617agenda-e.pdf

20 January 2017 – Legislative Council Secretariat releases the Hong Kong Government’s proposed dedicated tax regime to attract to and encourage new investment in Hong Kong for offshore aircraft leasing (LC Paper No. CB(4)410/16-17(08)). See link: http://www.legco.gov.hk/yr16-17/english/panels/edev/papers/edev20170123cb4-410-8-e.pdf and LC Paper No. ISE17/15-16) http://www.legco.gov.hk/research-publications/english/essentials-1516ise17-key-drivers-for-developing-an-aircraft-leasing-centre.htm

23 January 2017 – Legislative Council Panel of Economic Development are briefed by the Secretary for Transport and Housing of Hong Kong and the Deputy Commissioner of Hong Kong’s Inland Revenue about the proposed dedicated tax regime. Chinese and English versions of the discussion can be found at: See link: http://webcast.legco.gov.hk/public/en-us/SearchResult?MeetingID=M17010015

April 2017 (expected) – Draft legislation amending the Inland Revenue Ordinance expected to be introduced in the Legislative Council.