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Consultation Conclusions Proposed Amendments to the Inland Revenue Ordinance (“IRO”) (Cap.112) and the Stamp Duty Ordinance

(“SDO”) (Cap.117) to Facilitate Development of an Islamic Bond (i.e. Sukuk) Market in Hong Kong

Question 1 Do you agree that the description in paragraph 3.2 can accurately reflect the general features of sukuk in the market? Please explain the reasons for your views. 1.   Wakalah sukuk

 Most respondents broadly agree that the description in paragraph 3.2 can accurately reflect the general features of sukuk in the market. A number of respondents suggest that the scope of the legislative proposal (i.e. the Bill) should include Wakalah (agency) sukuk, apart from the four common types of sukuk discussed (viz. Ijarah, Musharakah, Mudarabah and Murabahah). A few also note that other types of sukuk such as sukuk al-salam or sukuk al-istisna may be considered. 

Our view  We will consider including Wakalah (agency) sukuk in the Bill, apart from the four common types of sukuk mentioned in the Consultation Paper (“CP”), given its increasing popularity in the global sukuk market in recent years. The Bill will also build in flexibility to enable the expansion of the scope of the sukuk covered in the IRO and SDO by way of subsidiary legislation when necessary in future (see paragraph 3.13 of the CP).  

2.   Use of bond proceeds There are some views that the requirement for a bond-issuer to use the whole of the bond proceeds to acquire an asset or assets to be held under an alternative bond scheme may be too restrictive.

Our view We agree to the market views and will remove this restriction. We will further clarify in Inland Revenue Department (“IRD”)’s Departmental Interpretation and Practice Notes (“DIPNs”) that part of the bond proceeds may be used to defray necessary expenses in connection

Annex

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with the issuance of the alternative bonds. 3.   Definition of asset

A few respondents raise questions about the definition of “asset”, including whether it can be expanded to include intangible assets and whether it is restricted to certain types of investments.

Our view The Bill will define the term “asset” to cover any property (as defined in Cap 1) or any class of property. This will cover intangible assets.

4.   How “sukuk” should be named in the Bill? One respondent is of the view that the term “Bond Arrangements” can be named “Certificate Arrangement”, while another suggests that terminologies such as “sukuk” and “trust certificates” can be used.

Our view “Sukuk” are commonly termed as “Islamic bonds”. To distinguish “sukuk” from conventional bonds, we have added the word “alternative” before “bond” in the Bill. We do not propose using the term “sukuk” since a religion-neutral approach is adopted in drafting the Bill, as in the case in the United Kingdom ("UK"). We note that in the UK tax law, the term “alternative finance investment bond” is used.

5.   Overseas Special Purpose Vehicles (“SPVs”) There are questions on whether there will be any difference if the SPVs in a sukuk arrangement are not Hong Kong entities.

Our view The Bill allows the use of SPVs formed in or outside of Hong Kong, although the relevant tax exposure will depend on where the incomes or profits are sourced or derived.

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6.   Tripartite structures A few respondents recommend that the Bill should cover those structures which involve more than one SPV or no SPV. There are also observations that it is only the Middle East which requires sukuk to adopt a tripartite structure whereas in Malaysia two-party structure under the Shafi school is allowed.

Our view We understand from market players that the majority of sukuk in the global markets involves a tripartite structure. We suggest using this as the basis to characterise an alternative bond scheme under the Bill. We will consider how to deal with other sukuk structures in future, having regard to evolving market demand and products.

7.   Asset-backed sukuk Since asset-backed sukuk are also covered under the proposed amendments, a respondent suggests making it clear that all relevant taxes or duties payable under conventional asset-backed securities are also applicable to asset-backed sukuk.

Our view It has been our intention that all relevant taxes or duties payable under conventional asset-backed securities are also applicable to asset-backed sukuk. Asset-backed sukuk may be able to enjoy the proposed tax treatment so long as all the relevant qualifying conditions are met, bringing them on par with conventional asset-backed securities.

Question 2 Do you agree that the description in paragraph 3.4 can accurately reflect the key features of the underlying structure of Ijarah sukuk in the market? Please explain the reasons for your views. 8.   Concept of servicing agency

Many respondents agree that the description in paragraph 3.4 can accurately reflect the key features of the

Our view We are aware of the servicing agency concept underpinning some Ijarah structures. The Bill will only

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underlying structure of Ijarah sukuk in the market. However, there are some views that it is preferable to include the servicing agency concept as part of the key features of the Ijarah sukuk, in which case the bond-issuer as owner of the specified asset appoints the originator as its servicing agent for services such as major maintenance and structural repair of the specified asset, procurement of insurance and payment of ownership taxes.

set out the core or most important features or characteristics of major types of sukuk. We will cover other parameters in the DIPNs and Stamp Office Interpretation and Practice Notes (“SOIPNs”) as appropriate.

9.   Originator fails to complete the repurchase Question arises as to what will happen if the originator is unable to complete the repurchase in particular circumstances, given that one of the specific features for a leaseback arrangement is that the bond-issuer is to dispose of the specified asset to the originator, whether or not in stages, by the end of the specified term. Some respondents are also concerned that, if the originator is unable to do so in particular circumstances, the arrangement will be disqualified as a specified investment arrangement and will trigger retroactive withdrawal of the special tax treatment.

Our view As far as the proposed tax treatment is concerned, our intention is that if the failure to complete the repurchase is due to default on the part of the originator, this will not render the disqualification of a qualified investment arrangement. This will be further illustrated in the DIPNs and SOIPNs.

10.   Shariah requirement A few respondents suggest that the proposed legislation should be written in a way to clarify the Shariah

Our view As far as this tax legislation is concerned, we will take a religion-neutral approach without specific references to

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requirement with respect to the underlying asset and, if a headlease and sublease structure is used, the leasehold interest. A respondent also suggests clarifying that the originator would purchase back the specified asset through a unilateral purchase undertaking in favour of the bond-issuer, since an agreement between parties for future sale of assets is not allowed under Shariah.

Shariah principles. We will only set out the core or most important features of the common types of sukuk concerned in the Bill. This will not preclude sukuk from complying with Shariah principles, or preclude Shariah-compliant products from benefiting from the proposed tax treatment.

11.   Use of assets by originator A few respondents ask whether, under the leaseback arrangement, the originator needs to use the asset itself or whether it can further sub-lease the specified asset to third parties.

Our view To cater for the evolving market, we do not intend to impose a restriction on the use of the specified asset by the originator under the Bill.

12.   Originator must be the asset owner? Some respondents note that, in practice, under the leaseback arrangement, sometimes the originator is not the “asset owner”.

Our view Taking into consideration market views, the Bill will provide flexibility to cater for the scenario under which the asset comes from a third party other than the originator.

Question 3 Do you agree that the description in paragraph 3.5 can accurately describe the asset replacement scenarios? Please explain the reasons for your views. 13.   Clarification of certain concepts

Respondents in general agree that the description in

Our view For the sake of giving the market the necessary

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paragraph 3.5 can accurately describe the asset replacement scenarios. However, some respondents wish the Administration to clarify certain concepts, such as absence of cash flow or payments in the case of asset substitution, the use of insurance proceeds in the case of a partial loss or total loss, as well as the detailed replacement mechanism and requirements.

flexibility, we would suggest not specifying such parameters or further restrictions in the Bill. It will be sufficient for the Bill to set out the core characteristics or elements underpinning a leaseback arrangement. We will clarify some of the issues asked by respondents in the DIPNs and SOIPNs, insofar as these issues may relate to the proposed tax treatment.

14.   Partial redemption mechanism with only one asset A question is raised on how the partial redemption mechanism will work to transfer the ownership of the asset if there is only one underlying asset.

Our view Partial redemption can happen when the specified assets consist of more than one individual asset, or if there is only one asset, the asset can be disposed of in parts or shares.

15.   How “insurance” should be named A few respondents suggest replacing the word “insurance” by “Takaful” or an “indemnity” arrangement.

Our view We do not propose using the term “Takaful” since a religion-neutral approach is adopted in taking forward the proposed legislation.

Question 4 Do you agree that the description in paragraph 3.6 can accurately reflect the key features of the underlying structure of business-plan Musharakah and Mudarabah sukuk in the market? Please explain the reasons for your views. 16.   Share of tangible assets in specified asset

Respondents agree in principle the description in paragraph 3.6 is correct. Some suggest the

Our view We understand that, for Shariah compliance purposes, a certain percentage of the capital should be invested in

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Administration to clarify that, in case of Musharakah and Mudarabah sukuk, for tradability purpose it is important that at least one-thirds of the sukuk proceeds should always be invested in tangible assets.

tangible assets. However, as we are adopting a religion-neutral approach in drafting the Bill, we will not include this requirement for the purposes of the proposed tax treatment. This approach will also enable the proposed tax regime to cater for evolving market developments.

17.   Types of business activities A few respondents suggest clarifying that the bond-issuer can also contribute its capital in the general business of the originator as part of the business activities under a profits sharing arrangement.

Our view In order to allow for flexibility, there will be no restriction on the types of business activities that can be carried on by the business undertaking formed by the originator and the bond-issuer. This will be further clarified in the DIPNs and SOIPNs.

18.   Shortfalls and liquidity facility / guarantee Several respondents indicate that, other than the advance incentive fee being used to make good any shortfall between the profits receivable by the bond-issuer and the expected return payable to the bond-holders, there is often a Liquidity Facility/Guarantee in place to cater for any potential shortfalls, in the event that there may be insufficient money in the sinking fund to make good any shortfalls. They believe that the advance incentive fee should be treated as tax deductible expense for the issuer, whereas any payments made to bond-holders from

Our view There will be no restriction in the Bill on the use of the liquidity facility or guarantee to cater for any potential shortfall during the term of the arrangement. And if the specified investment arrangement meets the required conditions, the amount of investment return will be treated as interest payable. We will elaborate on these further in the DIPNs and SOIPNs.

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Liquidity Facility/Guarantee should not have any adverse tax/legal implications.

19.   Bond-issuer to bear losses? It is proposed that the clause wherein the bond-issuer will bear losses of a business undertaking should be subject to there not being any breach and negligence from the originator as Mudarib (manager).

Our view While a bond-issuer may need to bear losses, we will clarify in the DIPNs and SOIPNs that this does not apply to any losses incurred by the business undertaking as a result of any negligence on the part of the originator in managing the business undertaking.

20.   Value of proceeds of disposal There are concerns that, in the case in which we allow the proceeds of the disposal to be equal to the fair market value of the bond-issuer’s share in the business undertaking at the time of sale, the bond may not be construed as a senior debt instrument from capital market perspective as the bond-holders’ capital is at risk.

Our view We understand that the Accounting and Auditing Organisation for Islamic Financial Institution (“AAOIFI”) requires that the sale must be at the fair market value under certain sukuk structures. Such arrangement can be accommodated under our regime as long as the product can meet all the relevant conditions prescribed in the Bill, such as the limit on return condition, financial liability condition and bond-issuer as conduit condition, which suggest that the product in question is economically equivalent to debt arrangement.

Question 5 Do you agree that co-ownership Musharakah sukuk structure can be accommodated under the leaseback arrangement? If not, please explain the reasons for your views and the detailed structure of this kind of sukuk in the market.

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21.   General Respondents generally agree that co-ownership Musharakah sukuk structure involving leasing feature can be accommodated under the leaseback arrangement. A respondent, however, opines that not all co-ownership Musharakah structures would have a leasing feature and should therefore be accommodated separately.

Our view We note the views of the respondents. Regarding co-ownership Musharakah sukuk structure without leasing feature, we will consider how to deal with this in future.

Question 6(a) Do you agree that the description in paragraph 3.10 can accurately reflect the key features of the underlying structure of Murabahah sukuk in the market? Please explain the reasons for your views.22.   Originator to appoint an agent

Respondents generally agree that the description in paragraph 3.10 can accurately reflect the key features of the underlying structure of Murabahah sukuk in the market. However, there are a few respondents suggesting that it may be clarified that the originator can appoint a facility agent or a trustee services company as its agent to undertake the asset/commodity transactions.

Our view We note that originator can appoint an agent to undertake the asset/commodity transactions. Such case will not be precluded from the Bill. We will elaborate on the relevant details in the DIPNs and SOIPNs.

23.   Inah structures There is a suggestion to provide some flexibility with regards to the use of Inah structures (which typically involve sale and buy-back between two parties).

Our view We note that most of the Inah structures in Malaysia are two party structures without setting up a SPV between the originator and the bond holders. Please refer to our

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views in item 6 (Tripartite structures). 24.   Specified asset for originator’s own use

There are suggestions that to date there are no instances of a Murabahah sukuk issued with the underlying asset intended to be retained by the originator. That said, such scenario does not violate any Shariah principles and may also provide flexibility for future sukuk issuances.

Our view We note the views of the respondents.

Question 6(b) The description in paragraphs 3.10.1 to 3.10.3(a) above is mainly intended to cater for a fixed-rate commodity Murabahah sukuk structure. Is it very common to see a floating-rate commodity Murabahah sukuk structure in the market? If so, please explain the detailed operations of this kind of structure. 25.   Fixed-rate and floating-rate commodity Murabahah sukuk

structure Respondents indicate that fixed-rate commodity Murabahah sukuk structures are more common than floating-rate structures in the market. However, the same concept can also be applied to a floating-rate commodity Murabahah sukuk structure.

Our view We are minded to facilitate product development in the market. The Bill will provide flexibility to allow fixed-rate or floating-rate commodity Murabahah sukuk structure.

Question 6(c) Is it very common to see replacement of asset due to destruction or loss under a Murabahah sukuk structure? If so, please explain the detailed arrangement under this scenario.

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26.   Replacement of asset Respondents are of the view that it is unlikely to see replacement of assets due to destruction or loss under a commodity Murabahah sukuk structure.

Our view We note the views of the respondents.

Question 6 General comments 27.   Trading of Murabahah sukuk

There are suggestions that it needs to be made clear that some Shariah scholars do not allow trading of Murabahah sukuk as they consider this as “debt trading”. Trading of debt is allowed by these scholars if it is done at par, but commercially it is always done at discount or premium. That said, some Shariah scholars take a different view and they allow trading of Murabahah sukuk even if it is done at discount or premium.

Our view We understand that tradability of Murabahah sukuk appears to be subject to diverse views of Shariah scholars. As we are taking a religion-neutral approach, we will not specify tradability of sukuk as one of the requisite features for Murabahah sukuk structure. This approach will enable our proposed regime to cater for evolving market developments.

Question 7 Do you agree with the qualifying conditions proposed for the bond arrangement and investment arrangement under IRO? Please explain the reasons for your views.28.   Limit on return condition

Many respondents are of the view that what is considered to be a “reasonable commercial return” is subjective and recommend further guidance on the application of the

Our view The condition requires that both the “maximum return payable” and the “actual return paid” in each period from the commencement of the specified term up to the

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condition. There are also views that the “limit on return” condition is more restrictive than any similar regime in other jurisdictions. In the UK, volatile coupon payments during the sukuk term is not acceptable for tax purposes only if the total amount of coupon payments exceeds a reasonable commercial return during the whole sukuk term, whereas the Administration proposes to look at the payments in each period starting from the commencement of the specified term up to the date of any periodic payments. Some query the need for such a restrictive approach, in light of the existing anti-avoidance provisions in tax law.

scheduled and actual payment dates respectively under a sukuk arrangement should not exceed an amount that would be a reasonable commercial return on money borrowed of the amount of the bond proceeds. Our intention is to screen out, via this condition, equity or equity-like sukuk, so that the tax benefits will only be shared by sukuk economically equivalent to debt securities common in markets. Both the maximum return payable test and the actual return paid test are designed according to the characteristics of typical coupon payments under conventional debt securities. The actual return paid test also ensures that the actual payments are per terms of the arrangement. Application of both tests in each individual period from the commencement of the specified term up to the scheduled and actual payment dates respectively will help deter any abuse by issuers to disguise low return equity sukuk, characterised with large profits in earlier periods and low profits or losses in later periods, as debt-like instruments, just to benefit from the special tax treatment. The Administration is mindful that there is a wide variety of sukuk structures in the market. Sukuk that

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Some also suggest that, to the extent that interest paid exceeds an arm’s length commercial rate, only the excess interest should be disallowed.

are issued to raise funds in capital markets will, in most cases, be economically equivalent to conventional debt securities, giving the holder a return akin to coupon payments. Some issuers may issue equity sukuk whereby the sukuk holders are taking equity interest in the underlying asset, but these products are not the target of the proposed tax treatment. The condition is particularly necessary as the scope of our proposed legislation covers both listed and unlisted sukuk. Besides, some sukuk issuance may only have stamp duty implication, and the SDO in Hong Kong does not have any general anti-avoidance provision like Schedule 22 of the UK’s Finance Act 2009 (relief not available if purpose of the arrangement is improper). As the scope of the UK’s legislation covers only listed sukuk, for which chances of abuse are considered to be significantly smaller, the one-time test may be sufficient. IRD will apply the test to exclude sukuk with return which is blatantly above what will be reasonable commercial return for a debt security, or which is linked to profits. If the sukuk fail the test and thus are not regarded as “debt-like” arrangements, they should not be

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subject to the proposed tax treatment. We note that the concept of “reasonable commercial return” appears in the definition of “loan capital” in section 2 of the SDO.    We believe that most genuine sukuk issuances should easily meet the condition. IRD will issue DIPNs to elaborate on the operation of this condition, with reference to the experience in the UK.

29.   Fixed/floating interest rates, step-up/step-down coupon There are a few respondents suggesting that commercially the return on the sukuk can be structured as a step-up coupon (where the return rate may increase during the tenor of the sukuk) or a step-down coupon (return rate decreases during the tenor), or the sukuk is with a floating rate. They suggest the Administration to clarify that these arrangements should still be treated as “debt arrangements” because the bond-holders are not taking any equity interest in the originator and this is not equity like arrangement.

Our view We understand that the return on sukuk can be fixed, floating or determined by other ways. There will be no restriction in the Bill on how the return can be determined so long as it does not exceed a reasonable commercial rate of return. In case there is any uncertainty (e.g. with regards to step-down coupon rate), taxpayers may seek an advance ruling under section 88A of the IRO or a similar informal arrangement for stamp duty payments.

30.   Bond arrangement as financial liability condition There are views that consideration should be given to

Our view The financial liability condition is one of the conditions

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whether determining the tax treatment based solely on the accounting standards is an appropriate test. The reference to accounting standards represents a significant departure from the current practice in Hong Kong in the tax law in Hong Kong.

to determine if the proposed tax treatment will be applied. It is modelled on the UK’s legislation, and is designed to screen out equity or equity-like instruments. The condition can be met if the relevant bond arrangement is wholly or partly treated as a financial liability of the bond-issuer in accordance with the prescribed Financial Reporting Standards. The adoption of the financial liability condition does not reflect any change to the IRD’s general position that the starting point in analysing the tax position of a financial instrument is to consider its nature according to its legal form rather than the accounting treatment or the underlying economic characteristics.

31.   Maximum term length condition A number of respondents opine that the “maximum term length condition” (which requires that an alternative bond scheme should not have a term length longer than 10 years to be eligible for the proposed tax treatment) may be over restrictive. There is no condition governing the term length of conventional bond products for the purposes of IRO and SDO.

Our view The proposed condition seeks to strike a reasonable balance between the need to facilitate market development and the need to address tax avoidance concerns. We note that there is also a time limit of 10 years on the transfer back of the asset to the originator, which effectively limits the sukuk term to 10 years under the legislation of the UK. In view of the market response, the Administration is inclined to extend the time limit to 15 years. The Bill will also provide

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flexibility to enable the Financial Secretary (“FS”) to further amend the time limit by way of subsidiary legislation when necessary in future.

32.   Nexus with Hong Kong condition Most respondents do not see any difficulties in meeting this condition. However, there are some views that this requirement may restrict Hong Kong based companies to tap the local currency Islamic liquidity in other markets. They suggest that there are a number of instances where foreign issuers have tapped the Malaysian Ringgit sukuk market in which case the sukuk was issued and marketed in Malaysia but the originator was based in an offshore jurisdiction. A respondent also asks if any threshold must be met.

Our view This condition is intended to ensure that the alternative bonds eligible for the special tax regime will have some nexus with Hong Kong in a way that will help promote the development of sukuk market and encourage the use of the Islamic finance platform in Hong Kong. In addition to listed sukuk, this condition will also provide flexibility to cater for unlisted sukuk, as either issuance or marketing in Hong Kong will be able to satisfy the proposed condition. We do not intend to set any threshold for meeting the proposed condition in the Bill. In order to provide further flexibility, we are inclined to include an additional option for market players to satisfy the proposed condition. The additional option is to lodge and clear the alternative bonds through the Central Moneymarkets Unit operated by the Monetary Authority. This would enable sukuk issuers to meet the proposed condition even though the sukuk are not listed, issued or marketed in Hong Kong.

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33.   Apportionment of acquisition cost in partial redemption Some respondents wonder what criteria will be used to determine the respective acquisition cost.

Our view Where the proceeds of disposal is used to fund the partial redemption of the alternative bonds, we will ascertain the portion of the bond proceeds attributable to that part of the alternative bonds to be redeemed, which will then be taken as the acquisition cost in respect of that part of the specified asset disposed of.

Question 8 Do you agree that the special tax treatment in paragraphs 3.16 and 3.17 is sufficient to provide a level playing field for sukuk vis-à-vis their conventional counterparts in terms of tax liabilities? Please explain the reasons for your views. 34.   Disregarding bond-holder’s legal and beneficial

interest/bond-issuer’s role as the trustee in respect of the specified asset for tax treatment purposes There are suggestions that it may be clarified in the law that the bond-holder’s legal and beneficial interest in the bond-issuer’s role as the trustee in respect of the specified asset is disregarded only for tax treatment purposes and does not affect the validity and legality of the bond-holder’s interest in the specified asset/bond-issuer’s role as trustee from other legal and regulatory perspectives.

Our view We will make clear in the Bill that those treatments are for the purposes of IRO and SDO only.

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35.   Tax liability of the bond-issuer There are views that the bond-issuer is a special purpose vehicle (“SPV”) that has been set up to facilitate sukuk issuance. It should be tax neutral in that it would not be subject to any profits tax. The bond-issuer should be exempted from having to lodge a profits tax return and meet any obligations under the IRO.

Our view Section 14 of the IRO provides that profits tax shall be charged for each year of assessment at the standard rate on every person carrying on a trade, profession or business in Hong Kong in respect of his assessable profits arising in or derived from Hong Kong for that year from such trade, profession or business. Section 15 deems certain sums including interest as receipts arising in or derived from Hong Kong from a trade, profession or business carried on in Hong Kong. We do not see the case for a blanket exemption. The form of the SPV (or otherwise) will not change the tax liability insofar as the relevant transactions or incomes are taxable or chargeable under the IRO or SDO. The Bill will provide additional certainty by disregarding certain tax exposures underpinning sukuk transactions to provide for a comparable tax regime vis-à-vis those exposures concerning conventional debt arrangements.

36.   Transfer pricing adjustments/mark-up at arm’s length price There are observations that most of Hong Kong’s

Our view In the scenario that the investment return is equal to the

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comprehensive double taxation agreements contain an allocation of profits clause allowing transfer pricing adjustments to take place between entities where one entity participates directly or indirectly in the management, control or capital of the other. This may apply in the case of a profits sharing arrangement. It is also possible that the originator and the bond-issuer are in any case related parties. Given that it is a condition of the arrangements that the issuer cannot make a profit on the transaction, it would be helpful to clarify that transfer pricing adjustments will not be sought in respect of such transactions.

bond return, the bond-issuer merely acts as conduit and is set up solely for the purposes of sukuk issuance (like its counterpart in conventional bond issuance). Generally speaking, most SPVs are set up in offshore jurisdictions and have no staff. The coupon rate payable to the bond-holders is at prevailing market rate. That means if the originator had issued the bonds directly to the bond-holders, the originator would have paid the same coupon rate. As the set-up of a SPV is a specific feature in a tripartite sukuk arrangement with a view to complying with Shariah principles, we do not consider that transfer pricing adjustments could be sought in such cases.

37.   Tax treatment of “investment return” and “additional payment” Some respondents propose that it should be made explicit in the legislative proposal that, for an “investment return” or “additional payment” which is deemed to be interest payments/expense, the same payments are not taxable under other provisions of the tax act.

Our view It will be clearly stated in the proposed tax treatment provisions that the IRO applies to a qualified bond arrangement (or a qualified investment arrangement) as if it were a debt arrangement and the additional payments (or investment return) were interest payable. That means the additional payments and the investment return will only be taxed under the provisions for interest income.

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Similarly deemed interest expenses which do not fulfill the deduction requirements for interest should not be deductible under other general/specific deduction provisions.

In addition to the interest being incurred in the production of chargeable profits, IRO requires that any claim for interest deductions must satisfy at least one of the six prescribed conditions in section 16(2)(a) to (f). That means deemed interest expenses might not be deductible under other general/specific deduction provisions.

38.   How source rules should be applied? A few respondents suggest that the law should go further to state how the source rules should be applied where the payments are deemed by the IRO to be interest income. As a majority of Hong Kong tax’s source rules have been developed by case law, it is currently unclear whether a court would consider the sources rules based on the legal form of a payment, or its deemed nature.

Our view As the bond-issuer’s principal activity is borrowing and lending of money, the taxation of its deemed interest income will be governed by the operation test. As regards sukuk-holders, the taxability of the deemed interest income depends on the nature of their business and the locality of the income, just like conventional bond-holders. IRD’s DIPN 13 discusses the source of interest and the tests applied to different types of recipients of interest income. The same interpretations will apply to sukuk-holders. Once the arrangements are deemed as debt arrangements, the taxation of deemed interest income and the deduction of deemed interest expenses will follow those applying to conventional debt

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arrangements. Question 9 Do you have any other views or comments on the proposed amendments to IRO?39.   Record keeping requirement

The majority of respondents are of the view that the record keeping requirement (not less than 7 years after the end of the sukuk term instead of after the completion of the relevant transactions) puts the sukuk arrangement at a less favourable position than a conventional bond arrangement. The necessity of such more stringent requirement is questionable.

Our view In view of tax avoidance concerns, we have originally proposed that the originator and bond-issuer will be obliged to keep business and recent records once the special tax treatment has been applied, for not less than 7 years after the end of the specified term of the alternative bond scheme. In setting any modified time limit, we have to take into consideration the following: (a) The special tax treatment granted to the arrangements

will be retrospectively withdrawn if they breach any one of the qualifying conditions. Some sukuk are long-term arrangements and their tenor could exceed 6 years. If the breach occurs near the end of the specified term, most of the books and records will not be available under the current time limit – 7 years from the completion of the relevant transaction.

(b) Section 60 of the IRO empowers IRD to raise any assessment or additional assessment within 6 years after the expiration of the relevant year of assessment, against a record keeping requirement of

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not less than 7 years from the completion of the relevant transaction. The Bill will contain provisions to modify the application of section 60 of the IRO so that the relevant time limits will run after the expiration of the year of disqualification if that year falls after the specified year of assessment.

Taking into consideration market views, we propose to relax the record keeping requirement to “3 years (instead of 7) after the end of the sukuk term” or “7 years after the relevant transaction”, whichever is longer. We believe that this will strike a right balance between addressing the concerns against tax avoidance and lessening the compliance cost of issuers or originators.

40.   Additional profits tax assessment Many respondents feel that the proposed time period for raising additional profit tax assessment (the 6 year limitation period begins to run after the expiration of the year of disqualification, rather than the end of the particular year of assessment) may put the sukuk arrangement at a less favourable position than a conventional bond arrangement. There are observations that the time bar provisions are not extended where disqualification occurs in the UK legislation. Moreover,

Our view The proposed extension of the time frame is needed to plug the tax avoidance loophole arising from breaching of the qualifying conditions near the end of the specified term of the alternative bond scheme. Unlike the tax laws in the UK, our proposed legislation covers both listed and unlisted sukuk. In the absence of the extended time limit for raising the assessments, there may be a risk that, especially in the case of unlisted

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respondents are of the view that the anti-avoidance under section 61A of the IRO could be used to combat any tax avoidance arrangement, for example, deliberately delaying the disqualifying event until the end of the term.

sukuk which can be offered to a few professional investors, taxpayers might abuse the provisions by breaching the qualifying conditions near the end of the specified term, such as making exceptional not-per terms additional payments or investment return or making not-per terms disposal of the specified asset. Such irregularities could not be foreseen at the start or in the earlier years of the sukuk term and may thus be out of the ambit of section 61A. Some sukuk are long-term arrangements with a term of more than 6 years. The proposed extension of time limit could effectively counteract any abuse and recover the tax that would have been payable. We also have reservation whether section 61A of the IRO could be effectively invoked to withdraw the special tax treatment granted to the sukuk arrangement which is not a debt arrangement in its legal form.

41.   Retroactive withdrawal of tax treatment It is proposed that, if at any time, a qualified bond arrangement or qualified investment arrangement fails to meet the requisite conditions and is disqualified, it will be treated as never having been a qualified bond arrangement of qualified investment arrangement. Many respondents

Our view The proposed arrangement seeks to address tax administration concerns to deter abusive tax avoidance schemes. Conventional bonds are taxed according to their legal

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perceive that this retroactive withdrawal of the tax treatment of the arrangement to be punitive and that it is not present within the UK’s alternative finance arrangements legislation on which these proposed legislative amendments are based.

form. Debt-like sukuk are not ordinary debt arrangements in their legal form. Most of the proposed qualifying conditions, in particular the limit-on-return condition and the financial liability condition, are therefore used to screen out equity arrangements. Equity arrangements should not be accorded with the proposed special tax treatment at the outset. Take the example of an equity arrangement disguised to meet the qualifying conditions so as to enjoy the special tax treatment and near the end of the specified term making not-per terms disposals or exceptional additional payments. If such disposals or exceptional additional payments had been disclosed in the offering document, the arrangement would not have been treated as a debt arrangement for tax purposes from the start. The scope of the sukuk provisions in the UK covers listed sukuk only and risks of disqualification are relatively much lower.

42.   Transitional provisions There are suggestions that additional provisions would be necessary to deal with the transition from taxation as a qualified bond or investment arrangement back to taxation

Our view Since the previous tax assessments are to be withdrawn, transitional provisions are not needed. Otherwise, the basis of assessments would be inconsistent.

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on general principles. 43.   CIR to disregard disqualifying event

There are views that the Commissioner of Inland Revenue (“CIR”) should be given power to disregard any disqualifying event provided there are reasonable excuses for such non-compliance. Currently, the CIR is only empowered to disregard any non-compliance in the delay in disposing of the specified asset (section 3.22) or with the diverse holding condition (section 3.24) but not other disqualifying events.

Our view We have considered such possibilities when preparing the Bill. Non-compliance with other qualifying conditions does not justify any concession on grounds of “reasonable excuse”.

44.   Deliberate/flagrant and unintended breaches There may be a number of factors outside the control of the relevant parties that may cause a breach of the rules to occur, e.g. change in accounting standards, change in market conditions, legal problems or the originator experiencing cash flow problems. Respondents are of the view that it is important to differentiate between deliberate and flagrant breaches designed to evade tax and breaches of a more technical nature which should be dealt with by agreeing a plan to rectify the situation.

Our view We would comment on the examples as follows - Change in accounting standards The accounting treatment is based on the substance of the arrangement. It is unlikely that the accounting standards will be drastically changed to present a debt arrangement as an equity arrangement. Change in market condition The reasonable commercial return is based on the prevailing market condition at the time of issue of the alternative bonds. Any subsequent change to market

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condition is not relevant. Delay in transfer due to legal problem Any delay with reasonable excuse will be disregarded. See paragraph 3.22 of the CP. Cash flow problem of the originator CIR will explain in DIPNs that any cash flow problem or insolvency on the part of the originator causing delayed payments or non-disposal of the specified asset will be disregarded. Total loss of specified assets CIR will explain in DIPNs that any total loss of specified asset resulting in early termination of the bond arrangement will not amount to a breach of features and conditions.

45.   Rectification of disqualifying event within a time limit There is a requirement that any bond-issuer will need to report to CIR in writing of the occurrence of any bond arrangement disqualifying event within 1 month after the event. There are suggestions that consideration should be given if the issuer rectifies any such disqualifying event within a 1 month period. The occurrence and the

Our view In view of market comments, we intend to incorporate a 1-month grace period in the case of delay in disposing of the specified asset to allow an issuer to rectify the breach. In addition, we are inclined to remove the diverse holding condition to minimise the compliance burden on issuers.

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rectification will both constitute a reportable event but respondents suggest that if the disqualifying event is rectified within the time limit, the disqualifying event should be ignored and the exemption on profits tax should not be withdrawn.

46.   Definition of associate/associated corporation Some respondents suggest that further consideration should be given to the impact on investors of the amendment to the definitions of “associate” and “associated company”. If the definitions were to be amended, they should be consistently used throughout all parts of the IRO.

Our view Taking into consideration market views and with the removal of the diverse holding condition, we will not amend the definition of “associate” and “associated corporation” in this legislative exercise but we will consider taking a holistic approach to amend these definitions later.

47.   Property tax A bond-issuer will potentially have a lease over Hong Kong immovable property and accordingly, will potentially fall within the charge to Hong Kong property tax. They recommend that both the bond-issuer and bond-holders are exempted from property tax in respect of any transactions arising under the alternative bond arrangements.

Our view Please refer to our views in item 37 (Tax treatment of “investment return” and “additional payment”). If a sukuk arrangement is qualified for the proposed tax treatment, there will not be any property tax liabilities arising. The Bill will make clear provisions for this. The tax treatment will be further explained in DIPNs.

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Question 10 Do you agree with the qualifying conditions and requirements proposed for the bond arrangement and investment arrangement under SDO? Please explain the reasons for your views. 48.   Single set of definitions applying to IRO and SDO

Some respondents note that the qualifying conditions set out in section 3.33-3.38 are described as being “essentially” the same as those under the IRO. Questions arise as to whether there are any differences in the concept of sukuk eligible for the proposed tax treatment in IRO and SDO.

Our view In the draft bill, the definitions of terms which are equally applicable under both IRO and SDO will be provided in the IRO. SDO will make reference to those definitions. A minor difference is that any reference to CIR in IRO will be replaced by a reference to the Collector of Stamp Revenue ("CSR") in SDO.

49.   Different conclusions by CIR and CSR? Some respondents are worried that CIR and CSR may possibly reach different conclusions.

Our view This is unlikely. The conditions are basically the same under IRO and SDO. There will be communications between the Profits Tax Unit and the Stamp Office before accepting, rejecting or withdrawing the relief.

50.   Security requirement Many respondents are of the view that the requirement that stamp duty relief will only be granted where security to the satisfaction of the CSR is given will impose additional cost and administrative burden for the sukuk arrangements and it is not providing a level playing field compared with

Our view The security requirement serves to protect government revenue associated with the granting of relief to sukuk arrangements. In respect of conventional bonds, the question of whether they are chargeable with stamp duty is readily ascertainable. If they fall under the definition

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conventional bonds. Some suggest that this should be removed, while some suggest that if this requirement is to be retained, it should be in a more simple form of a bank guarantee rather than as a security charge on the underlying assets.

of Hong Kong stock, stamp duty is payable on the instrument for transfer of the bonds. For conventional bonds, there is also no issue of “disqualifying event” and no requirement for transfer of underlying asset such as Hong Kong stock or immovable property from the originator to the bond-issuer. In fact, in the case of tax treatment for sukuk, the UK requires a legal charge of the property in favour of the HM Revenue & Customs (“HMRC”) (paragraph 5(7) of Schedule 61 of Finance Act 2009). We understand that the HMRC has stressed that there are significant avoidance risks associated with the relief, which the HMRC sought to address by introducing the charge as a deterrent to the abuse of the legislation. The charge provides a security required to protect government revenue. In the event of avoidance or in the event of the conditions of the relief not being complied with, the relief may be withdrawn. In such circumstances, the charge over the land will ensure that any tax that is due can be collected. In view of the market concerns, the CSR is prepared to accept a security which may include a registered first

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Some respondents also note that the relief under section 45 of the SDO for conveyance from one associated body corporate to another does not require security to be provided even though claimants for relief under that section may not be locally incorporated.

legal charge on the leasehold property, a pledge of quoted shares or a bank guarantee. This will be further prescribed in the SOIPNs. The amount of stamp duty involved in a sukuk issue normally can be very substantial, whereas the amount of duty involved in most of the cases under section 45 is comparatively smaller. Besides, the period of compliance under section 45 is 2 years only: the transferor and the transferee must remain “associated” companies during that period. Both the chance of non-compliance and the risks of irrecoverability of the stamp duty are very low. We do not think that the existing arrangement of section 45 of the SDO is directly applicable to the duty treatment for sukuk.

51.   Exemption for security requirement There is a question on whether the exemption currently available under section 45(2) of SDO would also apply to a bond-issuer and an originator that are associated, i.e. no additional security would be required.

Our view No exemption for security requirement will be granted if the stamp duty relief for sukuk transactions is opted.

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Question 11 Do you agree that the stamp duty treatment / relief in paragraphs 3.39 and 3.40 is sufficient to provide a level playing field for sukuk vis-à-vis their conventional counterparts in terms of stamp duty liabilities? Please explain the reasons for your views. 52.   Application of section 45 under profits sharing

arrangement In the case of a profits sharing arrangement, some respondents note that there is no mechanism to prevent the disapplication of section 45 to transfer of beneficial interest which, under a conventional financing arrangement, would have fallen entirely within the 90% group. Although transactions between the originator and the business undertaking will be exempted, there may be occasions when other group companies want to transfer assets to the business undertaking. There is a question on whether these are also intended to be exempted from stamp duty.

Our view We have not come across any past issuances of Musharakah sukuk and Mudarabah sukuk with the business undertaking taking the form of a corporate structure. What we have seen is akin to an unincorporated joint venture, in which case section 45 does not apply. If there is any sale of leasehold property or Hong Kong stock from the bond-issuer or the originator to their associated corporation or vice versa, section 45 will apply if their associated relationship meets the 90% test.

53.   Transactions between issuer and the originator under profits sharing arrangement Transfers between the originator and the bond-issuer will be exempted in the leaseback and the purchase and sale arrangements, whereas for the profits sharing arrangement the exemption will apply between the originator and the

Our view In general, any stock or immovable property of the business undertaking set up by the bond-issuer and the originator will be registered in their own names. For example: if an originator transfers its solely–owned

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business undertaking. In the profits sharing arrangement, stamp duty may arise on exit when the bond-issuer transfers its interest back to the originator. Respondents suggest that this will leave a gap whereby transactions between the issuer and the originator may be subject to stamp duty, either on a share transfer, or, in the case of a partnership, by reference to the underlying assets.

property to the business undertaking as its contribution to the share capital of the business undertaking, and assuming the bond-issuer makes the same amount of contribution in cash, the bond-issuer’s name will be added and the property becomes the joint property of the originator and the bond-issuer. Stamp duty relief will be given for the transfer of that 50% of the value of the property from the originator to the bond-issuer. Likewise, if at the end of the specified term, the bond-issuer sells its 50% interest in the business undertaking to the originator, the bond-issuer’s name will be removed and the originator becomes sole owner of the property. There will be stamp duty relief for the transfer of that 50% of the value of the property from the bond-issuer to the originator. We will clarify the above in the Bill.

54.   Administrative burden in filing an application An application will need to be filed in respect of all otherwise stampable transactions in respect of which an exemption is sought. Respondents opine that this will necessarily result in a higher administrative burden than for conventional financing.

Our view In order to effect a transfer of the immovable property or Hong Kong stock, legal documents should have been prepared. We expect not much additional administrative work will be involved.

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55.   Bond convertible to stock Some respondents note that there is an assumption under section 3.39 that most alternative bonds will not be “stock” for stamp duty purpose as they will fall under the definition of “loan capital”. However, a bond that is convertible to stock is not loan capital. In line with the policy to develop the sukuk market, it may be better for alternative bonds to be explicitly excluded from the definition of stock as a separate class of exclusion.

Our view The objective of the Bill is to provide a comparable tax framework for alternative bonds as compared with conventional bonds. If a conventional bond is convertible into Hong Kong stock and is denominated in Hong Kong currency, it is Hong Kong stock within the meaning of SDO and the instrument for transfer of which is chargeable with stamp duty. Same treatment should also apply to alternative bonds.

Question 12 Do you have any other views or comments on the proposed amendments to SDO? 56.   Return-furnishing requirement

Respondents advise that the return-furnishing requirements are much more stringent than for conventional bonds, which is not consistent with the principle of creating a level playing field. Some consider that this requirement should be removed, while some consider that annual returns, in-line with IRO, should be sufficient.

Our view Return-furnishing is required to cater for the unique nature of sukuk arrangement and protect government revenue. There is no issue of “disqualifying event” for conventional bonds. Besides, the question of whether a conventional bond is chargeable with stamp duty can be ascertained at the outset. It is also worth noting that section 19(13) of SDO requires returns (currently half-yearly returns) to be filed for stock borrowing and lending transactions. IRD may accept annual returns in some cases and we

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will explain the requirement in the SOIPNs. 57.   Record keeping requirement

Some respondents note that at present SDO does not impose any requirements on a taxpayer to maintain records for a specific period of time. They do not consider the proposed requirement to keep records necessary as a result of the proposed stamp duty relief particularly as there are currently no similar requirements in relation to other similar reliefs, i.e. stock borrowing and lending and conveyance from one associated body corporate to another.

Our view Record keeping is required for verifying whether there is any disqualifying event. In case of any dispute, the duty payer can provide evidence to defend his case. Section 19(13) of the SDO requires records to be kept for stock borrowing and lending transactions. Besides, the proposed record keeping requirement is commensurate with the complex transfer or lease structure of sukuk arrangements. Taking into consideration market’s views, we propose to relax the record keeping requirement to “1 year (instead of 7) after the end of the sukuk term” for stamp duty purposes.

58.   Rectification of disqualifying event within a time limit Similar to item 45 (Rectification of disqualifying event within a time limit) a grace period for rectification should be given for any disqualifying event under the SDO.

Our view If the whole arrangement is an equity arrangement but disguised as a bond arrangement, there is no justification to give any grace period. Please also refer to our views in item 44 (Deliberate/flagrant and unintended breaches) and 45 (Rectification of disqualifying event within a time limit).

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59.   Consequences of disqualification Some respondents suggest that the proposed consequences of disqualification should be considered further.

Our view Once disqualified, the sukuk will be treated as normal financial products, and stamp duty will be charged under the general provisions of the SDO.

60.   Time limit for recovery of stamp duty It is proposed that the 6 year limitation period for the recovery of stamp duty will begin to run after the occurrence of an investment arrangement disqualifying event instead of 6 years from the expiration of time for stamping such instrument. In this regard, a number of respondents consider that this does not provide a level playing field for sukuk from a tax perspective and that any limitation period should be in line with conventional bonds.

Our view Given the retrospective withdrawal of the stamp duty relief on the occurrence of a disqualifying event, stamp duty will not be recoverable if the term of the sukuk exceeds 6 years and the disqualifying event happens more than 6 years after the date of the instrument. To protect government revenue, the period of limitation for recovery of stamp duty must be extended. In conventional bonds, there is no equivalent multiple transfers and leasing of the underlying asset. In the UK, Schedule 61 of Finance Act provides similar retrospective revocation of stamp duty land tax relief for Ijarah sukuk. Please also see our views in item 40 (Additional profits tax assessment).

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61.   Application of section 21 of SDO Some respondents note that section 21 of SDO prohibits the passing of dividends or interest on Hong Kong stock. They recommend that the SDO should be amended to explicitly dis-apply this section to alternative bond arrangements.

Our view Section 21 of SDO facilitates collection of stamp duty on the transfer of Hong Kong stock by prohibiting dividend or interest payments to unregistered holders. So long as a sukuk arrangement is qualified for relief under the proposed legislation, the sukuk certificates will not be treated as Hong Kong stock and therefore section 21 will not apply to them.

General comments 62.   Existing administrative mechanism

Respondents suggest that for other Islamic instrument not specifically covered, the future legislation will need to address the issue on whether the existing mechanism under section 87 of the IRO and section 52 of the SDO to give tax exemption and stamp duty remission will still be available for Islamic instruments, and if so, whether the principles enshrined in the qualifying bond regime will be relevant in determining whether the exemption or remission will be granted.

Our view The proposed legislation covers five common types of sukuk which contributed to about 95% of sukuk issuances in 2011 and the first half of 2012. We will propose that the FS is empowered to add relevant types of sukuk in the IRO and SDO, by way of subsidiary legislation, to cater for further market developments. In this light, we believe that the current administrative mechanism under the IRO and SDO will be less relevant to such exemption or remission cases insofar as sukuk are concerned.

  

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Financial Services and the Treasury Bureau 29 October 2012