On September 7, Hong Kong and Thailand signed a comprehensive income tax treaty, the second such comprehensive agreement entered into by Hong Kong. The treaty will be effective in Hong Kong from April 1, 2006, and effective in Thailand from January 1, 2006.

While Thailand has signed several income tax treaties, Hong Kong has signed only one income tax treaty with Belgium. A Memorandum of Understanding for the Avoidance of Double Taxation with China does not address the treatment of dividends, interest, royalties, and capital gains.

Significant provisions of the tax treaty include:

the definition of a Hong Kong resident (article 4);

the definition of permanent establishment (PE) (article 5);

the elimination of Thai withholding tax on service fees;

a method for calculating the business profits of a PE (article 7);

a reduction in some withholding tax rates (articles 10 to 12);

the elimination of capital gains on the sale of Thai shares (article 13); and

the absence of a limitation on benefits provision.

Residence

The residence article, similar to the provision in the Belgium-Hong Kong income tax treaty, provides that companies that are not incorporated in Hong Kong but that have their "normal management and control" in the city will be treated as residents of the SAR for treaty purposes. As Hong Kong allows companies incorporated in China's mainland, the Cayman Islands, and Bermuda to list on the Hong Kong Stock Exchange, many of those companies whose managements are based in Hong Kong will be eligible for benefits under the agreement. The wording was changed slightly from "central management and control" in the Belgium-Hong Kong treaty, presumably to reflect the idea that the daily management of the company must be undertaken in Hong Kong. Under Hong Kong case law, "central management and control" has been defined, in many instances, to be where the board of directors' meetings are held, a test that can be more easily manipulated than the "normal management" test.

Permanent establishment

Article 5, covering PEs, affects Hong Kong residents because Thailand's domestic law has a very low threshold for creating a taxable presence in Thailand. Under the treaty, Thailand will not tax a resident of Hong Kong that provides services within Thailand unless the person is present for more than six months in any 12-month period.

Paragraph 4 of article 5 of the treaty excludes delivery of goods from the exemptions to the creation of a PE typically found in the OECD (Organization for Economic Co-operation and Development) model and in Hong Kong's tax treaty with Belgium. Paragraph 5(b) specifically provides that a PE will exist if goods are maintained in the other jurisdiction for delivery on behalf of an enterprise.

Paragraph 5(a) does not provide for an exception to the creation of a PE solely for the purchase of goods within the other contracting state. That is a departure from the wording under the Belgium-Hong Kong treaty and several of Thailand's tax treaties, including the treaty with Singapore. The issue is mitigated somewhat by wording in the business profits article (discussed below).

Paragraph 5(c) also provides for a PE if a dependent agent "secures" orders in the other contracting state, but does not habitually exercise authority to conclude contracts. The provision is typical of Thai treaties and reflects the idea that performing all the preparatory work for a sale, without having contractual authority to bind an enterprise, is still sufficient to create a PE. The concept is present in most tax treaties but is not specifically stated.

Elimination of withholding tax on service fees

Thailand's domestic law requires that Thai residents withhold 15 per cent of the gross amount paid to nonresidents for services provided to a Thai resident, even if the services are provided outside of Thailand. For situations in which the level of the services performed for a Thai resident does not rise to the level of a PE in Thailand, the treaty does not provide for any taxation of business profits, including profits related to services. Consequently, the Thai withholding tax on services is eliminated under the tax treaty.

Determining profits of a PE

Unlike the Belgium-Hong Kong tax treaty, article 7 of the Hong Kong-Thailand tax treaty allows apportionment of profits in determining the profits attributable to a PE. Article 7 also provides that profits will not be attributed to a PE merely for the purchasing goods or merchandise for the enterprise. Thus, although a PE will be created under article 5 if an enterprise purchases goods in the other contracting state, profits will not be allocated to the PE, and, consequently, tax will not be imposed. However, the creation of a PE resulting from purchasing activities may result in other types of taxation.

Dividends

Article 10 allows the source country to tax dividends at a maximum rate of 10 per cent of the gross amount of the dividends. Thailand's domestic law also provides for a 10 per cent rate. Because Hong Kong does not impose a dividend withholding tax, the tax treaty does not generally affect the amount of withholding tax on dividends.

Thailand imposes a profits remittance tax of 10 per cent on branch distributions. Significantly, article 10(5) states that a contracting state shall not subject a company's undistributed profits to tax, even if the undistributed profits relate to income arising in the other contracting state. That provision is included in many Thai tax treaties and is similar to the OECD model provision. However, it is our understanding that the Hong Kong authorities confirmed during treaty negotiations that article 10(5) would eliminate the profits remittance tax on branch distributions because the profits would not be considered distributed for purposes of the tax treaty until they are paid out by the Hong Kong entity to its shareholders.

Interest

Article 11 provides for a 15 per cent withholding tax rate on interest paid between persons located in Hong Kong and Thailand. Hong Kong does not withhold tax on interest payments. Thailand's domestic law also provides for a 15 per cent withholding tax on interest.

Under article 11, some interest will be subject to a reduced withholding tax rate of 10 per cent, including interest paid to financial institutions and insurance companies, and interest related to some sales on credit related to equipment, merchandise, or services. Interest paid directly to a government or some of its subdivisions will be exempt from withholding tax.

Royalties

Article 12 provides for a maximum tax rate of 15 per cent on the gross amount of royalties. The effective withholding tax rates under Hong Kong's and Thailand's domestic laws are 5.25 per cent and 15 per cent, respectively. Under the tax treaty, the withholding tax rate may be reduced to 5 per cent on payments for the use of, or the right to use, copyrights of literary, artistic, or scientific works. Payments related to patents, trademarks, designs, models, plans, secret formulas, or processes will be subject to a 10 per cent withholding tax.

The definition of royalties has been expanded to include the right to use "tapes used for radio and television broadcasting", but does not address payments for software. Hong Kong does not withhold tax on payments for embedded and shrink-wrapped software under its domestic law. Consequently, payments for software will arguably not be subject to withholding tax under the tax treaty and would be dealt with under the business profits article. In addition, article 12(3) provides that payments for the use of or the right to use industrial, commercial, or scientific equipment will also be subject to withholding tax. Similar payments are not subject to withholding tax under Hong Kong's tax treaty with Belgium and many of Thailand's income tax treaties, including its treaty with Singapore.

Capital gains

Thailand taxes gain from the disposal of Thai shares by a foreign entity at a 15 per cent tax rate. Hong Kong generally does not tax foreign residents on the disposal of shares in Hong Kong entities unless the sale is considered both Hong Kong-source income and income from a trade or business in Hong Kong, rather than a capital item. Article 13 provides for the elimination of tax on the sale of shares of a corporation resident in the other jurisdiction, provided 50 per cent or less of the value of the shares is derived from immovable property.

Limitation on benefits

The tax treaty does not contain a limitation on benefits provision. Presumably, all income received from an entity considered resident in Hong Kong under the tax treaty will be eligible for relief in Thailand. The Thailand-Singapore income tax treaty has a limitation on benefits article, which provides for only proportionate benefits depending on the taxation in the country of the resident.

Evan Blanco is Tax Partner (Hong Kong) and Tanapone Kaewsathit, Tax Partner (Thailand) of Deloitte Touche Tohmatsu.

(HK Edition 10/26/2005 page4)