The purpose of this paper is to evaluate the effects of the structure of the Hong Kong tax system on financial intermediation activities in Hong Kong. Hong Kong is a major financial centre for investment and related activities in Asia. The vibrancy of its financial sector has been a significant contributor to economic growth and jobs, as most of its manufacturing industry has shifted to Mainland China. At the same time, other financial centres in Southeast Asia, especially Singapore, have been growing in competition with Hong Kong. Thus, taxation of financial activities can have a significant impact on the growth and competitiveness of the Hong Kong economy.
Taxes are an important part of any modern economy as they help finance public goods and services. In this paper, we do not concern ourselves with the overall burden of taxation or with the expenditures made by governments with the tax revenues raised to finance them. Instead, we focus on the structure of taxes, but only in regard to the taxation of financial activity in Hong Kong.
Hong Kong, unlike many other developed countries, has adhered to the principle of territorial income taxation whereby only income earned in Hong Kong is subject to Hong Kong tax. Residents are not subject to tax on income earned offshore. Moreover, Hong Kong, unlike most of its neighbours, has carefully avoided the utilisation of targeted tax preferences in order to keep its tax base broad and its rate of tax low. This has resulted in Hong Kong having one of the simplest and most efficient tax systems in the world. The tax system is also relatively competitive by international standards in that Hong Kong rates for income-based taxes in the range of 15-16% are among the lowest in the world’s taxing jurisdictions.
This is not to say that issues that are often confronted by any government in designing an effective tax structure do not affect the Hong Kong tax system. Two specific concerns that have been raised with respect to the Hong Kong tax system relate to the taxation of financial activities. The first of these is competitiveness and the second is the impact of the tax structure in distorting capital markets.
The competitiveness issue arises from a concern that the position of Hong Kong as the major regional financial centre for Asia could be challenged by other financial centres like Singapore, Malaysia and Taiwan. Based upon the territoriality principle used by Hong Kong for income taxation, financial income is only taxed in Hong Kong if the income is earned from a source in Hong Kong, thereby exempting any income earned from foreign sources. The exemption of foreign-source income provides substantial benefits to investors and businesses that make Hong Kong a centre for conducting investments in other countries in the region. Moreover, compared to Singapore and other Southeast Asian countries, the simplicity of the Hong Kong’s tax system is a major benefit to taxpayers since the economic burden of complying with the tax system is minimised.
On the other hand, interest and trading income earned by Hong Kong financial institutions from some foreign activities is subject to a tax rate of 16% while in Singapore financial income earned by financial institutions from qualifying sources may be subject to a concessionary rate of 10%. In addition, unlike Hong Kong, Singapore and some other countries in the region have extensive networks of bilateral tax treaties, which provide some assurance to investors that they will be subject to protection from onerous taxation and not subject to discrimination under domestic law. Thus, concerns arise as to the ability of Hong Kong to maintain its dominance as a regional financial centre.
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