Companies Law and Taxation in Hong Kong

According to the Fraser Institute’s annual Economic Freedom of the World report released on 7 October 2014, Hong Kong is ranked as one of thetop 10 most economically free jurisdictions.  The maturity law and taxation systems are two valuable assets of Hong Kong.  Many businessmen are in favour of these two advantages which attracting them to invest in Hong Kong.  These advantages helpHong Kong to be ranked onthe front row in business world.  This articlediscusses the Hong Kong New Companies Ordinance and a recent tax case about unrealised profits.
 
Facilitation of business subsequent to the New Companies Ordinance (CAP. 622) announced on 3 March 2014
 
With the aim to further strengthenHong Kong’s status as an international business and financial centre, the HKSAR Government has recently completed a rewrite of the Companies Ordinance (“CO”) (CAP. 32).  The last major overhaul of the CO was almost 20 years ago.  A broad scope of consultation and exercise at phases to rewrite the CO took place between 2006 and 2013. 
 
Starting from mid-2006, the HKSAR Government launched a major and comprehensive exercise to rewrite the CO.  The purpose of updating and modernising the CO is to make it more user-friendly and to help the conduct of business in order to improve Hong Kong's competitiveness and attractiveness as a major international business and financial centre.
 
The New Companies Ordinance (“NCO”) (CAP. 622) ensures better regulation and modernises the law.  In addition, it aims to achieve the improvement of corporate governance and business facilitation.  The new ordinance was brought into operation on 3 March, 2014. 
 
By the end of June 2014, the total number of live local companies registered was 1,233,780, up 70,849 from 1,162,931 as at the end of 2013. 
 
The improvement of corporate governance and Minority Shareholders Protection
 
As a new requirement for larger companies, directors are required to include a commentary of analytical and forward-looking business review in their directors’ report.  In the directors’ report, shareholders can get more information about the important issues affecting the company, namely environmental issues and staff matters.  Also, the company provides more opportunities for shareholders to participate in the process of business decisions-making in the company, as the threshold requirement for them to demand a poll at Annual General Meetings is lowered from 10%to 5% of the total voting rights. 
 
One of the most important changes relating to the protection of minority shareholders’ interests, brought about by the NCO, is the replacement of the “headcount test” by a new test for schemes of arrangement involving a general offer or a takeover offer.  In the new test, a high threshold for a scheme to be passed by shareholders is required - it can only be passed if, making light of the votes of the proponent of the scheme and his associates, the votes cast against the scheme is not more than 10% of the shares.  In the CO, there were the inherent deficiencies of the “headcount test”, such as share splitting.  In the NCO, the new test does not only avoid the headcount test, but also effectively preserve the minority shareholders’ interests and put the power to veto a scheme in the hands of the shareholders not associated with the proponent.  As an extra shield, challenging the scheme by a dissenting shareholder is allowed under the NCO, without worrying about the legal costs.  However, the challenge is not frivolous or vexatious.  The new test provides a more confident and predictable framework for potential proponents to assess whether or not to make a claim such schemes; for these reasons, it is more widely accepted.
 
Facilitating Business
 
To begin with, for a businessman looking to incorporate a company, the NCO has made the process more convenient than ever.  A common seal is no longer mandatory, and there are model articles of association for different types of companies to adopt.  In this way of simplified company formation, the company founders can save valuable time and effort as they pursue the business opportunities ahead of them.
 
Existing and new companies benefit by the NCO by reducing their compliance cost.  For instance, companies may dispense with Annual General Meetings with unanimous shareholders’ consent.  Small and medium-sized enterprises (“SMEs”) take advantage of the NCO, which are eligible for simplified financial reporting.  And the companies and shareholders can communicate in electronic or hard copy form, thus benefit by reducing costs and increasing the efficiency of communication.
 
Clarifying and Enhancing Legal Provisions
 
The NCO makes clear the duty of care, skill and diligence expected of directors to facilitate compliance.  Directors are required to follow more effective rules on fair dealings.  Particularly, shareholders have the right to approve the directors’ employment contracts if these exceed three years.  For directors of public companies, the requirement of the duty to declare interests to other directors in the NCO is extended.  The NCO requires that the shareholders’ approval is made without an interest in the transaction, where shareholders’ approval is necessary for a transaction between the company and its directors.
 
All the above changes help strengthen the accountability of directors and corporate governance, and in turn improve the protection of shareholders. 
 
In addition, members of the public benefit from the NCO if they deal with companies.  Financial statements of a company have been simplified by the abolition of the par value of shares.  It ensures that there are no misconceptions as to the real worth of a share.  Furthermore, the NCO strengthens the Companies Registry’s power in the maintenance of the system of the Companies Register and ensures that accurate and updated information about the companies can be accessed by members of the public.
 
The NCO is a big step towards modernising Hong Kong’s corporate regime and strengthening Hong Kong’s attractiveness as a major international business and financial centre.
 
Prospective change of the treatment of unrealised revaluation profits from trading securities in future
 
It is important to note that the Court of Final Appeal (CFA) held in Nice Cheer Investment Ltd. v CIR (the Nice Cheer case) in November 2013 that the unrealised profits arising from revaluation of trading securities are not taxable at the time of recognition because profits can only be taxed when they are realised (the so-called realisation basis), even though those unrealised profits arising from revaluation of trading securities recognised in the taxpayer’s financial statements that were prepared in accordance with the HKAS39.
 
Many years ago, the Inland Revenue Department (“IRD”) used to follow the fair value accounting treatment and to assess whether the unrealised revaluation profits/ (loss) recognised in the financial statements at the time of recognition provided that they are revenue in nature, was taxable or deductible.
 
According to the Nice Cheer decision, the realisation basis is required in the computation of assessable profits and the preparation of profits tax return by taxpayers.  That means the unrealised profits/ (loss) from revaluation of trading securities are non-taxable and non-deductible in the profits tax computation.  Possibly, other mark-to-market financial instruments recognised in their financial statements are the same, which are also excluded from the assessable profits for profits tax filing purposes.  The fair value accounting treatment is not taxable at the time of recognition as profits can only be taxed when they are realised. 
 
In order to cater to taxpayers’ different needs for preparing the profits tax filing based on the fair value basis or the realisation basis, an interim administrative measure was announced by the IRD.  The IRD agrees to accept the following arrangement: The year of assessment 2013/14 in which the assessable profits are computed on a fair value basis, as well as the year of assessment 2013/14 assessable profits already computed on a fair value basis can be revised if the realisation basis is subsequently adopted by taxpayers.  But, any request for revising the computation submitted is no later than the time limits set down in section 70A of the Inland Revenue Ordinance.
 
Although some taxpayers may decide which treatment is beneficial to them, other taxpayers may think that the two different bases only result in a timing difference for taxpayers and substantial costs have to be incurred in re-doing the computation of the assessable profits for tax filing purposes using the realisation basis. 
 
The IRD’s announcement emphasizes that the measures are just interim administrative measures for 2013/14 profits tax filing.  Taxpayers should consider whether or not the fair value basis can be continually adopted, if the adoption of fair value basis for preparing and computing the assessable profits or losses in profits tax return is not legally binding following to the Nice Cheer Case.  The announcement implies that the issues arising from the Nice Cheer decision are now being scrutinised by the HKSAR Government, particularly whether the HKSAR Government should amend Inland Revenue Ordinance (CAP. 112) to allow the use of the mark-to-market practice.

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