Tax Liability Insurance – An innovative strategy to mitigate offshore claim risks
Tax Liability Insurance: An innovative strategy to mitigate offshore claim risks By Martijn de Lange, Managing Director, Asia Tax Liability Insurance ( TLI ) is an innovative strategy to transfer potential tax liabilities from a taxpayer to an insurer. It is increasingly used by taxpayers as an alternative to traditional tax risk mitigation strategies. In Hong Kong, taxpayers face risks when seeking to rely on the territorial principle of taxation, by which offshore profits are not chargeable to Hong Kong tax. In this article, BMS’s Martijn de Lange discusses these risks and explains how TLI may help to mitigate against them. Hong Kong’s territorial system for business profits
consensus is that one only looks to the transaction that in substance gives rise to the profits to ascertain the locality of those profits. That necessarily means ignoring matters that may be commercially relevant, but do not actually generate the profits themselves. “Whilst the case law is very clear, the IRD’s assessing practice has become aggressive. They often argue that merely having a local bank account or carrying on activities that are on their face merely ancillary to the profit-making transactions is sufficient to cause the taxpayer’s profits to be Hong Kong sourced. In that regard, the IRD relies on the fact that most Hong Kong taxpayers are non-litigious and are, therefore, likely to compromise with the IRD rather than going to court. “In other words, the IRD is steering assessing practice in a direction that resembles residence based systems of taxation found in other jurisdictions: that is, if the principal place of business of a taxpayer is Hong Kong, then its profits must, the IRD assumes, be Hong Kong source. That approach is inconsistent with affirmed case law, but the cost and duration of litigation in Hong Kong in practice deter many taxpayers from asserting their rights before the Board of Review or higher courts.”
Unlike most advanced jurisdictions, Hong Kong does not tax worldwide business profits based on residence. Instead, it has a territorial tax system. Section 14 of the Inland Revenue Ordinance ( IRO ) charges a person to tax if it: (i) carries on a trade, profession or business in Hong Kong ( Business Test ); and (ii) derives Hong Kong source profits from such trade, profession or business ( Source Test ). Both the Business Test and the Source Test must be met for a charge to tax to arise. Challenges with the Source Test It is usually straightforward to determine whether the Business Test is met, but the question of the Source Test is considerably more complex. Stefano Mariani, Tax and Trusts partner of the law firm Deacons, notes: “There is extensive case law from which general rules on the source can be distilled: the source of income is a hard-practical matter of fact, which is to be judged not as a technical matter, but a commercial one. The fundamental test is what the taxpayer’s operations from which profits arise were, and where these were carried on, discounting antecedent or incidental matters. This seems reasonably straightforward, but its application depends on the characterisation of a taxpayer’s trade or business. The judicial
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Increased scrutiny on offshore claims It would follow that “offshore claims” (that is, a taxpayer filing a Hong Kong tax return on the basis that it does not have any Hong Kong source profits, and is therefore not chargeable to tax in Hong Kong) have been subject to greater scrutiny by the IRD. Many taxpayers who enjoyed exemption from profits tax in the past have recently been audited by the IRD and requested to furnish comprehensive documentation to substantiate their offshore claims. Unsurprisingly, the IRD has begun to treat profits it traditionally accepted were sourced outside of Hong Kong as being taxable, which has in turn led to an increase in tax disputes. Mariani commented: “The IRD’s increasingly aggressive approach can partly be explained in the context of a global movement to combat MNE’s tax avoidance practices. Some fiscal policymakers view that Hong Kong’s attractive territorial tax system might not be in line with modern international taxation principles. Although Hong Kong does seem keen to protect its tax system, the IRD may feel urged to critically review Hong Kong tax structures, including those banking on successful offshore claims. It is not so much a question of law, but of interpretation and administrative practice.” Traditional risk mitigation strategies Within the local tax community, it is no secret that the restrictive approach of the IRD to the territorial tax regime has become the leading tax risk in Hong Kong. To reduce the risk of being challenged on the territoriality point, taxpayers may deploy several strategies, of which Mariani summarises three: • Documentation. Comprehensive contemporaneous documentation is crucial with respect to offshore claims and should be prepared with a view to being supplied promptly to the IRD if called upon. The IRDmay inquire into, amongst other matters, the contractual basis of profitmaking transactions, how those transactions were booked, how and where clients were solicited, and merchandise was stored. To supply credible and comprehensive responses to IRD inquiries, taxpayers should produce and retain contemporaneous documentation evidencing each stage of its commercial and decision-making activities. Similarly, where the carrying out of certain activities in Hong Kong is internally prohibited to prevent the triggering of substantive commercial activity in the jurisdiction, it is important that the internal procedures in place to procure the geographic segregation of functions be clearly set out in internal documentation and applied stringently. • Advance ruling. It is possible to request for an advance ruling from the IRD. Taxpayers should be
wary of this option as it could result in an adverse ruling which would not be appealable (absent judicial review). An adverse ruling will send the taxpayer back to ‘square one’, guaranteeing that the IRD, who is bound to the assessment, will raise an additional assessment. • Apportionment. Where the same unit of profit has both onshore and offshore components, taxpayers may wish to argue that at least the offshore component should not be chargeable to profits tax. This is where the concept of apportionment comes into play. Apportionment is appropriate where profit-generating activities or value-addition take place both in and outside of Hong Kong. The effect of this would be that only the portion of profit arising in Hong Kong is taxable. Though the IRD prefers an ‘all or nothing’ approach, it does not exclude apportionment of profit in its published guidance. Tax Liability Insurance as an alternative While said strategies may lower the risk of challenges from the IRD, they may not fully eliminate it. Taxpayers are, therefore, left with uncertainties as to whether their ‘offshore claim’ or zero-tax position in Hong Kong will be respected. Additionally, taxpayers also need to consider the risk of the IRD asserting that profit tax returns have been incorrectly filed and imposing severe penalties. This is where TLI can be utilised to gain a critical risk management advantage. A TLI policy offers the taxpayer a quick and capital-efficient tool to eliminate a financial exposure by transferring offshore claim risks to an insurer. In exchange for a premium payment, the insurer covers the potential financial loss resulting from the IRD’s successful challenge of an insured offshore claim position. Insurable offshore claim risks Insurers generally prefer to underwrite tax risks with a low probability of materializing and a high quantum. Furthermore, there must be a sound legal basis for the tax position being taken as insurance cannot be obtained for an incorrect tax position based only on detection risk. Before considering underwriting an offshore claim risk, an insurer will require a tax opinion from a reputable law/tax advisory firm supporting the technical soundness of the offshore claim. Such advise should detail (i) the tax-technical analysis of the taxpayer’s position; (ii) the financial exposure; and (iii) the likelihood of IRD success in challenging the offshore claim before a tribunal or court. Insurers normally will not require a percentage to be attributed to the chance of success if challenged, rather they would expect to see a ‘should’ or ‘more likely than not’ level of opinion.
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Coverage, policy period & timing A TLI policy would protect the insured (the taxpayer) against ‘losses’ arising from the insured offshore claim position. These losses include: (i) t ax due following the IRD’s assessment or determination, (ii) interest and non-criminal penalties (if applicable) (iii) d efense costs incurred by the insured in defending a challenge from the IRD; and (iv) t ax gross-up for payments made under the policy (if applicable) The policy period is typically aligned with the period during which the IRD can challenge the offshore claim (statute of limitations). Policy periods are normally 7 years but can be extended up to 10 years. It is possible to cover multiple fiscal years under one TLI policy. A considerable benefit of a TLI policy is the short time frame to obtain certainty: a policy can be put in place in as little as one to two weeks. Costs The premium is a percentage of the insured amount and is paid post-inception as a one-time-only premium. Pricing primarily depends on the strength of the tax position, while factors such as market conditions, amount and dispute history are also relevant. Premiums generally range between 2% and 6% of the sum insured. In addition to the premium, insurers charge underwriting fees to cover their costs to seek external tax advisors’ advice on the tax position to be insured. Claims An insurance policy is only effective when it pays out in the event of a valid claim. Claims handling procedures and track records are critical factors when selecting an insurer to underwrite a tax risk and a broker needs to carefully consider these factors when advising clients.
Insurers are sensitive when it comes to their reputation in terms of claims handling. Most insurers have in-house claims teams to warrant a streamlined, thorough claims process and practice shows that claims under TLI policies are being handled with due care. Tom Roth, who leads Liberty’s GTS APAC tax risk insurance practice, notes: “Insurers are being increasingly judged on their claims service, but there are significant differences in terms of how individual insurers are set up to handle claims. Selecting an insurer that has a specialist in-house claims handling function can save time and money down the line in the event that it becomes necessary to make a claim under the policy.” Required information To approach insurers and provide a sense of pricing and coverage for an offshore claim risk, BMS would need to receive the following information: 1. A copy of the tax opinion detailing (i) the tax- technical analysis; (ii) the financial exposure and (iii) the likelihood of the IRD’s success in challenging the offshore claim. 2. A calculation of the likely tax liability and associated costs (e.g. defense costs, applicable interest and penalties). Conclusion In Hong Kong, taxpayers face risks when seeking to rely on the territorial principle of taxation by which offshore profits are not chargeable to Hong Kong tax. While traditional risk mitigation strategies may lower the risk of challenges from the IRD, they may not fully eliminate it This is where TLI can be utilised to gain a critical risk management advantage: a TLI policy offers the taxpayer a quick and capital-efficient tool to eliminate a financial exposure by transferring the offshore claim risk to an insurer.
Contacts We hope you enjoyed the read. For a confidential discussion please contact us: Martijn de Lange Aris Wong Managing Director Managing Director T: +852 3579-5486 T: +65 6230-7987 M: +852 9772-9951 M: +65 8321-6236 martijn.delange@bmsgroup.com aris.wong@bmsgroup.com
BMS Asia Risk Solutions Pte. Ltd is registered by the Monetary Authority of Singapore as a direct insurance broker and a general reinsurance broker. 138 Market Street #05-01, CapitaGreen, Singapore 048946. Incorporated in Singapore (UEN: 202017234M). Switchboard: +65 6230-7980 BMS Asia (Hong Kong) Ltd, an Insurance Intermediary, licensed by the Insurance Authority. 4/F, Lee Garden Three, 1 Sunning Road, Causeway Bay, Hong Kong. Incorporated in Hong Kong (2955974). Switchboard: +852 3579 5490 This is a marketing communication. Formal terms of engagement must be agreed to secure the services of BMS Asia Risk Solutions Pte. Ltd and BMS Asia (Hong Kong) Ltd.
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