Brighter future of Hong Kong: Enhancements to the Aircraft Leasing Preferential Tax Regime

Recap: what are the tax benefits provided under the 2017 Regime?

The Inland Revenue (Amendment) (No. 3) Ordinance 2017 came into effect on 7 July 2017, which introduced the 2017 Regime and increased the competitiveness of Hong Kong to rival other jurisdictions such as Singapore in the aircraft leasing and financing industry.

The 2017 Regime has two key features:

(1)   50% reduced tax rate on the qualifying profits of the qualifying aircraft lessors and qualifying aircraft leasing managers

The qualifying aircraft lessors and qualifying aircraft leasing managers are offered the concessionary 50% reduced tax rate, i.e. 8.25% instead of 16.5%. 

(2)   compensation for loss of depreciation allowances

Under section 39E of the IRO, tax depreciation allowances in respect of the capital expenditure (i.e. acquisition cost) of an aircraft cannot be enjoyed by lessors if the aircraft is leased to a non-Hong Kong aircraft operator. To address this loss of depreciation allowances for lessors, the 2017 Regime provided that the assessable profits derived from leasing of an aircraft to an aircraft operator by a qualifying aircraft lessor is equal to only 20% of the net lease payments (i.e. gross lease payments less deductible expenses, but excluding depreciation allowance).[10]

What has happened after the 2017 Regime?

According to the Trade Consultation Paper by TLB in November 2022, the aircraft lessors based or with subsidiaries set up in Hong Kong have since then leased around 95 aircraft to aircraft operators in the Mainland China, Chile, Cambodia, Indonesia, Japan, Malaysia, South Korea, Qatar and Vietnam, etc. This is a positive signal that Hong Kong is stepping up in the aircraft leasing industry.

However, there remains substantial room of growth in Hong Kong in comparison with other major aircraft lessor jurisdictions.[11] According to Commercial Market Outlook 2022-2041 published by Boeing in July 2022, it is estimated that a total of over 41,100 aircraft will be delivered in the next 20 years and over 20% of which will be delivered to China. Financing this growth presents huge business opportunities to Hong Kong. Therefore, to capitalise Hong Kong’s existing strengths and to attract more aircraft leasing businesses to set up subsidiaries in Hong Kong, the Hong Kong government is considering whether to revise, in a beneficial manner, the tax benefits provided to the aircraft lessors consistent with their commitment to BEPS.

Proposed enhancements to the 2017 Regime

When reconsidering the 2017 Regime, the Hong Kong government has proposed the following enhancements in the Legislative Council paper[12] for the discussion on 10 July 2023:

• Tax deduction on the acquisition cost of aircraft replacing the 20% tax base concession;
• Removal of some specific anti avoidance provisions in respect of the eligibility of the 20% tax base concession;
• Expansion of the scope of the 2017 Regime;
• Deduction of interest payable for acquisition of aircraft to a financier outside Hong Kong who is not a financial institution and may be an associate of the borrower; and
• Prescribing threshold requirements for aircraft lessors and aircraft leasing managers under the 2017 Regime to comply with the OECD’s requirements.

A.   Tax deduction on the acquisition cost of aircraft

What is the current situation in Hong Kong?

Qualifying aircraft lessors are not entitled to tax allowances on acquisition cost where they lease aircraft to non-Hong Kong aircraft operators.

To address the loss of depreciation allowances to the lessor, a 20% tax base concession was introduced to compensate for the denial of the tax allowance on the acquisition costs of the aircraft in the 2017 Regime. The reduced tax base at 20% could render the internal rate of return achieved from leasing to non-Hong Kong aircraft operators comparable with that from leasing to Hong Kong aircraft operators.[13]

What is the problem?

As the aircraft leasing business involves huge outlays in aircraft acquisition, its relevant tax treatment for the acquisition cost of aircraft is an important consideration for the companies to decide where to conduct business. Having no tax deduction on the acquisition cost puts Hong Kong in a relatively disadvantaged position when compared with aircraft lessors conducting business in other jurisdictions (such as Ireland and Singapore) where capital allowances are generally allowable to aircraft lessors. In particular, the lack of a tax deduction, even with a reduced tax base of 20%, can still result in the lessor paying tax earlier than may have been the case if a tax deduction was allowed (in substitute for the 20% tax base).

In addition, any benefit the 20% tax base would provide to the lessor could be reduced on the implementation of the various BEPS 2.0 rules throughout the world[14].

What is proposed?

The Hong Kong government proposed to amend the IRO to replace the 20% tax base concession with a 100% deduction of the acquisition cost of the aircraft. Aircraft lessors will be allowed a one-off full deduction of the acquisition cost of the aircraft for the year of assessment in which the aircraft is acquired on or after the commencement of the legislative amendments.

This is likely to result in the lessor carrying forward the tax losses from the tax deduction into future years. In such circumstances the lessor is unlikely to be in a tax paying position for a number of years.  

B.   Expansion of the scope of the 2017 Regime

What is the current situation in Hong Kong?

Under the 2017 Regime, the scope of aircraft leasing activity is confined to leasing of an aircraft to an aircraft operator and only non-finance lease of an aircraft under a dry lease for a term of over one year is allowed for the tax deduction. 

What is the problem?

Leasing arrangements are typically not confined to operating lease or dry lease. Aircraft lessors may lease an aircraft by way of operating lease (including dry lease or wet lease) or finance lease.

In addition, aircraft lessors now lease aircraft to other entities including private companies, public organisations or even individuals. In other words, lessees are not confined to aircraft operators.

What is proposed?

To address these issues, the Hong Kong government has proposed to amend the IRO to:

1. include wet lease and finance lease;
2. remove the 1-year restriction on the lease term; and
3. expand the general meaning of “aircraft leasing activity” – leasing of an aircraft by an aircraft lessor irrespective of whether the aircraft is leased to an aircraft operator or non-aircraft operator.

This allows flexibilities to the qualified aircraft operators when leasing to private companies and individuals.

C.   Deduction of interest payable for acquisition of aircraft to a financier outside Hong Kong who is not a financial institution and may be an associate of the borrower

What is the current situation in Hong Kong?

Interest incurred by an aircraft lessor to finance the acquisition of the aircraft is allowable for deduction if the lender is a financial institution overseas or it is not an associate of the borrower. 

What is the problem?

The financers who are located outside Hong Kong may be an associate of the borrower and hence will not be a financial institution which can satisfy the requirements for deduction of interests.

What is proposed?

Hong Kong government proposed to amend the IRO to allow deduction on interest in recognition of the different financing means that have developed.

D.   Prescribing threshold requirements for aircraft lessors and aircraft leasing managers under the 2017 Regime to comply with OECD’s requirements

What is the current situation in Hong Kong?

There is no threshold requirement for aircraft lessors under the 2017 Regime nor the IRO to show Hong Kong is complying with the international standard.

What is the problem?

To avoid harmful tax practices, OECD will consider whether a tax preferential regime has incorporated a substantial activity requirement to ensure that only those entities which undertake their core income generating activities in the jurisdiction would benefit from the regime.  OECD expects that a qualifying taxpayer should, in the jurisdiction providing the regime –

1. employ an adequate number of full-time qualified employees; and
2. incur an adequate amount of operating expenditure.[15]

What is proposed?

To meet the requirements of OECD substantial activity requirement, the Hong Kong government intends to amend the IRO by prescribing the following threshold requirements for Hong Kong based aircraft lessors and aircraft leasing managers:

E.   What has been done otherwise by the Hong Kong government so far?

Hong Kong government has already implemented enhancement measures via administrative means on the following two aspects[16]:

1. recognition of the Irish stock exchange; and
2. specification of leasing model involving bare trust.

Recognition of the Irish Stock Exchange

Interest is allowed for deduction if it is payable on debentures listed on a stock exchange in Hong Kong or on any other stock exchange recognised by the Commissioner of Inland Revenue. However, the Irish Stock Exchange is not on the list. The problem is that many aircraft leasing groups raise bond financing or have notes in asset-backed securitisation structures which are listed in Ireland.

To facilitate the financing of aircraft lessors, starting from 1 April 2023, the Irish Stock Exchange has been recognised by the Commissioner, and the interest payments under listed debentures will be allowed for deduction.

Specification of leasing model involving bare trust

There has been an increase in the use of bare trustee which holds the legal ownership of an aircraft and the aircraft lessor acts as the beneficial owner of the aircraft. Since leasing aircraft via a bare trust is already eligible for the tax concession under the 2017 Regime, there is no need to further amend the IRO. Thus, the Inland Revenue Department has updated the Departmental Interpretation and Practice Notes No.54 to further clarify such eligibility.

Conclusion

The enhancements will make Hong Kong a more attractive jurisdiction for aircraft lessors.

The proposals above, if legislated, will strengthen Hong Kong’s position as a preferred jurisdiction for aircraft lessors.

The chart below compares key relevant parameters between Hong Kong, Ireland and Singapore (assuming the proposal comes into effect). It should be noted though that Hong Kong’s tax regime dictates that tax shall be paid in cash each year. There is no tax deferral concept as there is in Singapore and Ireland which can be an incentive for lessors to prefer those jurisdictions.

* The proposal is to replace the 20% tax base concession with a specific tax deduction of the aircraft acquisition cost; but it is not clear whether the choice will be between a tax deduction or a 20% base concession.

**As of 1 November 2023.

*** There are 98 double tax treaties but 4 of them are not in force.

Beyond the tax enhancements?

Tax is an important factor that contributes to the attractiveness of a place of business for aircraft lessors. However, Hong Kong's appeal to aircraft lessors extends far beyond. Its well-established infrastructure, solid legal foundation, strong financial system with a vast array of financial services, business-friendly environment, and world-class talent pool would all contribute to making Hong Kong a preferred destination for aircraft leasing activities.

What lies in the proposal beyond tax enhancements is the city’s aspiration to nurture the aircraft leasing community, an aspiration that would help further cement its position as a global hub for lessors.

Any reference to “Hong Kong” or “Hong Kong SAR” in this article shall be construed as a reference to “Hong Kong Special Administrative Region of the People’s Republic of China”.

References

[1] OECD BEPS: https://www.oecd.org/tax/beps/about/

[2] OECD BEPS – Understanding tax avoidance. Available at: https://www.oecd.org/tax/beps/

[3] Ibid.

[4] OECD BEPS – press release 138 countries and jurisdictions agree historic milestone to implement global tax deal; 12 July 2023 at:  https://www.oecd.org/tax/beps/138-countries-and-jurisdictions-agree-historic-milestone-to-implement-global-tax-deal.htm

[5] Two-Pillar Solution to Address the Tax Challenges Arising from the Digitalisation of the Economy – Frequently asked questions. Available at: https://www.oecd.org/tax/beps/faqs-two-pillar-solution-to-address-the-tax-challenges-arising-from-the-digitalisation-of-the-economy-july-2022.pdf

[6] Section 14H, IRO.

[7] Section 14J, IRO.

[8] Under section 14L of the IRO, the Commissioner may, on application by a corporation, determine that the corporation is a qualifying aircraft leasing manager for a year of assessment.

[9] Section 14G, IRO.

[10] Section 14I, IRO.

[11] Ireland and Singapore each captures over 60% and 20% of the global market share in aircraft leasing whereas the market share for Hong Kong is expected to reach 18% in 2037 (with the 2017 Regime) according to Hong Kong government’s estimation. Source: https://www.pwc.ie/industries/aviation-finance.html; https://www.mti.gov.sg/Newsroom/Parliamentary-Replies/2018/07/Written-reply-to-PQ-on-Singapore-as-aircraft-leasing-hub; https://www.fsdc.org.hk/media/30yodket/aircraft-leasing-paper_e.pdf

[12] Legislative Council Panel on Economic Development - Enhancements to the Aircraft Leasing Preferential Tax Regime. LC Paper No. CB(4)662/2023(02).

[13] Enhancing the Aircraft Leasing Preferential Tax Regime, Trade Consultation Paper by Transport and Logistics Bureau Inland Revenue Department (November 2022). Available at: https://www.tlb.gov.hk/eng/publications/transport/consultation/air02/consultation%20paper_en.pdf

[14] On the assumption that the lessor is an entity in an in-scope MNE; refer to pages 6 and 7 of Enhancing the Aircraft Leasing Preferential Tax Regime, Trade Consultation Paper by Transport and Logistics Bureau Inland Revenue Department (November 2022).

[15] For more details on OECD’s requirement: https://www.oecd.org/tax/beps/substantial-activities-in-no-or-only-nominal-tax-jurisdictions-guidance.pdf

[16] Paper No. CB(4)662/2023(02).