We look at the HK Government's opium-like addiction to stamp duty revenues, which have more than quintupled in 7 years. The budget asks for another fix. Stamp duty is sand in the wheels of the economy, distorting economic decisions and reducing economic output. It should be abolished rather than increased further. Higher stamp duty does not improve property affordability. HK needs a root-and-branch review of taxation to refocus on fair taxation of GDP rather than one-off measures and distortive policies.

HK's stamp duty addiction
2 March 2010

One of the notable features of last week's Hong Kong Budget was another opportunistic move to throw sand in the wheels of Hong Kong's economy, increasing frictional taxation on immovable property valued at over HK$20m (US$2.56m) and further swelling government coffers, even after projecting a 2009-10 budget surplus partly due to the high revenues from stamp duty.

By "frictional taxation" we mean taxation of actions which in themselves bear no relation to economic output. This type of taxation simply slows down the free market. When a property changes hands, the transfer in itself does not create any economic output, or GDP. For first-hand sales, there is usually a developer's profit, taxed with profits tax. For primary and secondary transactions, estate agents and lawyers earn fees which may generate taxable profits. For all the second-tier beneficiaries, such as newspaper companies which carry new and second-hand property advertising, there may be taxable profits. For all the people who work in those firms, there is income subject to salaries tax. But the simple transfer of the property in itself does not generate GDP. The same applies to shares, which we cover below.

The new rates of property stamp duty take effect on 1-Apr-2010 and the revised table is as follows:

From HK$ Stamp duty Effective rate
0 100 NA
2,000,000 $100+10% of excess 0.005%-1.50%
2,531,760 1.5% 1.5%
3,000,000 $45k+10% of excess 1.5%-2.25%
3,290,320 2.25% 2.25%
4,000,000 $90k+10% of excess 2.25%-3.00%
4,428,570 3.00% 3.00%
$,000,000 $180k+10% of excess 3.00%-3.75%
6,720,000 3.75% 3.75%
20,000,000 $750k+10% of excess 3.75%-4.25%
21,739,120 4.25% 4.25%

Simplifying this somewhat, from 1988 to the new budget (if passed by LegCo), here is the 22-year history. Keep in mind that nominal property prices escalated substantially from 1988 to 1997:

Up to $k 1-Apr-88 1-Apr-94 1-Apr-96 1-Apr-97 1-Apr-99 28-Feb-07 1-Apr-10
250 - - - - - - -
500 0.75 - - - - - -
750 1.50 0.75 - - - - -
1,000 1.50 0.75 0.75 - - - -
1,500 2.00 1.50 0.75 0.75 0.75 - -
2,000 2.75 1.50 1.50 0.75 0.75 - -
2,500   2.00 1.50 1.50 1.50 1.50 1.50
3,000   2.00 2.00 1.50 1.50 1.50 1.50
3,500   2.75 2.00 2.00 2.25 2.25 2.25
4,000     2.75 2.00 2.25 2.25 2.25
6,000       2.75 3.00 3.00 3.00
20,000         3.75 3.75 3.75
+             4.25

As the table shows, until 1999 the maximum rate was 2.75% on properties over $4m, so the sale of a $21.74m property 11 years ago was taxed at that rate, and will now be taxed at 4.25%, which is a 54.5% increase in the tax take.

Higher stamp duty does not improve affordability

It may seem like an obvious point, but the Financial Secretary obviously doesn't get it, so here goes. He says:

"we will increase the transaction cost of property speculation with appropriate tax measures so as to reduce the risk of creating a property bubble. I propose that with effect from 1 April this year the rate of stamp duty on transactions of properties valued more than $20 million be increased from 3.75 per cent to 4.25 per cent, and buyers will no longer be allowed to defer payment of stamp duty on such transactions. In parallel, we will closely monitor the trading of properties valued at or below $20 million. If there is excessive speculation in the trading of these properties, we will consider extending the measures to these transactions".

This is pure opportunism. With escalating property values and higher rates of property stamp duty since 1999, the HK Government has become increasingly fixated on the revenue, like a junkie on opium (on which the colony was founded). The easiest way for the junkie to get another fix is to knock up stamp duty. This does nothing to make property more affordable - it simply siphons off an additional part of the property price that a buyer is willing to pay (or a seller is willing to receive) for a property.

Furthermore, increasing transaction costs affects all buyers, not just "speculators", whatever he means by that. Increasing transaction costs will reduce turnover and the taxable profits of estate agents, lawyers and others in the industry, and will increase the incentive to use companies to avoid the tax on future sales (see below).

The Government collected HK$7.5bn in stamp duty in the year to 31-Mar-2003. According to the latest budget, the Government now expects $40.5bn in stamp duty for the year ending 31-Mar-2010, up by more than $33bn, or 440%, in 7 years. A good portion of this comes from the 0.2% stamp on each share transaction (see below) but we are unable to find any breakdown of stamp duty revenues between property and stocks on the Treasury or Inland Revenue web sites, and this may be a state secret.

Stamp duty addiction

Distortion of rent v buy

One of the effects of the property stamp duty is to distort the economic choice between renting and buying. For any property over $6.72m, you are already paying 3.75% stamp duty, or about 100% of one year's rent (more in luxury property where yields are even lower than 3.75%).

By contrast, if you rent a property, then the stamp duty on that contract is 0.5% of the average yearly rent (up to 3 years). For a typical 2-year residential lease, that's 0.25%  of the rent per year, or in a typical 3-year commercial lease, about 0.17% of the rent per year.

So if you plan on moving home more than once every 400 years, then the stamp duty (ignoring other factors) favours renting rather than buying. Your editor lived in rented property for the first 15 years that he lived in HK - not because he couldn't afford to buy, but partly because he expected his space and facilities requirements would keep changing. First he was a singleton, then half of a couple, then with one child, and now with two. He's rented 7 different homes before buying one. What is the point, we wondered, of paying almost one year's rent in stamp duty every time you need to move?

Avoidance

The second issue of property stamp duty is that, to paraphrase the late Leona Helmsley, "only the middle class needs to pay stamp duty". It's not entirely accurate, but the point is this: once a property has been acquired by a company, you can freely transfer the ownership of that company without paying any further property stamp duty, because the registered owner of the property does not change. If the company has a share register in HK (as all HK-incorporated companies do) then you will be liable for stamp duty on the value of the shares, but only at the rate of 0.2%, and the value of those shares may be less than the property anyway if the company was funded with a shareholder loan or mortgage. For example, when the Langham Place complex was sold by Great Eagle Holdings Ltd (0041) to Champion REIT (2778) in 2008, a HK company was transferred at a valuation of $12,500m, and stamp duty was only $25m (at 0.2%), rather than $468.75m (at 3.75%), legally avoiding HK$444m of duty.

However, you don't even need to pay that 0.2% if the company is incorporated overseas with no share register in HK, because no transfer of shares takes place in HK. For example, on 13-Dec-06 Pacific Century Insurance Holdings Ltd (now Fortis Asia Holdings Ltd) bought HKL (King's Road) Ltd, a BVI company which owned Foundasia (HK) Ltd, which in turn owned the office block at 1063 King's Road, Quarry Bay, from Hongkong Land Holdings Ltd. The price of HK$1,472m attracted zero stamp duty, because a BVI company was sold, legally avoiding HK$55.2m of stamp duty (at 3.75%). Incidentally, HK Land acquired the site, then occupied by the old Crown Motors Building, from Richard Li's privately-held Pacific Century Group in Aug-1996 for US$105m and then redeveloped it, so it came almost full circle. Pacific Century Group had bought it from Inchcape Pacific (the Toyota distributor) for about HK$675m in Jan-1996. The hapless HK Land managed to make a loss on the deal, selling the company for less than the shareholder loans due from it.

The buyer of a property-owning company takes some risk that the company may have undisclosed liabilities, but the savings on stamp duty can offset that, particularly as the rate increases. If the vendor is a financially credible and trustworthy person or company which offers an indemnity against any such liabilities, then the risk is minimal.

So whenever you see a hotel, office property or luxury residential property being bought or sold by a listed company, particularly in a related party transaction, then it is quite often the case that the property itself is not sold, but the offshore company which ultimately owns it is sold, and no stamp duty is payable. When a company is sold, you will never see any sign of a change of ownership on the land registry.

So, naturally, when your editor finally bought a flat in HK, he used an offshore company to make the purchase. The company paid stamp duty (about 1 year's rent), but if anyone ever trusts him enough to buy the company, then neither side will have to pay stamp duty, and both sides will likely be better off. Using a company also provides privacy, because the public land registry only records the name of the company as the owner.

Recently there has been a lot of attention on the purchase of flats at 3988 Conduit Road and in the Monsterpiece in Tsim Sha Tsui. For almost every flat, the buyer was a separate company. Stamp duty, at least on secondary-market purchases, is a middle-class tax which is legally avoidable by the tycoons.

Taxing "speculators"

There's another wrinkle in the budget. Paragraph 31 says:

"The Inland Revenue Department (IRD) has established procedures to track property transactions involving speculation and will follow up each case closely. If it is found that such transactions constitute a business, the IRD will levy profits tax on the persons or companies concerned for profits arising from such transactions."

What exactly is "speculation" in this context? Anybody who buys a flat knows that its future value is uncertain - he is putting his capital at risk, often several times his net worth, by using a mortgage. Is that speculation? Can you prove that someone is buying a property purely for the purpose of selling it "for a profit"? In an efficient market, why would anyone rationally expect a profit? What if they originally planned to rent it out for investment income (taxable), but then got an attractive offer and sold it? Does that make them a speculator?

And how do we know what "constitutes a business"? Is there some magic number of apartments that one can invest in, and subsequently sell, before being accused of running a business involved in property trading? Is there some magic holding period, beyond which an investor can safely sell without being accused of running a business?

These uncertainties are similar to those in the closed-end investment company industry which is largely absent from the HK market because of the uncertainty over whether the gains they make on selling shares are "capital gains" or "trading profits", as we explained in our article of 18-Dec-09. In these areas, HK's much-trumpeted rule of law is undermined by the lack of legal certainty. In layman's terms, moving goalposts does not a fair game make.

The simple fact is that properties are capital assets which produce an income in the form of rent, which generates taxable profits. Any change in their capital value is a change in the net present value of their future income stream (rent minus expenses) and that income stream will be taxable when it comes. Taxing the change in value of the property is thus a form of double taxation, whether it is a short-term gain or one made after many years.

All that the Government is doing, by threatening to label people as "speculators" and tax them, is to incentivise those people to hold their investments through offshore companies and avoid the argument altogether.

Stamp duty on shares

Hong Kong is one of the last markets to still apply a transaction tax on shares. The same arguments apply to shares as they do to properties - the transfer of a share does not in itself generate any GDP. It is a frictional tax which inhibits turnover and reduces business for brokers, exchanges and other intermediaries. Not only that, but it only applies to shares in companies, not to warrants, callable bull-bear certificates or other derivatives. As a result, punters have an incentive to buy and sell their exposure to equities through derivatives rather than buying the actual stock. The stamp duty distorts the equity v derivative decision.

In case you think this problem does not apply to you, stop and think about your MPF or ORSO scheme, or the HK mutual funds you own, which pay stamp duty each time they buy or sell HK shares. If they turn over their portfolio once per year, then over a 20-year period you will lose about 4% of your equity investments in stamp duty.

Perhaps it is only the Listing Rules which prevent a derivative issuer from innovating stamp duty away, by coming up with a 100-year call warrant with a strike price of $0.0001 which automatically adjusts the conversion ratio whenever a dividend is declared. That would give you all the economic benefits of the underlying stock, but without the voting rights or stamp duty. Anyone up for it?

The following notable countries have no stamp duty on shares: USA, Australia (abolished 1-Jul-2001) and New Zealand. In the EU, only Denmark, Ireland and the UK have stamp duty on shares. Ireland charges 1%. The UK has the second-highest rate in Europe, charging 0.5% on one side of the transaction, but this is widely avoided by professional investors using contracts for differences and various exemptions for market makers. In 2007 the London Stock Exchange and others commissioned a consultancy to estimate the benefits of abolition for the UK economy. Amongst other things, the report pointed to the likely increase in share prices and reduction of cost of capital for issuers due to the elimination of the net present value of future stamp duty costs on the investment portfolio.

Refocus on GDP

Rather than tinkering with hand-outs and other "one-off measures", HK badly needs a root-and-branch review of its taxation policy. There is huge scope to make the system simpler, fairer and more efficient. The aim should be to tax the economic output (GDP in the form of corporate profits and personal earned income) in a uniform but efficient way, and not to distort economic choices with taxation incentives or disincentives. We've written in the past about the problems with housing benefits, for example, and there are many more areas for reform beyond the scope of this article.

Make Stamp Duty history

Stamp Duty has an interesting history - it was introduced in the UK in 1694 as a duty on vellum, parchment and paper during the joint reign of King William III of Orange and Queen Mary II, to finance a war in France. William of Orange was Dutch by birth, and stamp duty had been introduced in Holland in 1624, so perhaps he imported the idea. It was only supposed to last 4 years in the UK, but is still going 316 years later, albeit on different assets. The attempted enforcement of the Stamp Act of 1765 in the English colonies of America led to the outcry of "no taxation without representation" and was a contributing factor to the American War of Independence. With a history like that, it is time for this former British colony to stamp out the stamp duty.

© Webb-site.com, 2010


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