In geographical terms, the peninsula and collection of islands in south eastern China which make up the territory of Hong Kong are a little over 400 square miles in size, but in economic terms, the former British colony, which in 1997 was handed back to greater China, packs a serious punch on the world stage and can claim to be the globe’s third largest financial centre after New York and London, and the ninth largest economy in the world.

How has this been achieved? Well, the story of Hong Kong’s economic success has its roots in Britain’s colonial past, and is not really the focus of this feature. However, factors such as Hong Kong’s low business and personal taxation burden, its laissez-faire business environment enshrined in a common law system based upon English principles and its unique position as a trading and investment gateway to China have certainly helped.

One Country, Two Systems

Politically, since July 1, 1997, Hong Kong has been a Special Administrative Region of the People's Republic of China and the constitution known as the ‘Basic Law’ is modelled on the constitution of the People's Republic. Under the slogan of ‘one country, two systems’ which was established before the handover, the Chinese Government agreed that Hong Kong's capitalist system would remain unchanged until the year 2047. This means it has been pretty much business as usual in terms of the day to day functioning of the Hong Kong’s economy, (although it has to be said that question marks remain over Beijing’s desire to promote democracy in the SAR).

Nevertheless, the decision by China not to interfere in the local economy means that little has changed since 1997 to upset Hong Kong’s financial services system (apart from external economic factors beyond its control). Tokyo aside, Hong Kong is Asia’s largest banking hub in terms of external transaction volume. At the end of February 2012, there were 153 licensed banks, 20 restricted licence banks and 25 deposit-taking companies in business. These 198 authorised institutions operate a comprehensive network of 1,300 local branches. In addition, there were 60 local representative offices of overseas banks in Hong Kong. Total bank deposits have grown steadily over the past 12 months, and at the end of January 2012 stood at over HKD7.6 trillion (just under USD1 trillion), up from HKD6.86 trillion a year earlier. Renminbi banking is restrained so far, but as much as RMB588.5bn (USD93bn) in renminbi deposits were held in Hong Kong banks at the end of 2011, five times more than was held in mid 2010. Total employment in the banking sector numbers about 100,000.

Furthermore, Hong Kong is recognised as the leading fund management centre in Asia, with the industry defined by its international and offshore characteristics and it has become a popular choice for hedge fund managers. Until 2006, hedge funds were frequently domiciled elsewhere, owing to the fact that they are subject to profit tax in Hong Kong. But under The Revenue (Profits Tax Exemption for Offshore Funds) Act 2006, offshore funds owned by non-resident entities (which can be individuals, partnerships, trustees of trust estates or corporations) administering a fund, are exempt from tax in respect of profits derived from dealings in securities, dealings in futures contracts and leveraged foreign exchange trading in Hong Kong carried out by specified persons such as corporations and authorized financial institutions licensed or registered under the SFO to carry out such transactions.

Hong Kong’s hedge fund industry has also continued to register growth. According to the Hong Kong Securities and Futures Commission's last survey report of the sector, released in March 2011, assets under management or advisory in Hong Kong increased 14% from the time of the previous survey in March 2009 to USD63.2bn as at September 30, 2010. The number of hedge funds managed by the SFC-licensed hedge fund managers in Hong Kong stood at 538 as at September 30, 2010, nearly five times the level in 2004, the earliest year covered in similar SFC surveys.

The CEPA agreements (Closer Economic Partnership Arrangement) with mainland China have already gone a long way towards opening access for Hong Kong financial institutions to the mainland, and the city’s financial services industry is beginning to play a key role in the growth of fund management and international banking on the mainland, with China opening up its banking and investment sector under WTO rules.

Low Taxation

A great deal of Hong Kong’s economic success is undoubtedly attributable to a policy of low taxation. A big advantage is that tax is levied on a territorial basis, meaning that taxes are only charged on income arising from or derived in Hong Kong itself. Furthermore Hong Kong does not levy capital gains taxes, withholding taxes, annual net worth taxes or sales tax, although recent budgetary constraints forced the government to actively consider the latter some years ago. Despite the government's efforts to convince taxpayers of the merits of a sales tax, the proposal was deeply unpopular with Hong Kong's public, however, and is no longer on the agenda.

The main tax encountered by business entities in Hong Kong is profit tax which is charged at a standard rate of 16.5% (15% for unincorporated businesses).

Property tax is also relatively low, and charged at 15% of the annual assessed rental income of the property. Corporations can set it off against profits tax. Hong Kong does buck the world trend somewhat by retaining stamp duty on the transfer of shares and market securities (charged at 0.2%) although it is the intention of the government to eventually phase out stamp duty altogether. Stamp duty on property transactions rises on a graduated scale to a maximum of 4.25%. A Special Stamp Duty (SSD) on residential properties was introduced in November 2010 to curb speculation as 'hot money' flowed into Hong Kong's real estate market (see below). This is charged at rates of up to 15% depending on length of ownership.

Personal income taxes are also low by world standards and constitute a major draw for foreign residents. Income tax, known in the SAR as ‘salaries tax,’ is based on the previous year's income. It is charged at either 15% of assessable income after deductions, or at progressive rates to 17% (March, 2012), whichever is lower. The territorial nature of Hong Kong’s tax system means that there is much scope to reduce taxation on various forms of income derived from foreign jurisdictions.

Prudent management of Hong Kong's fiscal finances in recent years allowed Financial Secretary John Tsang to sprinkle the cash around in the 2011/12 budget, announced in February 2011. As a result, every Hong Kong permanent resident aged 18 or over got a cash grant of HKD6,000 (USD770), and and a 75% reduction in salaries tax and tax under personal assessment, capped at HKD6,000. The tax reduction mirrors a similar policy adopted in Tsang’s 2010/11 Budget. These measures replaced Tsang's original proposals to inject HKD6,000 into mandatory retirement accounts - a move that Tsang was forced to rescind following strong protests from some Legislative Council members, who argued that most taxpayers would not feel the benefit of this for many years.

Hong Kong until 2006 levied an estate tax, charged at a maximum of 15% on estates valued over USD1,350,000 (HKD10.5 million); but it was abolished in that year.

Residence

Hong Kong owes much of its success to international input, and its colonial past means that British influences abound. English can still be heard as the territory’s official language alongside Chinese. However, the overwhelming majority of Hong Kong’s densely packed 7 million population (according to the 2010 census) are of ethnic Chinese origin, with the major non-Chinese elements coming from the British Commonwealth, the US, Japan and Portugal.

All foreign nationals attempting to gain entry into Hong Kong must obtain a visa. The one exception to this rule is for British citizens, who may remain in the territory for up to six months before having to acquire a visa. However, the visa rules in Hong Kong are complex, and have become especially so since 1997. As a general rule those seeking to reside or work in Hong Kong who do not already have the right to abode or ownership of land in the territory need a visa. Whilst it may also be possible to arrive in Hong Kong on a tourist visa and obtain employment, it is becoming increasingly difficult for employers to obtain residential visas via this method, and it is therefore not the recommended path.

Employers will find the transfer of specialised staff or management posts within a firm is usually a straightforward business in Hong Kong, although the SAR government’s policy on importing labour makes recruiting specialised staff more difficult, and procedures are in place to ensure that local workers have ample opportunity to fill a vacancy ahead of foreign candidates.

Real estate

Real estate prices in Hong Kong have generally bucked the general global trend witnessed over the last ten years. While prices soared in certain parts of Europe, Northern America and Australia in the years before the credit crunch, Hong Kong’s market was actually deflating as it continued to reel from the effects of the Asian financial crisis of 1997/98.

By the end of the last decade however, things began to reverse, and in January 2008, prices were 90% above those seen five years earlier. The market went into reverse again in 2008, of course, with falls of up to 25% in most categories of property. However, while the property sector in most of the mature economies struggles to stage any sort of recovery, the Hong Kong government is now in a position where it is attempting to prevent a potentially dangerous real estate bubble from inflating too far, as strong demand from international investors, and particularly from China, drive up prices. Indeed, mainland Chinese buyers now make up 25% of prime market purchases in Hong Kong, where prime apartment prices rose by a further 4.6% in 2011, compounding the 60% growth seen since 2009, according to The World Wealth Report 2012, published by Knight Frank in association with Citi Private Bank.

So, with space very much at premium, USD1m will buy you a mere 21 square metres in Hong Kong, marginally more than in Monaco (17 square metres), but less than half that in Paris (38 square metres) and Manhattan (43 square metres).

Gross rental yields for residential properties are running at about 2% for luxury units and 3% for smaller units. Apartments cost between HKD3,000 (USD385) and 8,000 (USD1,025) per square foot depending on location; but larger apartments in fashionable neighbourhoods would cost a lot more than that.

In its 2010/2011 budget, the government introduced measures to cool the market, including an increase in stamp duty on properties valued at over HKD20m (USD2.6m) from 3.75% to 4.25%; and buyers will no longer be allowed to defer payment of stamp duty on such transactions. The government will also closely monitor the trading of properties valued at or below HKD20m. If there is excessive speculation in the trading of these properties, it will consider extending the measures to these transactions.

Following a significant inflow of 'hot money,' leading to substantial increases in asset prices in Hong Kong, Financial Secretary Tsang announced new anti-property speculation measures in November 2010. Among them was the Special Stamp Duty (SSD) on residential properties, which is charged on top of the current ad valorem property transaction stamp duty.

Any residential property acquired on or after November 20, 2010, either by an individual or a company, listed or unlisted, and regardless of where it is incorporated, and resold within 24 months will be subject to the proposed SSD.

The SSD is payable jointly and severally by both the buyer and the seller in the resale transaction, and is calculated based on the consideration for the resale transaction at regressive rates for different holding periods. It is charged at 15% if the property is held for six months or less; 10% if the property is held for more than six months but for 12 months or less; and 5% if the property is held for more than 12 months but for 24 months or less.

It was also proposed to disallow deferred payment of stamp duty, including SSD, for residential property transactions of all values, while, to deter non-compliance, the existing statutory sanctions were to be extended to cover the SSD. Any person who fails to pay the SSD by the deadline for payment is liable to penalties up to 10 times the amount of the SSD payable.

Since the SSD came into effect and up to end-January 2012, 98 transactions have been charged with special stamp duty, involving a total of HKD29.6m. In 10 cases, the properties sold for less than their purchase price. In addition, a total of 200 cases were exempted from duty, including, for example, the sale or transfer between close relatives and of residential property through inheritance from a deceased person's estate.

Since the special stamp duty's introduction, the monthly average number of cases fell from 320 to 80, a 75% drop. However, the government has no plan to review the SSD at this stage.

Closer Economic Partnership

As mentioned, Hong Kong’s unique relationship to China allows it to serve as a convenient base for international manufacturers and investors with plans to tap into the Chinese market place. Beijing and Hong Kong have sought to oil the wheels of the trading machinery that exists between the two jurisdictions by agreeing to the Closer Economic Partnership Arrangement (CEPA), which came into effect on 1st January 2004, and has been extended several times since.

Chief Executive Donald Tsang says that CEPA has brought encouraging economic benefits to both the Mainland and Hong Kong. During the first three years since its implementation in 2003, CEPA had created 36,000 new jobs for Hong Kong and brought additional capital investment of HKD5.1bn. It also attracted investment from the Mainland and overseas. At the end of 2007, more than 900 Mainland enterprises had been granted approval to invest in Hong Kong, with investment amounting to more than USD5.5bn, and at the end of August 2008, more than HKD14.5bn worth of goods had entered the Mainland market making use of the zero-tariff preferential treatment under CEPA, of which 65% was exported to Guangdong. As for trade in services, more than 2,000 Certificates of Hong Kong Service Suppliers had been issued.

CEPA, in parallel with China's accession to the World Trade Organization, has set in motion a process of trade liberalisation in goods and services between the SAR and China and has cemented Hong Kong’s position as the conduit for investment into the mainland. Tariffs have been removed on a wide range of goods and services; it has also removed or reduced geographical, financial and ownership constraints on a variety of services sectors including professional services, communications and media, financial services and trade related services, legal services, construction, information technology, conventions and exhibitions, audiovisual, distribution, tourism, air transport, road transport, and individually owned stores. Importantly, these liberalizations apply to companies of any nationality provided the firm is incorporated in Hong Kong, has operated there for a minimum of three years, is liable to pay tax in the territory, and employs at least 50% of staff locally.

However, overseas firms without a presence in Hong Kong can still take advantage of the CEPA provisions by outsourcing to, or partnering with, a qualified Hong Kong-based manufacturer or service provider. Foreign manufacturers can achieve this by satisfying rules of origin requirements which essentially means that goods must be ‘substantially changed’ in Hong Kong to qualify. Overseas service providers meanwhile, can partner with or invest in a CEPA-qualified firm to gain greater access to the mainland market.

CEPA also includes a number of rules enabling mutual recognition of professional qualifications as part of the services rules in a number of sectors.

CEPA has been extended twice recently. Supplement VII, agreed in May 2010 and effective from January 2011, provides for a further 35 market liberalization and trade and investment facilitation measures in 19 sectors. Supplement VII further relaxes the market access conditions in 14 service sectors, including: technical testing, analysis and product testing; specialty design; banking; securities; tourism; and air transport. Among them, "technical testing, analysis and product testing" and "specialty design" are new sectors, bringing the total number of liberalized service sectors under the CEPA from 42 to 44. Supplement VIII was signed on December 13, 2011 and allows Hong Kong's traders to include the value of raw materials and component parts originated from the Mainland when calculating ‘value-added content’, such that they will be able to utilize the zero tariff preferential treatment offered to Hong Kong goods under the CEPA. In addition, the new Supplement allows Mainland banks to make use of Hong Kong's international financial platform to develop their international businesses, and supports Hong Kong insurance companies entering the market through the setting up establishments or taking capital participations, to participate and share in the development of the Mainland insurance market.

In total, CEPA currently covers more than 1,600 products and 40 services sectors.

In January 2012, Invest Hong Kong announced that it had assisted 3030 overseas and Mainland Chinese companies to set up or expand in Hong Kong in 2011 - the 11th consecutive year that it has beaten its annual target for the number of completed projects. According to InvestHK, of the completed projects, the Chinese mainland continued to represent the largest single source of investment into Hong Kong with a total of 56 projects, with the rest of the top five comprising the US with 48 projects, the UK (30), Japan (23) and Australia (19). The high prevalence of Chinese expansions and start-ups among the 303 completed projects seemed to suggest that the Closer Economic Partnership Arrangement (CEPA) between Hong Kong and the mainland, and the expanded liberalisation measures that have come as part of the Agreement, in areas such as education services, innovation and technology, and cultural and creative industries has have played a significant part in the investment decisions of businesses looking to establish or expand.

Renminbi

More recently, CEPA has led to the easing of restrictions on the trading of the Chinese currency, the renminbi, in Hong Kong. Hong Kong importers are now allowed to settle direct import trades from the Mainland in renminbi, while financial institutions in the Mainland have begun to issue renminbi financial bonds in Hong Kong on a pilot basis.

While the renminbi is not yet fully convertible, the Chinese government has taken several steps to incrementally liberalize the currency in recent years. In March 2011, the State Administration of Foreign Exchange (SAFE) confirmed that it will look for a developing use of China's currency, the yuan, in capital account transactions . While it will continue its close monitoring of capital account flows, it is now to be expected that convertibility of the yuan for cross-border investment purposes will mirror the use of the yuan for cross-border trade settlement, which is already much further developed. It was reported that it is also proposed to extend the trial of yuan-denominated cross-border trade settlement to all cities in China by the end of the year. The central bank has said that such settlement reached a total of more than CHY506bn (USD77bn) in 2010. In addition, by the end of the year, more than 67,000 Chinese companies had joined the yuan settlement programme.

Inevitably, much of the growth in offshore renminbi business is taking place in Hong Kong, and progress has been seen in various areas, including cross-border trade settlement, deposits, bond issuance and the introduction of financial products. Moreover, in February 2011, the Tsang announced in his budget presentation that further measures will be taken to foster growth in offshore renminbi trade.

As part of Hong Kong’s attempts to consolidate its position as a platform to raise international capital and enhance the competitiveness of its asset management industry, Hong Kong’s RMB bond market will be further developed. As at end-January 2010 there were a total of 31 RMB bond issues with an issuance size of about RMB74.4bn. The range of issuers has expanded from Mainland financial institutions to multinational non-financial institutions. Hong Kong will continue to encourage overseas enterprises to issue RMB bonds in Hong Kong, solicit more Mainland enterprises to issue bonds in Hong Kong and seek the expansion of channels for enterprises to invest the RMB capital raised in Hong Kong back in the Mainland. In addition, the government plans to optimize the RMB clearing platform to attract more enterprises to use Hong Kong’s RMB settlement services. Another milestone was celebrated in December 2011, when the Hong Kong Monetary Authority welcomed the announcement by the China Development Bank (CDB) of its forthcoming issuance of renminbi (RMB) bonds in Hong Kong through the bond tendering platform of HKMA’s Central Moneymarkets Unit (CMU) - the first financial institution in mainland China to make use of the CMU platform to issue RMB bonds, following the inaugural issuances by the Chinese Ministry of Finance through the platform in December 2010 and August 2011.

Alexa Lam, the Acting Chief Executive Officer of the Securities and Futures Commission (SFC) confirmed in September 2011 that Hong Kong’s securities regulator stands ready to facilitate the implementation of Mainland policy initiatives aimed at accelerating the pace of transforming the renminbi (RMB) into an internationally accepted and widely used currency. Speaking at an offshore RMB market conference, she said that the RMB bond market will take off “in an impressive fashion” when the new foreign direct investment measures are in place, permitting RMB raised or borrowed in Hong Kong to flow into the Mainland for direct investment. She believed that: “With more RMB bond issuances, there will be wider secondary trading and related activities. A deeper and more liquid RMB bond market would lead to more bond funds and other RMB products.” This would in turn create a deeper pool of RMB assets essential for achieving the goal of further liberalization of the RMB, she added. Lam confirmed that Hong Kong’s regulatory platform is ready to authorize retail fund products managed by holders of Renminbi Qualified Foreign Institutional Investors (RQFII) quotas, with the initial total RMB20bn (USD3.1bn) RQFII quota being “an encouraging start.” She also thought that Hong Kong has a crucial role to play in the process of RMB liberalization, which requires international participation and support. “The players must include not just Mainland firms but also Hong Kong and international entities which bring to the table the best of international experience, global liquidity and world standards. It is Hong Kong’s role to connect all these players, and give each of them an open opportunity to excel,” she concluded.

In addition, the vice-chairman of the China Securities Regulatory Commission (CSRC), Yao Gang, told the Asian Financial Forum in January 2012 that more Chinese companies would be encouraged to introduce RMB-denominated IPOs in Hong Kong in 2012, while he also suggested that the RMB20bn investment cap on the Renminbi Qualified Foreign Institutional Investor pilot programme, in which the Hong Kong subsidiaries of qualified Chinese fund managers and securities companies are allowed to channel RMB raised in Hong Kong to invest directly in the China bond and equity markets, would also be increased in due course.

The Outlook

Economically speaking, Hong Kong hasn’t had an altogether easy ride in recent years, and has had to deal with a long period of deflation and the widespread impact of 9/11 and the SARS epidemic in early 2003, which joined with cyclical factors to slow economic growth considerably.

However, the government is determined to avoid a repeat of the SARS crisis which virtually shut down the city for a number of weeks in 2003, in the process crippling the economy across all sectors and eventually claiming the lives of 300 people.

Realising that there is much at stake if another epidemic were to occur, Hong Kong in 2003 earmarked some HK$1.3 billion (US$100 million) to be spent on various public health projects whilst laws have been changed to strengthen and enforce hygiene standards and promote a more hygiene-conscious culture among the city’s population.

Economic growth has see-sawed somewhat since the Asian financial crisis of the late 1990s, but the territory’s economic performance improved rapidly in 2005, with gross domestic product rising 7.3% in the year. Hong Kong's economy continued to expand briskly in 2007, with gross domestic product growth accelerating to 6.4%. However, not even Hong Kong's dynamic economy could escape the economic fall-out from the credit crunch, and growth slowed to 2.2% in 2008, before the economy shrank by 2.7% in 2009. The economy rebounded sharply in 2010, by 6.8%. A similar level of growth looks likely to have been recorded in 2011, with the government announcing in March 2012 that GDP grew by 6.5% in the fourth quarter.

As an entrepot and trading city, with only a small domestic manufacturing base, Hong Kong's performance has historically tended to reflect overall global trading conditions, which have scarcely been benign in the last four years. One success story at least has been the performance of the new issues market during this time: in 2011 the Hong Kong securities market remained the world’s biggest IPO centre for the third consecutive year, and had a record high of about 40 trillion shares traded and 215 million deals last year. The figures highlight Hong Kong's growing dependence on business from China however: In terms of funds raised through IPOs, 36% went to Mainland issuers, and at the end of 2011, Mainland enterprises accounted for nearly 56% of total market capitalisation and 66% of average daily turnover value. Other highlights of the Hong Kong stock exchange's performance in 2011 included that turnover in the Derivatives Market rose to its best level ever reaching an all-time high of 140,493,472 contracts, a 21% increase from 2010.

Whatever short-term travails it may have experienced, however, Hong Kong holds an enviable position as the conduit for global investment into China, and with its economy built firmly on a foundation of low taxation and decades of expertise as a financial services hub, it seems that prospects for the former British colony appear bright. The jurisdiction is likely to remain popular both as a place to do business, and a place where foreigners can take advantage of an attractive tax regime, for some time to come.