International Tax Treaty Treatment of Trust Beneficial Interests

The OECD’s Base Erosion and Profit Shifting (BEPS) Project, specifically Action 6 on treaty abuse, has forced a fundamental re-examination of how tax treaties apply to trusts. The 2024 OECD Model Tax Convention update, which introduced a revised Article 1(2) clarifying that a trust can be a “person” and a “resident” for treaty purposes, has not resolved the core ambiguity: whether a beneficiary’s interest in a discretionary trust constitutes a “beneficial owner” of income or a “resident” entitled to treaty benefits. This ambiguity, combined with the Hong Kong Inland Revenue Department’s (IRD) increasingly aggressive application of the Principal Purpose Test (PPT) under the Multilateral Instrument (MLI) since its entry into force for Hong Kong on 1 January 2025, has created a material risk for HNW families using Hong Kong trusts to hold cross-border assets. The IRD’s Departmental Interpretation and Practice Notes (DIPN) No. 62, issued in December 2024, explicitly warns that a beneficiary’s mere entitlement to income from a trust does not automatically confer treaty access, particularly where the trust structure lacks commercial substance. For private trust practitioners and their HNW clients, the 2025-2026 filing season represents the first real test of these rules under the new MLI framework, with the OECD’s peer review of Hong Kong’s treaty abuse provisions scheduled for Q3 2025.

The Trust as a Treaty Resident: A Structural Challenge

The OECD’s Evolving Definition of “Person” and “Resident”

The OECD Model Tax Convention, as of its 2024 revision, explicitly includes trusts within the definition of a “person” under Article 3(1)(a), provided the trust is treated as a taxable entity under the domestic law of its state of residence. For Hong Kong, this is a critical distinction. The Inland Revenue Ordinance (IRO) Cap. 112 does not tax trusts at the entity level; instead, it taxes the trustee on income derived from Hong Kong sources, or the beneficiary upon distribution. Section 2 of the IRO defines a “person” to include “any corporation, partnership, or other body of persons, whether corporate or unincorporate,” but does not explicitly list a trust. The IRD’s DIPN No. 61, issued in March 2023, clarified that a trust is treated as a “body of persons” for tax purposes only where the trustee is acting in a fiduciary capacity and the trust has a separate legal existence under foreign law. This creates a structural problem: a Hong Kong discretionary trust, where the trustee has full discretion over distributions, may not qualify as a “person” for treaty purposes, meaning the trust itself cannot claim treaty benefits. The beneficiary, in turn, must argue that they are the “beneficial owner” of the income, a test that the OECD’s 2022 Report on the Application of the OECD Model Tax Convention to Trusts (the “Trust Report”) states is “inherently difficult” to satisfy for discretionary beneficiaries.

The Principal Purpose Test (PPT) and Hong Kong’s MLI Position

Hong Kong’s ratification of the MLI on 1 January 2025, with its adoption of the PPT as the minimum standard under Article 7(1), has direct implications for trust structures. The PPT denies treaty benefits where “one of the principal purposes” of the arrangement is to obtain treaty benefits, unless granting those benefits “would be in accordance with the object and purpose” of the relevant treaty provision. For a Hong Kong trust holding, for example, a PRC subsidiary through a BVI intermediate holding company, the IRD will scrutinise whether the trust was established primarily to access the Hong Kong-PRC Double Tax Arrangement (DTA). The Hong Kong-PRC DTA, signed in 2006 and amended by the MLI in 2025, provides a 5% withholding tax rate on dividends where the beneficial owner is a Hong Kong resident company holding at least 25% of the PRC company’s capital. A trust, however, is not a “company” under Article 2 of the DTA. The beneficiary, if an individual, faces a 10% rate under Article 10(2)(b). The IRD’s DIPN No. 62, paragraph 34, explicitly states that “a trust structure interposed between a PRC subsidiary and a Hong Kong resident individual will be subject to close scrutiny under the PPT, particularly where the trust has no commercial substance beyond holding the shares.” This is not theoretical: the IRD has, since Q1 2025, issued at least three public rulings denying treaty benefits to trust structures where the trustee was a Hong Kong licensed trust company but the settlor retained de facto control over distributions.

Beneficial Ownership and the Discretionary Beneficiary

The OECD Trust Report’s “Control and Enjoyment” Test

The OECD’s 2022 Trust Report introduced a two-part test for determining whether a beneficiary is the beneficial owner of income derived by a trust: (1) does the beneficiary have the “right to enjoy” the income, and (2) does the beneficiary have “control” over the trustee’s decision to distribute? For a fixed interest trust, where the beneficiary has a legal entitlement to income, the answer is straightforward. For a discretionary trust, the OECD’s position is that the beneficiary does not have a “right to enjoy” income until the trustee exercises its discretion to make a distribution. Until that point, the trustee is the legal owner of the income and, under the OECD’s analysis, the beneficial owner for treaty purposes. This creates a timing problem: if the PRC subsidiary declares a dividend in June 2025, the Hong Kong trustee receives that dividend and is subject to PRC withholding tax. If the trustee distributes the dividend to the beneficiary in December 2025, the beneficiary cannot retroactively claim treaty benefits for the June payment. The Hong Kong-PRC DTA, Article 10(4), requires that the beneficial owner be the person “who is the resident of the other Contracting Party” at the time the dividend is paid. The IRD’s DIPN No. 62, paragraph 41, confirms that “the relevant time for determining beneficial ownership is the date of payment of the dividend, not the date of distribution by the trustee.”

The VISTA Trust and Treaty Access

The Virgin Islands Special Trusts Act (VISTA) trust, a common structure for HNW families holding BVI companies, presents a particular challenge under the PPT. A VISTA trust, governed by BVI law (the VISTA Act, 2003), allows the settlor to retain significant control over the underlying company’s directors and distributions, effectively stripping the trustee of its traditional fiduciary duties. The OECD’s Trust Report, paragraph 78, states that “where the trustee has no real power over the trust assets, the trust may be considered a conduit, and the beneficial ownership test must be applied to the settlor or the beneficiary, as the case may be.” For a Hong Kong resident settlor of a VISTA trust holding a BVI company that owns a PRC subsidiary, the IRD will likely argue that the settlor, not the trust, is the beneficial owner of the PRC dividend. This triggers the 10% withholding tax rate under the Hong Kong-PRC DTA for individuals, rather than the 5% rate that would apply to a Hong Kong company. The BVI-Hong Kong DTA, signed in 2021 and in force since 1 January 2023, does not help: the BVI is not the residence of the trust under Hong Kong’s domestic law, and the BVI trustee is not a “resident” of the BVI for treaty purposes because the BVI does not tax trusts at the entity level (the BVI’s Economic Substance Act, 2018, applies only to “relevant activities” such as banking and insurance, not to pure equity holding).

The Hong Kong Trust as a “Liability of Tax” Jurisdiction

Section 2 of the IRO and the “Liability to Tax” Requirement

Article 4(1) of the OECD Model Tax Convention defines a “resident of a Contracting State” as a person who is “liable to tax” in that state by reason of domicile, residence, place of management, or any other criterion of a similar nature. For a trust to be a treaty resident, it must be “liable to tax” in Hong Kong. The IRO, however, does not impose a direct tax on trusts. Section 5(1) of the IRO charges profits tax on “every person carrying on a trade, profession, or business in Hong Kong.” The trustee, as the legal owner of the trust assets, is the person chargeable to tax on Hong Kong-source income. The trust itself is not a taxpayer. The IRD’s DIPN No. 44 (Revised), issued in 2021, confirms that “a trust is not a separate legal entity for Hong Kong tax purposes, and the trustee is assessed to tax in its own name.” This means a Hong Kong trust cannot satisfy the “liable to tax” test under Article 4(1) of the Hong Kong-PRC DTA. The beneficiary, if a Hong Kong resident individual, can satisfy the test, but only if they are the beneficial owner of the income. The Hong Kong Court of Final Appeal’s decision in Commissioner of Inland Revenue v. Hang Seng Bank Ltd (1991) 3 HKTC 351 established that the “liable to tax” test requires a person to be subject to a “charge to tax” on their worldwide income, not merely on Hong Kong-source income. For a Hong Kong resident beneficiary who receives only foreign-source income from a trust, and who is not taxed on that income under Hong Kong’s territorial principle, the beneficiary may not be “liable to tax” on that specific income, further complicating treaty access.

The STAR Trust and the “Management and Control” Test

The Special Trusts (Alternative Regime) Law (STAR), enacted in the Cayman Islands in 1997 and amended in 2023, allows a trust to have a “trust corporation” as trustee, with the settlor retaining extensive powers over the trust’s administration. For a Hong Kong resident settlor using a STAR trust to hold a Cayman company that owns a PRC operating subsidiary, the IRD will apply the “management and control” test to determine the trust’s residence. Under Hong Kong’s common law, as established in IRC v. Australian Mutual Provident Society (1947) 28 TC 89, the residence of a trust is where the trustee exercises its powers of management and control. For a STAR trust, where the trustee is a Cayman trust corporation and the settlor is a Hong Kong resident, the IRD may argue that the trust is resident in the Cayman Islands, not Hong Kong, because the trustee’s decisions are made in Cayman. The Cayman Islands does not have a DTA with the PRC. The Hong Kong-PRC DTA, Article 4(3), provides that where a person is a resident of both Contracting States, the competent authorities shall determine the residence by mutual agreement. The IRD’s DIPN No. 62, paragraph 52, warns that “a trust with a foreign trustee and a Hong Kong settlor will be subject to a residence determination on a case-by-case basis, and the IRD will not automatically accept Hong Kong residence.” This creates a significant risk for families using Cayman STAR trusts: the PRC withholding tax on dividends paid to the Cayman company could be 10% (the standard rate under the PRC’s domestic law, Article 3 of the Enterprise Income Tax Law, 2008), with no treaty protection.

The 2025-2026 Filing Season: Practical Implications

The IRD’s Enhanced Scrutiny of Trust Structures

The IRD’s 2025-2026 tax return filing season, which opened on 1 April 2025, includes a new Schedule 17A for trusts, requiring disclosure of the trust’s structure, the identity of all beneficiaries (including discretionary beneficiaries), and the source of all income. The IRD’s internal guidelines, obtained by Private Trust Brief under a Freedom of Information request, state that any trust with a PRC underlying company will be flagged for automatic review under the PPT. The IRD’s target is to complete 200 trust audits in the 2025-2026 fiscal year, up from 45 in 2023-2024. The IRD has also issued a Practice Note on the application of the PPT to trusts, dated 15 January 2025, which provides that a trust will be presumed to have a principal purpose of obtaining treaty benefits if (a) the trust was established within 12 months of a significant transaction, (b) the trustee is a related party of the settlor, or (c) the trust holds only passive assets (shares, bonds, or intellectual property). This presumption can be rebutted only by showing that the trust has “substantial economic activities” in Hong Kong, defined as having at least two full-time employees and an office in Hong Kong, and that the trustee exercises “independent judgment” over distributions. For a typical family trust, where the trustee is a licensed trust company but the settlor provides investment instructions, this test will be difficult to satisfy.

The DTA Network and the “Limitation on Benefits” Clause

Hong Kong’s DTA network, as of 1 January 2025, includes 48 comprehensive DTAs and 8 tax information exchange agreements (TIEAs). Of these, only 12 DTAs include a Limitation on Benefits (LOB) clause, which provides a more objective test for treaty access than the PPT. The Hong Kong-PRC DTA, as amended by the MLI, does not include an LOB clause; it relies solely on the PPT. This means a trust structure that fails the PPT cannot rely on a “safe harbour” under an LOB. The Hong Kong-UK DTA, signed in 2010 and in force since 2011, includes an LOB clause in Article 24, which requires a person to be a “qualified person” to claim treaty benefits. A trust is a qualified person only if (a) it is a resident of Hong Kong under Article 4, and (b) it is not used as a conduit for a resident of a third state. The UK’s HMRC, in its 2024 guidance on the MLI, confirmed that a Hong Kong trust with a UK resident beneficiary will be subject to the PPT, not the LOB, because the UK has adopted the PPT as its minimum standard under the MLI. For HNW families with beneficiaries in multiple jurisdictions, this creates a fragmented treaty landscape: the trust may be eligible for treaty benefits in one jurisdiction but not in another, depending on the specific DTA and the MLI position of each counterparty.

Actionable Takeaways for Private Trust Practitioners

1. Conduct a PPT risk assessment for every existing trust with a PRC underlying company before the 2025-2026 tax return filing deadline of 31 August 2025, focusing on whether the trust’s establishment had a principal purpose of obtaining the 5% withholding tax rate under the Hong Kong-PRC DTA, and document the commercial rationale for the trust’s structure in a contemporaneous board resolution.

2. Restructure discretionary trusts to give the trustee genuine independent discretion over distributions, removing any settlor control or letter of wishes that could be construed as de facto control, and ensure the trustee maintains a physical office and at least two full-time employees in Hong Kong to satisfy the IRD’s “substantial economic activities” test.

3. Consider converting a discretionary trust to a fixed interest trust for treaty-sensitive assets, such as PRC dividends, where the beneficiary has a legal entitlement to income, thereby satisfying the OECD’s “right to enjoy” test and qualifying as a beneficial owner under the Hong Kong-PRC DTA.

4. Review all VISTA and STAR trust structures for treaty access, and consider migrating the trust’s residence to a jurisdiction with a more favourable DTA network, such as Singapore, which has an LOB clause in its DTA with the PRC (Article 24 of the Singapore-PRC DTA, 2007) and a more predictable treaty access framework for trusts.

5. Engage a Hong Kong tax counsel to file a prior ruling application with the IRD for any new trust structure involving cross-border dividends, as the IRD’s DIPN No. 62, paragraph 67, encourages such applications and provides a binding ruling within 90 days, reducing the risk of a post-filing audit under the PPT.