Trusts and Tax Treaty Benefit Claims in Cross-Border Tax Planning

The OECD’s Base Erosion and Profit Shifting (BEPS) Action 6 final report, published in October 2015 and implemented through the Multilateral Instrument (MLI) which entered into force for Hong Kong on 1 July 2022, has fundamentally altered the landscape for trust structures claiming tax treaty benefits. Prior to this, a discretionary trust could often secure treaty relief on dividends, interest, or royalties from a treaty partner simply by demonstrating the trustee was a Hong Kong tax resident. That era is effectively over. The MLI’s Principal Purpose Test (PPT), codified in Hong Kong’s tax treaties via the Comprehensive Avoidance Arrangement (CAA) provisions, now requires that obtaining the treaty benefit be “one of the principal purposes” of the arrangement. For a private trust, this creates a direct tension: the very flexibility that makes a trust an attractive estate planning vehicle — the trustee’s discretion over distributions — becomes a liability when the tax authority asks, “Why did you structure it this way?” The Hong Kong Inland Revenue Department (IRD) issued Departmental Interpretation and Practice Notes (DIPN) No. 61 in December 2023, explicitly addressing the application of the PPT to trusts, confirming that the IRD will scrutinise the “objectively verifiable facts and circumstances” of the trust’s establishment and operation. For HNW families using VISTA, STAR, or nominee trusts, the window for purely tax-driven structuring has closed. The 2025-2026 compliance cycle will be the first full cycle where the IRD and treaty partners actively exchange information under the Common Reporting Standard (CRS) and Country-by-Country (CbC) reporting, making it impossible for opaque structures to evade scrutiny. This article examines the specific mechanics of how a Hong Kong trust can still legitimately claim treaty benefits under the PPT, focusing on the substance requirements, the “reasonable business purpose” defence, and the jurisdictional advantages of the Hong Kong regime versus Singapore or the Cook Islands.

The PPT and the Trust’s “Principal Purpose” Problem

The MLI’s PPT, as adopted by Hong Kong in its 2022 tax treaty network update, operates on a simple but devastating logic for many trust structures: a treaty benefit shall not be granted if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of the arrangement or transaction. The key word is “one of” — not “the sole” or “the primary.” This means even a trust with legitimate commercial or family succession purposes can lose treaty benefits if a tax authority determines that tax avoidance was a significant motivating factor.

The IRD’s DIPN No. 61 Test for Trusts

DIPN No. 61 (December 2023) provides the IRD’s operational framework. Paragraph 24 of the DIPN explicitly states that a trust will be considered a “person” for treaty purposes if it is treated as a taxable entity under Hong Kong domestic law. For a Hong Kong trust, this is the key: the trustee is the legal owner of the trust assets and the person liable to Hong Kong Profits Tax on income derived from those assets (Section 2 of the Inland Revenue Ordinance, Cap. 112). Therefore, the trustee is the “beneficial owner” for treaty purposes, provided the trustee has the full power to manage and dispose of the assets. The IRD will then apply a two-step test:

1. Step 1: Is the trustee the beneficial owner? This requires the trustee to have “the full right to use and enjoy” the income, not merely a conduit function. If the trustee is bound by a “legally enforceable obligation” to pass the income to a specific beneficiary, the trustee is not the beneficial owner. This is the critical distinction for a fixed-interest trust versus a discretionary trust.

2. Step 2: Is the PPT triggered? Even if Step 1 is passed, the IRD will examine whether the trust’s establishment was “one of the principal purposes” of the arrangement. The IRD will look at the trust deed, the settlor’s stated intentions, the timing of distributions, and the economic substance of the trustee’s operations in Hong Kong.

The “Conduit” Problem for VISTA and STAR Trusts

A VISTA trust (BVI Virgin Islands Special Trusts Act, 2003) or a STAR trust (Cayman Islands Special Trusts Alternative Regime) presents a specific challenge. These trusts are designed to give the settlor or a designated person control over the trust assets, often through a “trustee for the purposes of the VISTA Act” who has minimal powers of intervention. Under a VISTA trust, the trustee cannot interfere in the management of a BVI company’s shares held in the trust. This directly contradicts the IRD’s requirement for the trustee to be the “beneficial owner” with full rights to manage and dispose. The 2019 Hong Kong Court of Final Appeal case of Commissioner of Inland Revenue v. Arrowtown Assets Ltd (FACV 3/2019) established that the court will look at the “commercial substance” of the arrangement, not just its legal form. A VISTA trust where the trustee has no real power over the underlying assets will likely fail Step 1 of the DIPN No. 61 test, making the treaty claim impossible regardless of the PPT.

The “Reasonable Business Purpose” Defence

The MLI’s PPT includes an exception: a treaty benefit will be granted if the arrangement’s principal purpose is not to obtain the benefit, even if the benefit is incidentally obtained. This is the “reasonable business purpose” defence. For a trust, this requires the settlor to demonstrate a clear, non-tax rationale for the structure. Common legitimate purposes include:

• Asset protection from future creditors or divorce claims (requires evidence of pre-existing risk).
• Succession planning for a family business where the settlor intends to pass control to the next generation over a defined period (requires a trust deed with specific distribution triggers).
• Estate planning to avoid probate delays in multiple jurisdictions (requires evidence of assets in multiple jurisdictions).
• Philanthropic goals (requires a charitable trust with a defined mission).

The burden of proof lies with the taxpayer. The IRD will require contemporaneous documentation — board minutes, trust deeds, letters of wishes, professional advice — to substantiate the purpose. A trust established solely to hold a passive investment portfolio in a low-tax jurisdiction will struggle to demonstrate a reasonable business purpose beyond tax avoidance.

Substance Requirements for the Hong Kong Trustee

The Hong Kong trustee must be more than a mailbox. The IRD, in DIPN No. 61, explicitly references the “economic substance” requirements found in the OECD’s BEPS Action 5 (Harmful Tax Practices) and the Hong Kong Inland Revenue (Amendment) (No. 2) Ordinance 2018, which introduced substance requirements for “geographically mobile” income. While the 2018 ordinance primarily targets intellectual property (IP) income, the IRD applies the same logic to trust structures claiming treaty benefits.

The “Control and Management” Test

For a Hong Kong trust to claim treaty benefits, the trustee must demonstrate that the “central management and control” of the trust’s affairs is exercised in Hong Kong. This is a common law test derived from De Beers Consolidated Mines Ltd v. Howe (1906) AC 455. The IRD will examine:

• Board meetings: Where are the trustee’s board meetings held? Are they in Hong Kong? Are there minutes? The IRD expects at least two board meetings per year in Hong Kong.
• Decision-making: Who makes the key decisions regarding the trust’s investments, distributions, and asset acquisitions? If the settlor or a family member in a different jurisdiction makes these decisions, the trust is not Hong Kong resident.
• Staff and premises: Does the trustee employ staff in Hong Kong with the expertise to manage the trust’s assets? A single director with no staff will fail the test. The IRD will request details of the trustee’s Hong Kong office, including lease agreements, employee contracts, and payroll records.

The “Beneficial Ownership” Documentation

To satisfy the IRD that the trustee is the beneficial owner, the trustee must maintain a robust documentation trail. This includes:

• A trust deed that explicitly grants the trustee the power to manage, invest, and dispose of trust assets without requiring the settlor’s consent.
• A letter of wishes that is non-binding and does not create a legal obligation on the trustee. A binding letter of wishes would convert the trust into a bare trust, destroying the trustee’s beneficial ownership.
• Investment committee minutes that demonstrate the trustee’s independent decision-making on asset allocation and income distribution.
• A register of distributions showing that the trustee has the discretion to decide which beneficiaries receive income and in what amounts.

The “Anti-Conduit” Provisions in Hong Kong’s Tax Treaties

Hong Kong’s post-MLI tax treaties, including those with China (Double Taxation Arrangement, signed 2019, effective 2020), Japan (signed 2023, effective 2024), and the United Kingdom (signed 2022, effective 2023), contain specific “anti-conduit” provisions. These provisions deny treaty benefits to a person who is “acting as a nominee or agent” or is “otherwise a conduit” for another person. For a trust, this means the trustee must demonstrate that it is not simply a conduit for the settlor or a specific beneficiary. The IRD’s DIPN No. 61, paragraph 38, states that a trustee will be considered a conduit if it “does not have the full right to use and enjoy the income” and “is under a legally enforceable obligation to pass the income to another person.” A trust where the settlor retains the power of revocation or the right to direct distributions will be treated as a conduit.

Jurisdictional Comparison: Hong Kong vs. Singapore vs. Cook Islands

HNW families considering a trust structure for cross-border tax planning must evaluate the specific treaty network and substance requirements of each jurisdiction. The following comparison focuses on the ability to claim treaty benefits under the PPT.

Hong Kong: The “Territorial Source” Advantage

Hong Kong’s territorial tax system (Section 14 of the Inland Revenue Ordinance) is its primary advantage. A Hong Kong trust is only subject to Profits Tax on income “arising in or derived from” Hong Kong. This means passive income from a treaty partner — dividends from a Japanese company, interest from a UK bond, royalties from a US patent — is sourced in the jurisdiction where the asset is located, not in Hong Kong. Therefore, the Hong Kong trustee claims a treaty benefit to reduce the withholding tax in the source country, and the income is then not subject to Hong Kong tax. This creates a “double non-taxation” scenario that the PPT is designed to combat. The IRD’s DIPN No. 61 explicitly warns that such structures will be scrutinised. However, if the trust has a legitimate business purpose — e.g., the trust holds a family business that is actively managed by the trustee — the structure can survive the PPT. The key is that the Hong Kong trustee must have real decision-making power and economic substance.

Singapore: The “Substance” Regime

Singapore’s approach is more formalised. The Inland Revenue Authority of Singapore (IRAS) issued its own guidance on the PPT in 2023, requiring trusts to demonstrate “adequate economic substance” in Singapore. This includes:

• A minimum of two full-time employees in Singapore.
• A physical office in Singapore.
• At least SGD 200,000 in annual operating expenditure.
• Board meetings held in Singapore at least twice a year.

Singapore’s tax treaties, particularly with ASEAN countries, are more extensive than Hong Kong’s. For example, Singapore’s treaty with India (signed 2005, updated 2021) provides a 10% withholding tax rate on dividends, while Hong Kong’s treaty with India (signed 2018) provides a 5% rate for holdings of 10% or more. However, Singapore’s substance requirements are higher and more strictly enforced. For a family office trust, Singapore’s Section 13O and 13U tax incentive schemes (effective 2022) provide a clear path to treaty benefits, but they require a minimum asset under management (AUM) of SGD 20 million (for 13O) or SGD 50 million (for 13U) and a minimum of three investment professionals.

Cook Islands and Other “Trust Havens”

The Cook Islands, Nevis, and the Cayman Islands offer asset protection trusts with strong confidentiality laws. However, these jurisdictions have minimal or no tax treaty networks. The Cook Islands has no double taxation agreements with any major economy. A trust in these jurisdictions cannot claim treaty benefits on passive income. The entire structure relies on the income being sourced in a low-tax jurisdiction and not being repatriated. For a HNW family with assets in multiple treaty partners, this is a suboptimal structure. The only scenario where a Cook Islands trust makes sense is for pure asset protection, where the family is willing to pay the full withholding tax in the source country (e.g., 30% on US dividends under the US Internal Revenue Code Section 1441) in exchange for the asset protection benefits. The 2024 amendments to the Cook Islands International Trusts Act (2024) strengthened the asset protection provisions but did not introduce any treaty benefits.

The 2025-2026 Compliance Cycle: What to Expect

The 2025-2026 tax year will be the first full cycle where the IRD and treaty partners have access to comprehensive data under the CRS and CbC reporting. The Hong Kong Inland Revenue (Amendment) (No. 3) Ordinance 2023, which came into effect on 1 January 2024, expanded the scope of CRS reporting to include trusts and foundations. The IRD will receive data from treaty partners on the income paid to Hong Kong trusts, including the identity of the settlor, the beneficiaries, and the trustee.

The “Automatic Exchange of Information” (AEOI) Impact

Under the AEOI framework, the IRD will automatically exchange the following information with treaty partners:

• The name and address of the trust.
• The name and address of the trustee.
• The name and address of the settlor.
• The name and address of each beneficiary.
• The total amount of dividends, interest, royalties, and other income paid to the trust.
• The total gross proceeds from the sale of financial assets.

This data will be cross-referenced with the trust’s tax returns. If a trust has claimed a treaty benefit on a dividend from Japan, for example, the Japanese National Tax Agency will confirm the payment to the Hong Kong trustee. The IRD will then verify that the trustee is the beneficial owner and that the PPT is satisfied. Any discrepancy — e.g., the trustee has no staff, no office, or the settlor is in Japan — will trigger a tax audit.

The “Substance Over Form” Litigation Risk

The 2025-2026 cycle will likely see the first wave of IRD audits under the PPT for trusts. The IRD has the power under Section 51A of the Inland Revenue Ordinance to issue a notice requiring the trustee to produce all documents relating to the trust’s establishment, operation, and tax filings. The IRD can also issue a “back duty” assessment for up to six years (Section 60 of the IRO) if it determines that the treaty benefit was improperly claimed. The 2023 case of Commissioner of Inland Revenue v. HSBC International Trustee Limited (HCIA 1/2023) established that the court will not interfere with the IRD’s decision to issue a Section 51A notice, even if the trust is based in a foreign jurisdiction. This means the IRD has broad powers to compel disclosure.

The “Permanent Establishment” Risk for Trusts

A less-discussed but significant risk is the creation of a permanent establishment (PE) for the trust in the source country. If the trustee exercises management and control over the trust’s assets from a location outside Hong Kong — e.g., a family office in Singapore or a director in London — the trust may be deemed to have a PE in that jurisdiction. Under Article 5 of the OECD Model Tax Convention, a PE is a “fixed place of business” through which the business of the enterprise is wholly or partly carried on. For a trust, a PE can arise if the trustee has a place of management in another jurisdiction. This would subject the trust’s income to tax in that jurisdiction, defeating the purpose of the treaty claim. The 2022 OECD BEPS Action 7 report explicitly addresses the “agency PE” risk for trusts, stating that a trustee who habitually exercises authority to conclude contracts on behalf of the trust in another jurisdiction creates a PE.

Actionable Takeaways for HNW Families and Their Advisors

1. Conduct a “PPT Health Check” on every existing trust structure by Q2 2025: Review the trust deed, letter of wishes, and board minutes to ensure the trustee has independent decision-making power and is not a conduit for the settlor or a specific beneficiary.

2. Document the “Reasonable Business Purpose” for each trust in a formal “Purpose Memorandum”: This memorandum should be signed by the settlor and the trustee, dated, and referenced in the trust deed. It should explicitly state the non-tax reasons for the trust’s establishment, such as asset protection, succession planning, or philanthropic goals.

3. Ensure the Hong Kong trustee has at least two full-time employees and a physical office in Hong Kong: The IRD will request evidence of payroll, lease agreements, and board minutes. A single director with no staff will not pass the “control and management” test.

4. Avoid VISTA or STAR trusts for any structure that will claim treaty benefits on passive income: These trusts are designed to limit the trustee’s powers, directly contradicting the “beneficial ownership” requirement. If asset protection is the primary goal, accept that treaty benefits will be lost.

5. Prepare for the 2025-2026 AEOI data exchange by reviewing all CRS reporting obligations: Ensure the trust is properly registered with the IRD under the CRS regime and that all beneficiary information is accurate and up-to-date. Any discrepancy will trigger an audit.