Hong Kong Tax alert. New law allows tax deductions for registered trademarks, copyrights and registered designs

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1 10 January Issue No. 1 Hong Kong Tax alert New law allows tax deductions for registered trademarks, copyrights and registered designs The Inland Revenue (Amendment) (No. 3) Ordinance 2011 was enacted in December 2011 to grant tax deductions for capital expenditure incurred on the purchase of registered trademarks, copyrights and registered designs (hereinafter referred to as relevant intellectual property rights or IPRs ) effective from the year of assessment 2011/12. The new law however contains several anti-avoidance provisions. These include denial of the tax deductions when a relevant IPR is purchased from an associate. The term associate is so widely defined that it virtually precludes a group restructuring from qualifying for the tax deductions. Of all the built-in anti-avoidance provisions, section 16EC(4)(b) has caused the most controversy and debate. This section denies tax deductions when a relevant IPR is used outside Hong Kong under a licensing arrangement wholly or principally by a person other than the taxpayer. Section 16EC(4)(b) is modeled on section 39E(1)(b)(i) of the Inland Revenue Ordinance (IRO). The latter section has been controversially invoked by the Inland Revenue Department (IRD) to deny tax depreciation allowances on capital expenditure incurred by Hong Kong taxpayers for plant or machinery provided rent-free by such taxpayers to their contract manufacturers in mainland China established under import processing arrangements. The IRD has denied the relevant tax depreciation allowances in such scenarios even though the profits derived by taxpayers from import processing arrangements are fully chargeable to tax in Hong Kong. Despite the controversy, the section 16EC(4)(b) legislative proposal was passed into law in its original form without any changes. Clients who are contemplating to purchase a relevant IPR either as an individual acquisition or part of a broader business acquisition should be aware of section 16EC(4)(b) and the other anti-avoidance provisions of the new law. These provisions, together with the fact that the use and the purchase cost of a relevant IPR may be specially attributable to a particular territory, may provide scope for structuring the acquisition of the relevant IPR in a tax efficient manner (the below examples refer). These are complicated matters and clients who are required to deal with these issues should seek professional tax advice.

2 The tax deduction rules The new law has added three sections, namely 16EA, 16EB and 16EC to the IRO. Under section 16EA, capital expenditure incurred on the purchase of registered trademarks, copyrights and registered designs used in the production of profits chargeable to tax in Hong Kong will be tax deductible. 1 While trademarks and designs must be registered in Hong Kong or overseas in order to be deductible, there is no registration requirement for copyrights either for the purposes of legal protection or for deduction. The tax deductions for the purchase costs of a relevant IPR would generally be spread over 5 years in equal installments, commencing with the year of purchase of the relevant IPR. Where the maximum period of the legal protection for a copyright or a registered design expires before the expiration of the normal 5-year spread, the tax deductions for such a copyright or design would then be claimed in equal installments over the shorter period concerned. The legal protection of a trademark could be perpetual provided that its registration is properly maintained. Thus, the tax deductions in respect of a trademark will not be spread over a period shorter than 5 years. As the new law pertaining to trademarks and designs apparently only covers those which are registered as at the date of acquisition, it appears that taxpayers acquiring unregistered trademarks or designs would not be entitled to any tax deductions, even if the relevant designs or trademarks are registered immediately after acquisition. Furthermore, where a trademark or design has been successfully registered at the time it is purchased, any tax deductions previously granted would subsequently be withdrawn if the registration is later invalidated, revoked or surrendered. Where a relevant IPR is only used partly in the production of profits chargeable to tax in Hong Kong and partly for other purposes, the tax deductions or balancing adjustments (discussed below) would have to be proportionately reduced. 1 In addition to adding three sections to the IRO to grant tax deductions for these three new types of IPRs, the new law has also amended certain provisions of section 16E of the IRO as regards the then existing rules for tax deductions in respect of the acquisition costs of patents and know-how rights. You may refer to our Hong Kong Tax alert dated 15 March 2011, which discussed the relevant amendments to section 16E as contained in the legislative bill of the new law. The comments reflected in this earlier Tax alert are relevant because all the major provisions of the legislative bill were subsequently passed into law in their original form without any changes. 2 Hong Kong Tax alert

3 Balancing adjustments to be made under section 16EB when a relevant IPR is sold Where a relevant IPR is sold during a year of assessment, the one-fifth deduction otherwise available under section 16EA for the year concerned will be denied. Instead, under section 16EB, the sale proceeds will be compared with the balance of the cost of the IPR not yet allowed for deduction in order to arrive at a balancing adjustment for tax purposes. In the situation where a relevant IPR has been used only partly for the production of profits chargeable to tax in Hong Kong and partly for other purposes, the balancing adjustment would be proportionately reduced. Anti-avoidance provisions contained in section 16EC Section 16EC is an anti-avoidance section which seeks to deny the tax deductions for several perceived tax avoidance arrangements. These arrangements include: i. the purchase of a relevant IRP from an associate (the term associate being so widely defined that it virtually precludes a group restructuring from qualifying for the tax deductions) ; ii. a sale-and-license back of a relevant IPR between related persons; iii. the purchase of a relevant IPR which is financed wholly or predominantly by a non-recourse debt; iv. the use of a relevant IPR outside Hong Kong under a licensing arrangement wholly or principally by a person other than the taxpayer (section 16EC(4)(b) refers); and v. the early termination of a license agreement which subsisted before the new law was passed followed by the purchase of the IPR by the licensee at an unreasonable consideration. The use of a relevant IPR outside Hong Kong under a licensing arrangement wholly or principally by a person other than the taxpayer Of all the above anti-avoidance provisions, section 16EC(4)(b) which applies to the captioned situation has attracted much controversy and debate. Section 16EC(4)(b) is modeled on section 39E(1)(b)(i) of the IRO. This latter section has been controversially invoked by the IRD to deny tax depreciation allowances on capital expenditure incurred by Hong Kong taxpayers in respect of plant or machinery provided rent-free by such taxpayers to their contract manufacturers in mainland China under import processing arrangements. In this regard, the relevant depreciation allowances have been denied although the profits derived by such taxpayers from the import processing arrangements are fully chargeable to tax in Hong Kong. The administration s main justification for enacting section 16EC(4)(b) is similar to that for invoking section 39E(1)(b) in the circumstances described above. In this respect, the administration is of view that when a Hong Kong taxpayer allows its contract manufacturer outside Hong Kong to use a relevant IPR owned by it to manufacture goods ordered by it, the taxpayer has effectively granted a royalty-free license of the IPR to the contract manufacturer. As such, the administration considers that the relevant IPR is only used by the contract manufacturer for the purposes of producing Hong Kong Tax alert 3

4 the manufacturer s own profits, but not the profits of the Hong Kong taxpayer. As a result, the administration is of a view that the relevant IPR made available by a Hong Kong taxpayer to its contract manufacturer outside Hong Kong is not being used by the taxpayer to produce its profits which are chargeable to tax in Hong Kong. As such, tax deductions for the purchase cost of the relevant IPR should therefore be denied under section 16EC(4)(b). In seeking to justify the enactment of section 16EC(4)(b), the administration rejected the views submitted by many practitioners and professional bodies during the legislative bill stage of the new law. These practitioners and professional bodies took the view that when a taxpayer allows its contract manufacturer to use its relevant IPR solely for the manufacturing of goods ordered by the taxpayer, the relevant IPR could be said to be used by the taxpayer (instead of by the contract manufacturer) for the purposes of generating the trading profits of the taxpayer. Therefore, if such profits are fully chargeable to tax in Hong Kong, tax deductions should not be denied by section 16EC(4)(b). These arguments were however not accepted by the administration and the legislative proposal of the section as contained in the bill was passed into law in its original form without any changes. Nonetheless, the administration has admitted that when a relevant IPR such as a trademark is used both for manufacturing and sales outside Hong Kong in the place where the contract manufacturer is located, such trademark could be regarded as being partly used by the Hong Kong taxpayer itself. This is on account of the fact that, unlike the manufacturing activity, the relevant sales belong to the Hong Kong taxpayer. On this basis, the administration has accepted that the apportioned cost of the trademark which is used by the Hong Kong taxpayer in its sales operations is tax deductible, while the apportioned cost of the trademark used for the manufacturing operations of the contract manufacturer should not be deductible. The administration has used the following example to illustrate its stance. 2 Example 1 Company HK, carrying on a trading business in Hong Kong, has during the year of assessment 2011/12 purchased a trademark registered both in Hong Kong and the PRC at a total cost of HK$3,000,000. The Hong Kong registered trademark and the PRC registered trademark are each valued at HK$1,500,000. Company HK contracted Company M, a contract manufacturer located in the PRC, to produce goods bearing the trademark. Company M manufactured 1,000,000 pieces of goods during the year of assessment 2011/12 and they were sold by Company HK to customers in Hong Kong, the United States and the PRC in the respective quantities of 200,000, 200,000 and 600,000. The profits so derived are all chargeable to tax in Hong Kong. The above arrangement is depicted in the diagram below. 2 The example was presented by the administration to the Bills Committee of the Legislative Council during the scrutiny of new law whilst the law was at its bill stage. 4 Hong Kong Tax alert

5 Sales to customers in the US 200,000 units US HK registered mark purchased at HK$1,500,000 Company HK Sales to customers in HK 200,000 units HK PRC registered mark purchased at HK$1,500,000 PRC Sales to customers in the PRC 600,000 units Company M Contract manufacturer (established under an import processing arrangement) (Total no. of units of goods manufactured 1,000,000 units) The tax position taken by the administration Insofar as the mark registered in Hong Kong is concerned, it was used by Company HK itself in order to sell finished goods and generate profits chargeable to tax in Hong Kong. In addition, Company HK when selling the goods in the US market is not using the mark registered in Hong Kong. As such, section 16EC(4)(b) is not applicable. In the year of assessment 2011/12, Company HK is entitled to deduct one-fifth of the purchase cost of the Hong Kong registered mark pursuant to section 16EA(3) in the amount of HK$300,000 (i.e., HK$1,500,000 5). As for the PRC registered mark, it was partly used by Company M for production of goods in the PRC and partly used by Company HK for selling some of the finished goods in the PRC. In the circumstances, section 16EC(4)(b) is applicable to the part of the PRC registered mark that was used by Company M in the PRC manufacturing activities. Nevertheless, Company HK is still entitled to deduct part of the purchase price of the PRC registered mark which was used by Company HK to sell the finished goods in the PRC and thereby generate profits chargeable to tax in Hong Kong. The amount of deduction for the PRC registered trademark in 2011/12 would be calculated as follows: Purchase price of the PRC registered mark X No. of units sold in the PRC No. of units manufactured 5 and sold in the PRC = $1,500,000 x = $112, ,000 1,000, ,000 5 Hong Kong Tax alert 5

6 Purchase cost of a trademark may be specifically attributable to a particular territory In relation to how the use and the purchase cost of a trademark may be specifically attributable to a particular territory, the administration used the following example. 2 Example 2 Company HK, carrying on a trading business in Hong Kong, has during the year of assessment 2011/12 purchased a trademark registered in Hong Kong at a cost of HK$2,000,000. The trademark has not been registered in places other than Hong Kong. Company HK subsequently registered the trademark in the PRC and contracted a PRC manufacturer, Company M, to produce in the Mainland goods bearing the PRC registered trademark. The goods produced by Company M were sold in Hong Kong by Company HK and the profits derived are chargeable to tax in Hong Kong. The diagram below provides an illustration of the above arrangement. HK registered mark purchased at HK$2,000,000 Company HK Sales to customers in HK 1,000,000 units HK Subsequently registered the mark in the PRC PRC Company M Contract manufacturer (established under an import processing arrangement) (Total no. of units of goods manufactured 1,000,000 units) The tax position taken by the administration Company HK has only purchased the Hong Kong registered mark but not the PRC registered mark. It becomes the registered owner of the PRC registered mark because it has subsequently registered the mark in the PRC. The mark used by Company M in the production of goods in the PRC is the one registered in the PRC by Company HK and not the Hong Kong registered mark purchased by Company HK. As such, section 16EC(4)(b) is not applicable. Further to section 16EA(3), because the profits derived by Company HK from selling the finished goods are chargeable to tax in Hong Kong, it is entitled to deduct one-fifth of the purchase cost of the Hong Kong registered trade mark for the year of assessment 2011/12 in the amount of HK$400,000 (i.e., HK$2,000,000 5). 6 Hong Kong Tax alert

7 Ernst & Young Assurance Tax Transactions Advisory Commentary Despite the controversy, the section 16EC(4)(b) legislative proposal was passed into law in its original form without any changes. Clients who are contemplating the purchase of a relevant IPR either as an individual acquisition or as part of a broader business acquisition should be aware of section 16EC(4)(b) and the other anti-avoidance provisions of the new law. These provisions, together with the fact that the use and the purchase costs of a relevant IPR may be specifically attributable to a particular territory, may provide scope for structuring the acquisition of the relevant IPR in a tax efficient manner. These are complicated matters and clients who are required to deal with these issues should seek professional tax advice. Hong Kong office 22/F, CITIC Tower, 1 Tim Mei Avenue, Central, Hong Kong Tel: / Fax: About Ernst & Young Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 152,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential. Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit About Ernst & Young s Business Tax Advisory services Our Business Tax Advisory services in Hong Kong combines technical knowledge with practical, commercial and industry experience to give you advice tailored to your business. We have over 300 tax professionals who can bring you their deep understanding of critical tax issues and key sectors. We help you to reduce inefficiencies, mitigate risk and make the most of opportunities, building sustainable tax strategies that help your business achieve its potential. Principal tax contact Tracy Ho tracy.ho@hk.ey.com Hong Kong Tax partners James Badenach (Financial Services) james.badenach@hk.ey.com Agnes Chan agnes.chan@hk.ey.com Florence Chan (Financial Services) florence.chan@hk.ey.com Joe Chan joe-ch.chan@hk.ey.com Owen Chan owen.chan@hk.ey.com Wilson Cheng wilson.cheng@hk.ey.com Chee Weng Lee chee-weng.lee@hk.ey.com May Leung may.leung@hk.ey.com Rowan MacDonald (Financial Services) rowan.macdonald@hk.ey.com Loretta Shuen loretta.shuen@hk.ey.com Grace Tang grace.tang@hk.ey.com Jo An Yee jo-an.yee@hk.ey.com Rex Young rex.young@hk.ey.com 2012 Ernst & Young Tax Services Limited All Rights Reserved. FEA no This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither the Ernst & Young Tax Services Limited nor any other member of the global Ernst & Young organization can accept any responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor.