Enhanced deduction for qualifying R&D expenditure will be introduced in Hong Kong

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1 News Flash Hong Kong Tax Enhanced deduction for qualifying R&D expenditure will be introduced in Hong Kong April 2018 Issue 7 In brief The bill proposing an enhanced tax deduction for research and development (R&D) expenditure 1 in Hong Kong was gazetted on 20 April Subject to certain conditions, there will be a 300% tax deduction for the first HK$2 million of qualifying R&D expenditure incurred by enterprises and a 200% tax deduction for the remaining amount, without limit. R&D expenditure that does not qualify for the enhanced deduction may continue to enjoy a normal 100% tax deduction subject to fulfilment of the specified conditions. Once the bill is enacted into law, the new R&D tax deduction regime will take retrospective effect for expenditure incurred or payment made on or after 1 April While the bill represents a significant move of the HKSAR Government in the right direction for promoting R&D activities in Hong Kong, the proposed enhanced R&D tax deduction regime is considerably complex as it specifies numerous conditions for enjoying the enhanced tax deduction, introduces various deeming provisions that treat certain receipts in relation to R&D that would otherwise not be subject to profits tax as taxable trading receipts and includes anti-avoidance provisions to safeguard against abuse of the tax deductions (both normal and enhanced) for R&D expenditure. Hong Kong companies that are engaging in or planning to engage in R&D activities in and/or outside Hong Kong should review their R&D activity arrangements in light of the proposed regime and assess how to best structure their R&D activities for benefiting from the enhanced R&D tax deduction in Hong Kong. In detail The current tax deduction for R&D expenditure The current tax deduction for R&D expenditure is provided in section 16B of the Inland Revenue Ordinance. Under this section, R&D expenditure incurred by a taxpayer related to its trade, profession or business (including capital expenditure on plant or machinery but excluding capital expenditure on land or buildings or in acquiring any rights in, or arising out, of R&D) can be fully deducted (i.e. a 100% tax deduction) in the year of assessment in which the expenditure is incurred, subject to certain conditions. Based on the Inland Revenue Department s (IRD) interpretation, in order to qualify for the deduction, the R&D expenditure must either be (1) incurred in respect of inhouse R&D activities undertaken by the taxpayer itself or (2) a payment made to an approved research institute 3 (i.e. for subcontracted R&D activities). For a cost sharing arrangement within a group, the IRD s view is that only the actual staff costs of the employees of the Hong Kong taxpayer participating in the R&D activities, instead of the full amount of the R&D costs allocated to the Hong Kong taxpayer, can qualify for the deduction 4. For R&D expenditure incurred by a taxpayer outside Hong Kong (i.e. expenditure on R&D activities carried outside Hong Kong), an apportionment of the expenditure is required if the taxpayer s trade, profession or business is carried on partly in and partly outside Hong Kong (i.e. where only part of the taxpayer s profits are taxable in Hong Kong) 4.

2 The proposed enhanced R&D tax deduction regime To encourage more enterprises to invest in R&D in Hong Kong and promote local R&D activities, the HKSAR Government proposed in the 2017 Policy Address to introduce an enhanced tax deduction for R&D expenditure. The Inland Revenue (Amendment) (.3) Bill 2018 (the Bill), which was gazetted on 20 April 2018, set out the details of the proposed normal and enhanced tax deduction for R&D expenditure in Hong Kong. Once the bill is enacted into law, the new regime will take retrospective effect for qualifying expenditure incurred or qualifying payment made on or after 1 April With the introduction of the enhanced R&D deduction, section 16B is revamped and a new schedule (i.e. Schedule 45) is introduced to specify the details for the deduction of R&D expenditure. As specified in Schedule 45, there are two types of tax deductible R&D expenditure, namely Type A expenditure (which qualifies for a 100% tax deduction) and Type B expenditure (which qualifies for enhanced tax deduction of 300% for the first HK$2 million and 200% for the remaining amount). R&D expenditure that does not qualify for the enhanced deduction may continue to enjoy a normal 100% tax deduction subject to the fulfilment of the specified conditions. Please refer to Table 1 in the Appendix for the key features of the proposed normal and enhanced tax deductions for R&D expenditure, including the R&D activities qualifying for the deduction, the definition of R&D expenditure and what are regarded as Type A expenditure and Type B expenditure. One point that is worth to note is if any rights generated from the R&D activity are not, or will not be, fully vested in the taxpayer, no deduction (both Type A and Type B expenditures) will be granted. This requirement is not clearly specified in the existing section 16B. Comparing to other countries 5 that also offer tax incentives for R&D activities, some features of the proposed regime in Hong Kong are more competitive whereas the others are less attractive. Taking the Mainland China as an example, the current rates of enhanced tax deduction for qualifying R&D expenditure are only 175% (for qualified small and medium-sized technological enterprises) or 150% (for other enterprises), which are lower than the 300%/200% enhanced deduction rates in Hong Kong. On the other hand, while payments made for subcontracted R&D activities are generally not eligible for enhanced deduction in Hong Kong (unless the subcontractor is a designated local research institution), 80% of the expenditure incurred for R&D activities subcontracted to a related or unrelated party (either an organisation or individual) is eligible for enhanced tax deduction in the Mainland China provided that the R&D activities are conducted by a local Chinese party in China. Please refer to Table 2 in the Appendix for a comparison of the key features of the enhanced R&D tax deduction regimes in the Mainland China and Hong Kong. Certain receipts in relation to R&D deemed as taxable trading receipts In order to maintain tax symmetry, the following provisions (which are originally in section 16B) are retained in Schedule 45, with modifications to reflect the proposed enhanced R&D tax deduction: Proceeds from sale of plant or machinery used for an R&D activity where the capital expenditure on such plant or machinery has been allowed as a deduction under section 16B, with the deemed taxable amount limited to the amount of deduction previously allowed; and Proceeds from sale of any rights generated from one or more R&D activities for which the expenditure have been allowed as a deduction under section 16B, with the deemed taxable amount limited to the amount of deduction previously allowed. The Bill also introduces provisions that deem the following receipts as taxable Hong Kong sourced trading receipts: Royalties received for the use, or the right to use, outside Hong Kong of any intellectual property or know-how generated from any R&D activity in respect of which a R&D deduction is allowable under section 16B; and Sums received for imparting or undertaking to impart knowledge directly or indirectly connected to the use outside Hong Kong of any intellectual property or know-how generated from any R&D activity in respect of which a R&D deduction is allowable under section 16B. Assessment of eligibility for the R&D tax deduction For the purpose of assessing a claim or an advance ruling application made in relation to a deduction for R&D expenditure under section 16B, the Bill proposes to empower the Commissioner of Inland Revenue (CIR) to seek advice from the Commissioner for Innovation and Technology (CIT) in ascertaining whether (1) an activity falls within the scope of R&D activities qualifying for the tax deduction and (2) the expenditure should be regarded as incurred in relation to an R&D activity qualifying for the tax deduction. The CIR may disclose to the CIT any details which he considers necessary for the purpose of such consultation. However, the final decision on whether a deduction should be allowed for the R&D expenditure concerned will be made by the CIR. The takeaway While the Bill represents a significant move of the HKSAR Government in the right direction for promoting local R&D activities in Hong Kong, the proposed enhanced R&D tax deduction regime is considerably complex as it specifies numerous conditions for enjoying the enhanced deduction, introduces various deeming provisions that treat certain receipts in relation to R&D that would otherwise not subject to profits tax as taxable trading receipts and includes anti-avoidance provisions to safeguard against abuse of the tax deductions (both normal and enhanced) for R&D expenditure. Hong Kong companies that are engaging in or planning to engage in R&D activities in and/or outside Hong Kong should review their R&D activity arrangements in light of the proposed regime and assess how to best structure their R&D activities for benefiting from the enhanced R&D tax deduction in Hong Kong. 2 PwC

3 Endnotes 1. This is referred to as super deduction in some jurisdictions. 2. The Inland Revenue (Amendment) (. 3) Bill 2018 can be accessed via this link: /es pdf 3. For a list of the approved research institutes, please refer to the this link to the IRD s website: 16bc.htm 4. Please refer to the minutes of the 2013 annual meeting between the IRD and the Hong Kong Institute of Certified Public Accountants in this link for more details: /section5_membership/professional %20Representation/pdf-file/taxb/24.pdf 5. Countries with tax incentives for R&D activities (e.g. enhanced tax deduction or tax credits for qualifying R&D expenditure) include China, India, Japan, Korea, Singapore, the UK and the US, etc. 3 PwC

4 Appendix Table 1 - Key features of the proposed normal and enhanced tax deduction for R&D expenditure in Hong Kong 1) Rates of deduction (Section 13 of Schedule 45) 100% rmal deduction (Type A Expenditure) Enhanced deduction (Type B Expenditure) 300% for the first HK$2 million 200% for the remainder (no cap on the amount eligible for the 200% deduction) 2) R&D activities qualifying for the deduction (Sections 2 and 4 of Schedule 45) An R&D activity, which is defined as: a. an activity in the fields of natural or applied science to extend knowledge; b. a systematic, investigative or experimental activity carried on for the purposes of any feasibility study or in relation to any market, business or management research; c. any original and planned investigations undertaken with the prospect of gaining new scientific or technical knowledge and understanding; or d. the application of any research findings or other knowledge to a plan or design for the producing or introducing new or substantially improved materials, devices, products, processes, systems or services before they are commercially produced or used. A qualifying R&D activity, which is defined as an R&D activity that: falls within (a), (c) or (d); and is wholly undertaken and carried on in Hong Kong; but does not include certain activities that are not regarded as involving advancement in science or technology (e.g. efficiency survey, application of publicly available research findings with an anticipated outcome and without any scientific or technological uncertainty). 3) Definition of R&D expenditure (Section 6 of Schedule 45) A payment made to an R&D institution for an R&D activity Any other expenditure incurred on an R&D activity, including capital expenditure except capital expenditure on land or buildings But excludes a payment made to an R&D institution or an expenditure incurred for acquiring rights generated from an R&D activity tes: 1. The R&D expenditure must be for an R&D activity or a qualifying R&D activity related to the claimant s trade, profession or business or that class of trade, profession or business (e.g. an R&D activity that may lead to or facilitate an improvement in the technical efficiency of that trade, profession or business). 2. R&D institution means a designated local research institution or a university or college that is not a designated local research institution. 4) R&D expenditure qualifying for the deduction (Sections 8, 10 and 12 of Schedule 45) Type A expenditure, which is defined as an R&D expenditure other than a Type B expenditure e.g. payments made to a university or college that is not a designated local research institution for an R&D activity; and capital expenditure on plant and machinery used for an R&D activity. If a Type A expenditure is incurred for an R&D activity carried on outside Hong Kong in relation to a trade, profession or business that is carried on partly in and partly outside Hong Kong, an apportionment of the expenditure is required for deduction purpose. Type B expenditure, which is defined as an R&D expenditure that is: a payment made to a designated local research institution for a qualifying R&D activity; or an expenditure incurred for a qualifying R&D activity which is: o in relation to an employee engaged directly and actively in a qualifying R&D activity (remuneration and benefits paid to a director are specifically excluded); or o an expenditure on a consumable item that is used directly in a qualifying R&D activity. 5) Situations where no deduction is allowed (Section 14 of Schedule 45) deduction will be allowed for an R&D expenditure incurred by a person if: any rights generated from the R&D activity are not, or will not be, fully vested in the person; the R&D activity is undertaken for another person; the expenditure is or will be met directly or indirectly by a government, a public or local authority or another person; or the expenditure is incurred under an arrangement of which the main purpose, or one of the main purposes, is to enable the person to obtain a R&D deduction or a greater R&D deduction that the person would not otherwise be entitled to. 4 PwC

5 Table 2 - Comparison of the key features of the enhanced R&D tax deduction regimes in China and Hong Kong 1) Rates of deduction 300% for the first HK$2 million 200% for the remainder (no cap on the amount eligible for the 200% deduction) Hong Kong China 1 175% for qualified small and mediumsized technological enterprises (applicable for the period from 1 January 2017 to 31 December 2019) 150% for other enterprises (no cap on the amount eligible for the enhanced deduction) 2) Definition of R&D activities qualifying for enhanced tax deduction 3) Industries not qualifying for enhanced tax deduction 4) Qualifying R&D expenditure: Staff costs Please refer to the definition of qualifying R&D activity under Enhanced deduction in Table 1 t specified, apparently there is no restriction, but exclude remuneration and benefits paid to a director The continuous and systematic activities towards definite objectives carried out by enterprises for the purpose of procuring new knowledge of science and technology, using new scientific and technological knowledge in a creative manner or improving technologies, products, services or technique materially. Certain activities are specifically excluded e.g. marketing research, efficiency investigation, management research and routine quality control, etc. Tobacco manufacturing Accommodation and catering Wholesale and retail Real estate Leasing and provision of commercial services Entertainment Other industries stipulated by the Ministry of Finance and State Administration of Taxation of China (SAT) Consumables Building or structures (Depreciation) Plant and machinery (Depreciation) Intangibles (Amortisation) Other related expenses (e.g. legal & professional fees) 5) R&D activities conducted by the taxpayer itself: Within the jurisdiction, up to 10% of the total R&D expenditure eligible for enhanced deduction Outside the jurisdiction 6) R&D activities subcontracted to other parties: Within the jurisdiction, but only if the subcontractor is a designated local research institution (100% of the payment made would be eligible for the enhanced deduction.), and no need to be a designated or an approved organisation (limited to 80% of the actual R&D expenditure) Outside the jurisdiction 5 PwC

6 7) Cost sharing arrangement within the group Hong Kong China 1 t specifically mentioned, but R&D costs allocated to the Hong Kong taxpayer under a cost sharing arrangement should not be eligible for the enhanced deduction unless the group entity carrying out the R&D activities is a designated local research institution. te 1. Please refer to the following circulars for more details of the key features of the enhanced R&D tax deduction regime in China: Caishui [2015]. 119: SAT Public tice [2015]. 97: Caishui [2017]. 34: Guokefazheng [2017]. 115: SAT Public tice [2017]. 40: 6 PwC

7 Let s talk For a deeper discussion of how this issue might affect your business, please contact the following PwC members: PwC s Corporate Tax Leaders based in Hong Kong: Charles Lee China South and Hong Kong Tax Leader charles.lee@cn.pwc.com Cecilia Lee Transfer Pricing cecilia.sk.lee@hk.pwc.com Kenneth Wong Tax Controversy kenneth.wong@hk.pwc.com PwC s R&D Incentive Services Team: Roger Di R&D Incentive Services +86 (10) roger.di@cn.pwc.com Jeremy Choi Industrial Products jeremy.choi@hk.pwc.com Jeremy Ngai Mergers and Acquisitions jeremy.cm.ngai@hk.pwc.com Gwenda Ho Technology, Media and Telecommunication gwenda.kw.ho@hk.pwc.com Rex Ho Financial Services rex.ho@hk.pwc.com Jenny Tsao Corporate Tax and Consumer Markets jenny.np.tsao@hk.pwc.com With close to 2,700 tax professionals and over 170 tax partners in Hong Kong, Macau, Singapore, Taiwan and 22 cities in Mainland China, PwC s Tax and Business Service Team provides a full range of tax advisory and compliance services in the region. Leveraging on a strong international network, our dedicated Hong Kong Corporate Tax Leaders based in Hong Kong are striving to offer technically robust, industry specific, pragmatic and seamless solutions to our clients on their Hong Kong, PRC and international tax issues. Senior tax buyers name PwC as their first choice tax provider in Hong Kong.* * These results are based on an independent survey of 100 primary buyers of tax services in Hong Kong, conducted by research agency Jigsaw Research (Q1-Q4 2016). In the context of this News Flash, China, Mainland China or the PRC refers to the People s Republic of China but excludes Hong Kong Special Administrative Region, Macao Special Administrative Region and Taiwan Region. The information contained in this publication is for general guidance on matters of interest only and is not meant to be comprehensive. The application and impact of laws can vary widely based on the specific facts involved. Before taking any action, please ensure that you obtain advice specific to your circumstances from your usual PwC s client service team or your other tax advisers. The materials contained in this publication were assembled on 24 April 2018 and were based on the law enforceable and information available at that time. This Hong Kong Tax News Flash is issued by the PwC s National Tax Policy Services in Hong Kong and China, which comprises of a team of experienced professionals dedicated to monitoring, studying and analysing the existing and evolving policies in taxation and other business regulations in China, Hong Kong, Singapore and Taiwan. They support the PwC s partners and staff in their provision of quality professional services to businesses and maintain thought-leadership by sharing knowledge with the relevant tax and other regulatory authorities, academies, business communities, professionals and other interested parties. For more information, please contact: Matthew Mui +86 (10) matthew.mui@cn.pwc.com Please visit PwC s websites at (China Home) or (Hong Kong Home) for practical insights and professional solutions to current and emerging business issues. 7 PwC 2018 PricewaterhouseCoopers Ltd. All rights reserved. PwC refers to the Hong Kong member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see for further details.