3 January Issue No. 1. Court-free amalgamation - utilization of pre-amalgamation tax losses subject to strict restrictions post amalgamation

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1 Hong Kong Tax Alert 3 January Issue No. 1 Court-free amalgamation - utilization of pre-amalgamation tax losses subject to strict restrictions post amalgamation A potentially contentious and complicated tax issue specific to a court-free amalgamation is the availability of tax losses sustained in either an amalgamating company or an amalgamated company prior to the amalgamation, and whether these losses can be utilized to offset against the post-amalgamation profits of the amalgamated company. This alert discusses the assessing practice of the Inland Revenue Department (IRD) in this regard as stated in a guidance note issued by the IRD in December The same trade or business requirement and the financial resources requirement used in the guidance note to restrict the utilization of pre-amalgamation tax losses post amalgamation, were further explained by the IRD in its 2016 annual meeting with the Hong Kong Institute of Certified Public Accountants (HKICPA). Where appropriate, clients should seek professional tax advice on how the IRD s stated assessing practice or possible pending tax legislation in this regard may impact their amalgamation proposals, including possibly the choice of which companies should be the amalgamating and the amalgamated companies respectively.

2 Availability of pre-amalgamation tax losses post amalgamation Effective from 3 March 2014, the new Companies Ordinance (Cap. 622) (the new CO) has contained provisions allowing two or more wholly-owned companies within a group to amalgamate without the need to seek the approval of the Court. Such a court-free amalgamation would involve the business assets and liabilities of one or more (amalgamating) companies being merged into an (amalgamated) or surviving company under the procedures specified in the new CO. Upon completion of the amalgamation, all the amalgamating companies involved will cease to exist as separate limited liability companies. While the new CO has enacted provisions allowing for court-free amalgamations, no specific tax legislation has to-date been enacted to cater for the tax consequences of such amalgamations. As a result, the relevant tax consequences have to be determined based on the existing provisions of the Inland Revenue Ordinance (IRO). A potentially contentious and complicated tax issue specific to a court-free amalgamation is the availability of tax losses sustained in either an amalgamating company or an amalgamated company prior to the amalgamation, and whether these losses can be utilized to offset against the post-amalgamation profits of the amalgamated company. In this context, the post-amalgamation profits of the amalgamated company could include profits derived from (i) the trade or business previously carried on by the amalgamating company now succeeded and continued to be carried on by the amalgamated company post amalgamation; and (ii) the trade or business that the amalgamated company has all along been carrying on pre- and post-amalgamation. In December 2015, the IRD issued a guidance note (the Guidance Note) on its assessing practice in relation to the tax issues arising from court-free amalgamations under the existing provisions of the IRO, pending the possible enactment of specific tax legislation in this regard. This alert will focus on the availability or utilization of the pre-amalgamation tax losses sustained in either an amalgamating or an amalgamated company post amalgamation, as detailed in the Guidance Note and further elaborated by the IRD in its 2016 annual meeting with the HKICPA. As regards other tax issues arising from a court-free amalgamation, please refer to our previous Hong Kong Tax alert issued on 21 January Utilization of pre-amalgamation tax losses sustained in an amalgamating company The Guidance Note stresses at the outset that under the existing provisions of the IRO, tax losses are specific to a company and, as such, cannot be transferred by an amalgamating company to the amalgamated company by way of a court-free amalgamation. Nonetheless, as an apparent extra-statutory concession, the Guidance Note states that subject to satisfying certain preconditions, the pre-amalgamation tax losses sustained in an amalgamating company would be available to be utilized in the following restrictive manner post amalgamation: To offset only against the profits derived from the same trade or business that the amalgamating company previously carried on and is now succeeded and continued to be carried on by the amalgamated company post amalgamation, i.e., the pre-amalgamation tax losses sustained in the amalgamating company must be ringfenced in that same trade or business. In other words, in no case can such pre-amalgamation tax losses of the amalgamating company be utilized to offset against any other profits derived from any other trade or business of the amalgamated company post amalgamation. The same trade or business requirement In its 2016 annual meeting with the IRD, the HKICPA raised the point that once an amalgamation has been effected, there will be one company and it may be difficult from a practical point of view to determine the profits derived from the trade or business that was previously carried on by the amalgamating company. This will be practically true where the nature of the businesses carried on by the amalgamating and amalgamated companies is similar and the businesses are integrated from a management and reporting perspective once amalgamated. Furthermore, as trades and businesses change over time (e.g., markets, products etc.) how will the IRD determine whether the profits are still from the same trade or business? In reply, the IRD reiterated that the same trade or business requirement was to restrict the transfer of tax losses from a loss-making group company to a profit-making group company, the IRO containing no provisions allowing for the group relief of tax losses. The IRD then noted that the same trade or business requirement was also adopted in other jurisdictions to deal with tax losses succeeded to in an amalgamation. In this context, overseas case-law precedents indicate that the meaning of the word same in the phrase the same trade or business imported identity and not similarity (i.e., it meant an identical trade or business). 2

3 As regards changes of the nature of a trade or business over time, the IRD considered that it was a matter of whether a change stemmed from an organic growth of the trade or business concerned or a sudden and dramatic change brought about by either the acquisition or the loss of activities on a significant scale. The former type of change would not generally alter the identity of the trade or business concerned whereas the latter potentially would. The IRD emphasized that the issue of whether it was the same trade or business was ultimately a question of fact. In this regard, the IRD cited in support the UK case Rolls-Royce Motors Ltd v Bamford [1976] STC 162. The HKICPA then raised a specific follow-up question of whether a court-free amalgamation of a group wholesaler (as the amalgamating company) with a group retailer (as the amalgamated company) would be regarded as the amalgamated company succeeding and continuing the same trade or business that the wholesaler company previously carried on, given that the same product was sold before and after the amalgamation (diagram below refers). The IRD responded that the IRD considered that, in the circumstances of the situation given, the same trade or business requirement had not been satisfied since the amalgamated company ceased to carry on the wholesaling trade or business previously carried on by the wholesaler or the amalgamating company. In giving this response, the IRD apparently assumed that before the amalgamation, the group wholesaler company only sold the product to the group retailer company and did not have any other wholesale customers. As such, as a result of the amalgamation, the previous wholesaling business would not exist post amalgamation, there being no longer any wholesale sales after the amalgamation (the amalgamated company purchasing the product from suppliers post amalgamation for its own retail sales only). The consequence of the same trade or business requirement not being satisfied is that any preamalgamation tax losses sustained in the group wholesaler company would not be available to be utilized by way of offset against any of the profits derived by the amalgamated company post amalgamation. In other words, in the circumstances any pre-amalgamation tax losses sustained in the wholesaler company would effectively be lost or forfeited post amalgamation. Suppliers Wholesaler (amalgamating company) Retailer (amalgamated company) Customers Amalgamation Suppliers Retailer (amalgamated company) Customers Legend: Sale of product 3

4 Utilization of pre-amalgamation tax losses sustained in an amalgamated company Where the pre-amalgamation tax losses are sustained in an amalgamated company, the Guidance Note requires that the amalgamated company demonstrate that it would have had the financial resources to acquire the amalgamating company, had the merger of the companies concerned not undertaken through a courtfree amalgamation. If the financial resources requirement is satisfied, the utilization of such preamalgamation losses will, in general, not be subject to restriction post amalgamation. Otherwise, the IRD would presumably seek to invoke the general anti-avoidance provisions contained in section 61A of the IRO to deny the utilization of such preamalgamation tax losses by way of offset against profits derived by the amalgamated company from the trade or business that the amalgamated company succeeded from the amalgamating company through the court-free amalgamation. It should be noted that aside from the aforesaid possible denial, the utilization of the pre-amalgamation tax losses sustained in the amalgamated company to offset against other profits of the amalgamated company post amalgamation is generally not subject to restriction. The rationale for imposing the financial resources requirement appears to be that, under the existing provisions of the IRO, a company with tax losses can generally acquire a profitable business, and thereafter can utilize its pre-acquisition tax losses to offset against the profits of the business so acquired without restriction. The satisfaction of the financial resources requirement would indicate that even if not by way of the court-free amalgamation, the amalgamated company can in any case acquire the amalgamating company through a normal business acquisition by way of an asset deal. It is apparently on this basis that the Guidance Note indicates that, where the financial resources requirement is satisfied, the tax outcome of a court-free amalgamation in terms of utilization of the preamalgamation tax losses sustained in an amalgamated company would be on the same footing as that of a normal business acquisition by way of an asset deal. The financial resources requirement The IRD elaborated in the 2016 annual meeting that the term financial resources, while excluding intra-group loans, was broad and would include capital, liquid assets and cash and the ability of an amalgamated company to raise funds from third parties. In this regard, the IRD added that an application for an advance ruling should be considered if the facts were complex or involving details which were not obvious. Commentary The IRD s view that the word same in the phrase same trade or business means an identical but not a similar trade or business appears to be restrictive 1. This would particularly be the case where an integration of the businesses of an amalgamating company and an amalgamated company (such as the integration of the wholesaler and the retailer business discussed above) could involve the cessation of the trade or business previously carried on by the amalgamating company post amalgamation. The IRD s above assessing practice would presumably be reflected in any future tax legislation specifically enacted to cater for court-fee amalgamations. The IRD s strict approach to the utilization of the preamalgamation tax losses sustained in an amalgamating company post amalgamation may lead to a wider debate on whether Hong Kong should introduce some form of group relief for tax losses (i.e., relief that is not confined to court-free amalgamations). Regarding the financial resources test for the utilization of the pre-amalgamation tax losses sustained in an amalgamated company post amalgamation, there are views that such utilization is already subject to IRD s possible challenges under the conditions specified in the general anti-avoidance provisions contained in section 61A of the IRO. As such, the utilization of such preamalgamation tax losses post amalgamation should not be subject to the additional financial resources test. The above commentary illustrates that the availability or utilization of pre-amalgamation tax losses in a court-free amalgamation post amalgamation could involve complicated issues. Where appropriate, clients should seek professional tax advice on how the IRD s stated assessing practice, or possible pending tax legislation, may impact their amalgamation proposals, including possibly the choice of which companies should be the amalgamating and the amalgamated companies respectively. 1. The IRD has also recently updated the Guidance Note on its website as regards court-free amalgamations. The update was carried out in order to reflect the views of the IRD as expressed in the 2016 annual meeting with the HKICPA. The updated Guidance Note also contain three illustrative examples of whether changes to a trade or business post amalgamation could be regarded as arising from the organic growth of the previous trade or business (i.e., not altering the identity of the trade or business concerned), or whether such changes would be viewed as being sudden or dramatic changes in the previous trade or business (thereby altering the identity of the trade or business concerned). Briefly, these three illustrative examples indicate the IRD s view that: a property trading business is not the same business as a property investment business; a company changing its business from operating a Japanese restaurant to an Italian restaurant would likely involve a change of the identity of the business; and two amalgamating companies, trading the same products with similar operational modes, whilst covering different countries, could satisfy the same trade or business test where the surviving company extends its business of trading in the products to the countries previously covered by the other amalgamating company. The updated Guidance Note is accessible from: 4

5 EY Contacts Financial Services Hong Kong office Ian McNeill Managing, Tax, Asia-Pacific Principal tax contact, Ernst & Young Tax Services Limited Florence Chan Business Tax Services Paul Ho Napson Hon Executive Director Sunny Liu Executive Director International Tax Services James Badenach Jacqueline Bennett Rohit Narula John Praides Adam Williams Transfer Pricing Services Justin Kyte Indirect tax Liza Drew EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the 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 ey.com Ernst & Young Tax Services Limited. All Rights Reserved. APAC No ED None. This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax or other professional advice. Please refer to your advisors for specific advice. ey.com/china