News Flash. Hong Kong Tax. Tax deduction for the acquisition costs of specified intellectual property rights is finally in place

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1 News Flash Hong Kong Tax December 2011 Issue 11 Our Hong Kong Corporate Tax Team Contacts Peter Yu Partner Tel: Tim Leung Partner Tel: Reynold Hung Partner Tel: Our Hong Kong Corporate Tax team provides a full range of integrated professional services in tax consulting and compliance. Our tax specialists provide technically robust, industry specific and pragmatic solutions to our clients on Hong Kong, PRC and international tax issues. Tax deduction for the acquisition costs of specified intellectual property rights is finally in place In the 2010/11 Hong Kong Budget delivered in February 2010, the Financial Secretary proposed a profits tax deduction for capital expenditure incurred on the purchase of copyrights, registered designs or registered trademarks (collective referred to as specified IP rights ) with an aim of promoting the wider application of intellectual property by enterprises and the development of creative industry. The proposed tax deduction is in addition to the one that is available under section 16E of the Inland Revenue Ordinance ( IRO ) for acquisition of patent rights or rights to know-how. In March 2011, Inland Revenue (Amendment) (N0.2) Bill 2011 ( Bill ), which contained the proposed legislation for the suggested tax deduction, was introduced at the Legislative Council. A Bills Committee was then formed to study the Bill and review the submissions made by various interested parties on the Bill. On 7 December 2011, the Bill was finally passed by the Legislative Council. Subject to the completion of the necessary legislative procedures, it is expected that this new tax deduction will be available for year of assessment 2011/12 onwards. In this News Flash, we discuss the key provisions of the newly enacted legislation and share our observations on some of the potential limitations of the legislation in granting tax relief to Hong Kong taxpayers for their costs incurred on acquiring the specified IP rights under certain circumstances.

2 Key provisions of the legislation The legislation introduces three new sections to the IRO, namely sections 16EA, 16EB and 16EC. The legislation also amends existing section 16E that governs the deduction of capital expenditure incurred on purchase of patent rights or rights to know-how. The key provisions of the legislation are summarised below. Section 16EA Tax deduction for purchase costs of specified IP rights Under section 16EA, capital expenditure incurred by a person on the purchase of a specified IP right, including legal expenses and valuation fees incurred in connection with the purchase, can be deducted if all of the following conditions are met: The person must have acquired the proprietary interest of the specified IP right; The specified IP right is purchased for use in the production of that person s profits chargeable to Hong Kong profits tax; The subject trademark or design must have been registered under the relevant law of Hong Kong or any place outside Hong Kong 1 ; The specified IP right must have been used in the production of that person s chargeable profits during a part or the whole of the basis period for a year of assessment in which a deduction is claimed 2 ; and The purchaser must hold the specified IP right at the end of the basis period for a year of assessment in which a deduction is claimed. The purchase cost is to be deducted over five years of assessment on a straight-line basis starting from the year of assessment in which the capital expenditure is incurred. If the specified IP right is a copyright or registered design and the maximum period of protection is due to expire within the five-year deduction period, the purchase cost can be deducted in equal amounts over the number of remaining years of protection. If the specified IP right is used partly in the production of chargeable profits and partly for any other purposes, apportionment of the capital expenditure is required such that deduction is limited to the extent to which the specified IP right is used for the production of chargeable profits. The Commissioner is empowered to (1) determine the true market value of a specified IP right for tax deduction purpose (if the consideration for the purchase of that specified IP right does not represent the true market value of the right at the time of purchase) and (2) allocate the consideration for an individual specified IP right when such right is purchased together with another specified IP right or with any other assets for one consideration. Section 16EB Taxation of proceeds from sale of specified IP rights Section 16EB provides for a claw-back of the proceeds from sale of any specified IP right in respect of which a tax deduction has been previously allowed. In essence, the proceeds from sale of such specified IP right will be deemed as taxable trading receipts at the time of the sale but the taxable amount will be limited to the deduction previously allowed under section 16EA. If the specified IP right is sold within the five-year deduction period such that part of the purchase cost has not been claimed as deduction at the time of sale (i.e. the unallowed amount), any excess of the unallowed amount over the sale proceeds will be allowed as deduction in the year of sale whereas any excess of the sale proceeds over the unallowed amount will be subject to tax in the year of sale. The claw-back provision in section 16EB is similar to that under section 16G(3)(a) of the IRO that deals with prescribed fixed assets. Section 16EC Anti-avoidance provisions Section 16EC includes various anti-avoidance provisions that guard against the possible abuse of the tax deductions allowable under section 16E or 16EA. Situations in which a deduction will be denied include: 1. Where a specified IP right is purchased wholly or partly from an associate; 1 No such registration is required for copyrights as there is no registration regime for copyrights in Hong Kong and most jurisdictions. 2 However, there is no need for the specified IP right to be used in Hong Kong as far as it is used by the purchaser itself. News Flash Hong Kong Tax 2

3 2. Under certain avoidance arrangements involving transfer of a specified IP right in circular route for obtaining tax benefit (i.e. the sale and license back arrangements); 3. For any specified IP right that is licensed for use wholly or principally outside Hong Kong by a person other than the purchaser; and 4. For any specified IP right of which the whole or a predominant part of the consideration was financed directly or indirectly by a non-recourse debt (i.e. the "leveraged licensing arrangements"). The anti-avoidance provisions mentioned in (2) to (4) above are similar to those under sections 39E(1)(a) & (b) of the IRO that deal with plant or machinery. Amendments to existing section 16E Other than introducing the new deduction for capital expenditure incurred on the purchase of specified IP rights, the legislation also revises existing section 16E to unify the tax deduction regimes for patent/know-how rights (under section 16E) and specified IP rights (under section 16EA) respectively. In particular, the requirement that a patent right or right to know-how must be used in Hong Kong that was previously included in section 16E has been removed. Tax deduction is now granted to the extent that the right is used in the production of chargeable profits. On the other hand, the anti-avoidance provisions mentioned in (2) to (4) above, which were not previously included in section 16E, are now applicable to deduction claims under section 16E. In addition, the claw-back provision that applies to the proceeds of sale of patent / know-how rights has been refined such that the taxable amount is now limited to the deduction previously allowed. PwC observations While the legislation may be seen as a positive step taken by the Hong Kong SAR Government in promoting Hong Kong as a regional intellectual property hub, in the absence of a proper escape clause under some of the anti-avoidance provisions mentioned above, the legislation may be of limited benefits to Hong Kong taxpayers under certain bona fide commercial arrangements where there is no intent to avoid tax. Specified IP rights used outside Hong Kong under processing arrangements Among the various anti-avoidance provisions, the one contained in section 16EC(4)(b) is considered as the most controversial. Under section 16EC(4)(b), a tax deduction will be denied where the specified IP right is used outside Hong Kong under a licence by a person other than the purchaser. Based on the current interpretation of the term lease adopted by the Inland Revenue Department ( IRD ) in the context of applying the similar anti-avoidance provision in section 39E, the term licence in section 16EC(4)(b) will be interpreted by the IRD to include the situation where a specified IP right (say, a registered design) owned by a Hong Kong company is provided free of charge to an overseas manufacturing entity (say, in the Mainland) for use in the production of goods for the Hong Kong company under either a contract processing or an import processing arrangement. The Administration s views in this regard were documented in a paper dated 24 November 2011 ( Paper ) which reported the deliberations of the Bills Committee on the Bill and the Administration responses to issues raised. According to the Paper, the Administration is of the view that in order for the design to be used in the production process in the Mainland as well as the sale of the finished goods in Hong Kong, the design will have to be registered in both the Mainland and Hong Kong as the registration and protection of IP rights operate on a territorial basis. As a result, two registered designs are involved i.e. the Mainland registered design and the Hong Kong registered design. Contract Processing Arrangement Under a contract processing arrangement where the IRD agrees to apportion the profits derived by the Hong Kong taxpayer on a 50:50 basis for assessment of Hong Kong profits tax, the Paper stated that 50% deduction of the expenses incurred by the Hong Kong company for producing such assessable profits, including the capital expenditure incurred on the purchase of the Mainland registered design and the Hong Kong registered design, will be allowed. News Flash Hong Kong Tax 3

4 Import Processing Arrangement For an import processing arrangement, the Administration is of the view that if the Mainland registered design is granted by the Hong Kong company to the Mainland manufacturing entity at no cost for use in the latter s production activities in the Mainland, section 16EC(4)(b) is applicable and no tax deduction will be allowed for the part of capital expenditure incurred on the purchase of the Mainland registered design for use in the production activities. The denial of tax deduction is also based on the Administration s view that the profits derived from the production activities of the Mainland manufacturing entity (which is a separate legal entity) are not subject to Hong Kong profits tax. As such, the Mainland registered design is not used in the production of profits chargeable to tax in Hong Kong and therefore will not be allowed for tax deduction in Hong Kong. However, tax deduction will be available for the part of the purchase cost of the Mainland registered design used in the sale activities (if any) in the Mainland and the purchase cost of the Hong Kong registered design used in the sale activities in Hong Kong, provided that the trading profits derived from such sale activities performed by the Hong Kong company are chargeable to tax in Hong Kong. Based on the above, a Hong Kong company providing a specified IP right free of charge to a Mainland manufacturer for use in production of goods subsequently sold to the Hong Kong company at a reduced price will not be able to get a tax relief for the full purchase cost of the specified IP right, even though the resulting higher amount of trading profits (because of the reduced price charged by the Mainland manufacturer) derived by the Hong Kong company from the sale of the goods are fully subject to Hong Kong profits tax. Only the portion of the purchase cost of the specified IP used in the sales activities that are subject to tax in Hong Kong (not that used in the production activities) is deductible. This requires allocation of the purchase cost of the specified IP right to different territories in which the right is used and to different activities. Segregation of owner and user(s) of a specified IP right For various commercial reasons (e.g. better asset protection), a Hong Kong trading group may set up a designated group company in Hong Kong ( IP holder ) to purchase and own the specified IP right (e.g. a registered trademark) that is used by another operating group company ( OP Co ) in its trading activities performed in Hong Kong. Under such circumstance, even though the trading profits derived from the sale of goods by OP Co s will be fully subject to profits tax in Hong Kong, tax relief will not be available for the purchase cost of the specified IP right if the IP holder does not charge a fee to OP Co for using the specified IP right because the IP holder does not generate any profits chargeable to Hong Kong tax. In this regard, Hong Kong companies may have to reconsider their structure / arrangement in holding specified IP rights used in their business operations. Blanket denial of deduction for purchase from associate While we appreciate the necessity to include anti-avoidance provisions in respect of purchase of specified IPRs from an associated party, the current broad-brush approach of denying deduction in respect of any specified IPR purchased wholly or partly from an associate in section 16EC(2) would again affect some of the normal merger and acquisition transactions. An example is where a Hong Kong company plans to acquire a company (the target) which holds numerous specified IP rights registered in various jurisdictions and transfer the ownership of these specified IP rights to itself for a commercial or legal reason. Due to the complicated and lengthy legal procedures of transferring the ownerships of such specified IP rights in various jurisdictions, it is often difficult in practice for the Hong Kong company to finish the transfer of all the specified IP rights within a reasonable short period of time before the acquisition. In order to avoid any delay in the acquisition process, the Hong Kong company may instead purchase these specified IP rights from the target after the acquisition and by that time, the target has already become an associate of the Hong Kong company. In such case, the costs of acquiring the specified IP rights incurred by the Hong Kong company will be denied for deduction under section 16EC(2). Thus, companies planning to have merger and acquisition transactions that involve specified IP rights should seek professional advice in order to ensure the transactions are tax-efficient. News Flash Hong Kong Tax 4

5 Concluding remarks According to the Paper, a Departmental Interpretation and Practice Note ( DIPN ) will be issued by the IRD to cover the tax deduction arrangements and tax assessment practices involving specified IP rights under different scenarios, including the tax deduction for purchase of specified IP rights where the registration of assignment of which is still being processed, eligibility for tax deduction for purchase costs of specified IP rights used in cross-border activities (including the application of section 16EC(4)(b)) and licensing of specified IP rights for use outside Hong Kong, etc. Hong Kong taxpayers planning to undertake transactions involving acquisition of specified IP rights should stay tuned for the clarifications to be provided by the IRD in the forthcoming DIPN and careful planning will be required in order to structure such transactions in a tax efficient manner. News Flash Hong Kong Tax 5

6 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 PricewaterhouseCoopers client service team or your other tax advisers. The materials contained in this publication were assembled on 12 December 2011 and were based on the law enforceable and information available at that time. To make enquiries about our Hong Kong tax and business advisory services, please feel free to contact the following lead specialist partners: Entertainment & Media Colin Farrell Tel: colin.farrell@hk.pwc.com Industrial Products Medinah Ip Tel: medinah.ip@hk.pwc.com Info-Comms Suzanne Wat Tel: suzanne.wat@hk.pwc.com Financial Services Florence Yip Tel: florence.kf.yip@hk.pwc.com Logistics & Transportation Reynold Hung Tel: reynold.hung@hk.pwc.com Real Estate KK So Tel: kk.so@hk.pwc.com Retail & Consumer Products Tim Leung Tel: tim.leung@hk.pwc.com Investigation Services Tim Lui Tel: tim.lui@hk.pwc.com International Assignment Services Mandy Kwok Tel: mandy.kwok@hk.pwc.com Personal Financial Services John Wong Tel: john.cw.wong@hk.pwc.com Merger & Acquisition Nick Dignan Tel: nick.dignan@hk.pwc.com Transfer Pricing Cecilia Lee Tel: cecilia.sk.lee@hk.pwc.com Company Fiduciary & Administration Services Isabelle Young Tel: isabelle.a.young@hk.pwc.com Customs & International Trade Colbert Lam Tel: colbert.ky.lam@hk.pwc.com International Tax Advisory Nick Dignan Tel: nick.dignan@hk.pwc.com Tax Accounting Services Suzanne Wat Tel: suzanne.wat@hk.pwc.com Value Chain Transformation Tim Leung Tel: tim.leung@hk.pwc.com Our regional contacts: Beijing Edward Shum Tel: +86 (10) edward.shum@cn.pwc.com Chongqing Robert Li Tel: +86 (23) robert.li@cn.pwc.com Dalian Rex Chan Tel: +86 (411) rex.c.chan@cn.pwc.com Guangzhou Daisy Kwun Tel: +86 (20) daisy.kwun@cn.pwc.com Hong Kong Peter Yu Tel: peter.sh.yu@hk.pwc.com Macao Pat Wong Tel: pat.lk.wong@hk.pwc.com Nanjing Jane Wang Tel: +86 (25) jane.y.wang@cn.pwc.com Ningbo Ray Zhu Tel: +86 (21) ray.zhu@cn.pwc.com Qingdao Steven Wong Tel: +86 (532) steven.wong@cn.pwc.com Shanghai Peter Ng Tel: +86 (21) peter.ng@cn.pwc.com Shenzhen Charles Lee Tel: +86 (755) charles.lee@cn.pwc.com Singapore Lennon Lee Tel: lennon.kl.lee@sg.pwc.com Suzhou Linjun Shen Tel: +86 (512) linjun.shen@cn.pwc.com Taiwan Steven Go Tel: +886 (2) steven.go@tw.pwc.com Tianjin Kelvin Lee Tel: +86 (22) kelvin.lee@cn.pwc.com Xiamen Charles Lee Tel: +86 (592) charles.lee@cn.pwc.com Xian Elton Huang Tel: +86 (29) elton.huang@cn.pwc.com This Hong Kong Tax News Flash is issued by the PwC TAX Knowledge Management Centre 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 PricewaterhouseCoopers 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 Tel: +86 (10) matthew.mui@cn.pwc.com Please visit PricewaterhouseCoopers websites at (China Home) or (Hong Kong Home) for practical insights and professional solutions to current and emerging business issues PricewaterhouseCoopers Ltd. All rights reserved. In this document, PwC refers to PricewaterhouseCoopers Ltd. which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity.