Tax implications of HKAS 39: Financial Instruments, Recognition and Measurement

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Jack Curtis
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1 Tax implications of HKAS 39: Financial Instruments, Recognition and Measurement IAS 39 was first issued in March 1999 for adoption in Although many multi-national companies have adopted it, very few companies in Hong Kong have chosen to do so and indeed they are still struggling to understand its full implications. This standard will have to be implemented in Hong Kong in 2005 in the shape of HKAS39. While much has been written and debated about the various nuances and implications of IAS39 from an accounting perspective, there is a relative paucity of discussion on the tax consequences of this key standard. This article attempts to discuss some of the key tax issues that need to be considered while implementing HKAS39. While it does not deal exhaustively with all of the tax questions that arise on implementation of HKAS39, it is hoped that the article will provide some food for thought, for taxpayers as well as the Revenue authorities. Taxation of unrealised gains A fundamental objective of HKAS39 is to mark various financial assets and liabilities to market. This will no doubt give rise to unrealised gains and losses that will be recognised in the Income Statement or in Equity. Two key tax questions arise from this accounting treatment. First, will unrealised gains be subject to tax when they are recognised in accordance with the standard? Second, does it matter whether such gains are booked in the Income Statement or Equity? The short answers to both questions appear to be yes. With reference to unrealised gains, the attitude of the Inland Revenue Department (IRD) has hardened in recent years, as a consequence of the Secan case [(2002) HKRC ]. Secan is a decision of the highest court in Hong Kong. Instead of limiting the impact of this case to its unique facts, the IRD considers that the decision is the authority for the proposition that gains recognised by the taxpayer in the Income Statement should be taxed on recognition, regardless of whether they are realised or unrealised (unless they happen to be capital in nature). After all, Lord Miller stated in Secan that: Where the taxpayer may properly draw its financial statements on either of two alternative bases, the Commissioner is both entitled and bound to ascertain the assessable profits on whichever basis the taxpayer has chosen to adopt. The IRD argues that the above logic applies even more strongly under HKAS39, because the taxpayer will not have the option of choosing between two alternative accounting standards. Consequently, important cases like the House of Lords decision in Willingale [(1978) AC 834.], which stated that profits should not be anticipated for tax purposes, seem to be consigned to the dustbin of history, because they were predicated on the assumption that the taxpayer had a choice in deciding which accounting treatment should be adopted. It should be noted that although HKAS39 will have to be followed from 2005, this does not mean that the taxpayer will have no choices with respect to the accounting treatment that can be adopted for specific transactions. While in some cases the standard is inflexible, in other cases various decisions will have to be made because of the options available under the standard. For example, trading assets will have to be included in the fair value through profit and loss category. However, a debt security could be included in any one of three categories [fair value through profit and loss, held to maturity or available for sale], depending upon the underlying facts. However, leaving aside the technical question of whether Secan overrides Willingale and other similar cases, it would indeed be unfortunate if the IRD adopts an inflexible attitude on the taxation of unrealised gains. In particular cases this could create hardship; for example, unrealised gains on derivative positions at the end of the year could have vanished by the time the taxpayer files his tax returns. Since there is no provision in Hong Kong law to carry back losses to prior years, taxpayers could end up in the ludicrous situation where they are forced to pay tax on unrealised gains, when in fact they ultimately realise no gains or realise losses on closing out their positions, with no relief for those losses. In the past the IRD had adopted a more pragmatic approach of giving the taxpayer a one-time choice of electing to pay tax on an unrealised or realised basis. The IRD is urged to reconsider its position and allow taxpayers this choice, in the interest of equity and practicality. On the question of booking gains in Income Statement versus Equity, fortunately the IRD recognises that gains booked in Equity should not be taxed until they are recycled to the Income Statement. This will potentially limit the damage that could otherwise be done, if taxpayers are required to pay tax on all unrealised gains, regardless of whether they are recognised in the Income Statement or Equity. A subsidiary question that arises from mark to market treatment for a financial asset is whether the IRD will use this as evidence against the taxpayer with regard to the characterisation of that asset for tax purposes. Capital or Revenue Assets? It is generally accepted that where an asset is acquired as a long-term investment, it is treated as a capital asset, with the result 70

2 that any gain on the sale of the asset would not be taxed [Simmons v IRC (1980) 2 All ER 795]. Clearly a held to maturity asset should qualify for capital treatment. However, assets in fair value through profit and loss and available for sale will be marked to market. As stated previously, trading assets would, by definition, be included in the former category. However, a taxpayer also has the choice to designate (irrevocably) any asset to this category. As explained below, for hedging or other reasons, a taxpayer might designate to this category an asset that was acquired as a long-term investment and not for trading purposes. Similarly, available for sale is a catchall category that could include capital and revenue assets. HKAS39 should not have the effect of altering the fundamental classification of a capital asset for tax purposes, which is based on the taxpayer s intention at the time of acquisition of the asset. However, the mere inclusion of an asset in fair value through profit and loss or available for sale, might create a presumption that the asset was trading in nature, that is, the taxpayer did not really acquire it as a long-term investment. Therefore, taxpayers would be well advised to clearly document their rationale and motivation for acquiring an asset, if they wish to treat it as a capital asset for tax purposes. Economic hedge or hedge accounting? The process of entering into new transactions and establishing relationships between transactions, to provide an effective offset to reduce economic risk is economic hedging. For example, a company may borrow in Euros because a substantial portion of its sales are denominated in Euros. In the past, it was generally accepted that the nature and source of a hedging transaction for tax purposes should be the same as the nature and source of the underlying transaction. This is based on various authorities outside Hong Kong, for example, Australian law and practice. Thus if transaction A ( hedging instrument ) hedged transaction B ( hedged item ), the (i) capital versus revenue and (ii) onshore versus offshore classification, of A was based on the equivalent classification of B. The rationale for this was that from the perspective of the taxpayer, A and B were treated as effectively one transaction (albeit with two components). HKAS39 introduces a new twist to this approach and this in turn may influence the IRD s thinking, with the result that there could be three perspectives on hedging: economic hedging, hedge accounting and tax-effective hedging. Where an economic hedge does not satisfy the strict criteria for hedge accounting under HKAS39, the hedged item and hedging instrument will be accounted for separately, possibly on an inconsistent basis in the Income Statement (economic hedging). Where the criteria are satisfied and the hedging instrument is designated as a hedge of the hedged item, the accounting treatment of the two should be consistent in the Income Statement (hedge accounting). Since HKAS39 effectively creates a divergence in the manner in which identical hedging transactions are accounted for by different taxpayers, it would be unfortunate if the IRD concluded that for tax purposes, the tax treatment of the hedging instrument Exhibit 1 Macro Hedge should be determined on a stand alone basis, that is, without reference to the hedged item. The result of this approach could be that a pre-tax hedge may well turn out not to be a post-tax hedge (taxeffective hedging). Is the hedge tax effective? This query is best explained by the following example on macro hedging, where what the investor thought was an effective hedge may turn out not to be effective on a post-tax basis. As noted above, since the hedging transaction does not qualify for hedge accounting under the specific rules of HKAS39, a gain is booked in the Income Statement [subject to the rules on impairment]. Regardless of the accounting treatment, at least the hedge is effective on a pre-tax basis. If the hedging instrument is treated as unrelated to the hedged item for tax purposes, the hedge is no longer effective after tax. To avoid Income Statement volatility, the investor above may choose to designate the assets as fair value through profit & loss. In that case both the unrealised gains on the put option and the unrealised loss on the portfolio will Long term investor purchases $100 million in equities that make up the Hang Seng index in proportion to index component Investor classifies these assets as available for sale for accounting purposes and capital for tax purposes Investor hedges capital assets by purchasing put option on the index Portfolio declines by 10 per cent [$10m] and option appreciates by 10% [$10m] Exhibit 2 Accounting Treatment Portfolio loss [$10m] booked in Equity Derivative gain [$10m] booked in Income Statement Investor suffers no net pre-tax gain/ loss [economic hedge] but Income statement shows gain! Tax Treatment? Capital asset: no tax effect Derivative gain taxable, if option treated as a speculative asset: tax paid (say) $1.75m Investor suffers net post-tax loss of $1.75m [non tax-effective hedge] DECEMBER 2004 THE HONG KONG ACCOUNTANT 71

3 be booked in the Income Statement, so that they will cancel each other. However, this will not necessarily resolve the tax problem; in fact, it might compound it! Firstly, will the designation result in the IRD arguing that the portfolio assets are trading assets? Since the designation is merely to avoid Income Statement volatility, it should not mean that there has been any change in the intention of the taxpayer which was to acquire the assets for long-term investment purposes. Secondly, unless the option is also treated as a capital asset [because it is purchased to protect the aggregate value of a capital portfolio] the option gains may still be taxable, with the result that the hedge will not be effective post-tax. Similar examples can be constructed using the concept of source for tax purposes, where an offshore transaction is hedged by an onshore one or vice versa. If the hedging instrument is taxed on a standalone basis, there could be instances where there is an offshore, non-taxable gain on the underlying position, but the IRD gives relief for onshore losses on the hedging instrument, which clearly would work against the IRD. Similarly, there could be offshore, non-deductible losses on the underlying position, but the IRD would seek to tax the onshore gains on the hedging instrument, which would be very harsh for the taxpayer. It is hoped that the IRD will ultimately accept the basic proposition that regardless of the accounting treatment of the hedging instrument under HKAD39, its nature and source should be the same as those of the hedged item, so long as the taxpayer can effectively substantiate that his motive in acquiring the hedging instrument was to hedge an underlying transaction. The embedded derivatives question HKAS39 aims to ensure that the new requirements for marking derivatives to market are not avoided by embedding a derivative in a host contract that is accounted for differently, either at amortised cost or re-valued through Equity. The principle is that an embedded derivative should be split from the host Convertible Bond (redemption) Facts 1% convertible bond Term 2 years Principal = $1,000 Redeem for face, or convert into 70 Parent shares Parent share price: current $10 end year 1 $10 end year 2 $10 i.e. Investor will redeem, because out of the money Initial recognition Normal cost of debt 3% Initial recognition values pv of 3% $942 pv of 3% $19 bond liability $961 embedded derivative $39 total $1,000 Under HKAS 39, embedded derivative gets marked to market through P&L each year. Value of option at end of year 1 and 2 is $25 and 0, respectively. Journal entries (pre HKAS39) Redemption HKAS 39 Journal entries (HKAS39) Bond $961 Embedded derivative $39 P&L (Bond amortisation) $29 Bond $19 Embedded derivative $14 P&L (Unrealised gain - time erosion) $14 P&L (Bond amortisation) $30 Bond $20 Embedded derivative $25 P&L $25 Redemption 72

4 contract and accounted for separately if its risks are not clearly and closely related to those of the host contract. HKAS39 essentially is a rules-based standard that aims to look at the economic substance of a transaction and account for it accordingly. This creates a conflict with tax principles that essentially seek to tax commercial transactions in accordance with their legal form, in the absence of any artificial, tax avoidance structuring. Again let us consider the following contrasting examples of a convertible bond issued by the financing subsidiary of a listed company: the bonds are convertible into shares of the parent company and may not be cash settled. In the first case the bond is redeemed, whereas in the second case the bond is converted into shares, in accordance with its terms. It should be noted that the accounting treatment below pertains to the individual entity accounts and adjustments may well be required on consolidation. In the first instance, the conversion option embedded in the bond expires worthless. The present accounting treatment in accordance with the legal form of the instrument would be to record the $10 interest expense in the Income Statement. This would be deductible for tax purposes, assuming that the interest deduction rules are satisfied. However under HKAS39, the bond and option are accounted for separately. The bond is recognised as being issued at a discount of $39, which is amortised over the two-year life of the bond. Thus the bond interest expense is increased by $19 in the first year and $20 in the second year. Query whether this expense will be deductible for tax purposes? On the other hand, the option premium of $39 is written off to the Income Statement over the two-year life of the bond. Thus miscellaneous income of $14 and $25 are recognised in the first and second year, respectively. Query whether this income will be taxable? If the bond amortisation and option premium are taxable and deductible, no major damage will be done apart from timing differences which may work in favour of the IRD or taxpayer, depending upon market movements. Convertible Bond (conversion) Facts 1% convertible bond Term 2 years Principal = $1,000 Redeem for face, or convert into 70 Parent shares Parent share price: current $10 end year 1 $10 end year 2 $15 i.e. Investor will convert, because in the money Initial recognition Normal cost of debt 3% Initial recognition values pv of 3% $942 pv of 3% $19 bond liability $961 embedded derivative $39 total $1,000 Under HKAS 39, embedded derivative gets marked to market through P&L each year. Value of option is $20 at end of year 1 and $50 at the end of year 2. Journals entries (pre HKAS39) Conversion Issuer Conversion Parent Equity $1,000 Journal entries (HKAS39) Bond $961 Embedded derivative $39 P&L (Bond amortisation) $29 Bond $19 Embedded derivative $14 P&L (Unrealised gain time erosion) $14 P&L (Bond amortisation) $30 Bond $20 P&L (Derivative Loss) $25 Embedded derivative $25 Conversion Issuer Embedded derivative $50 Cash $1,050 Conversion Parent Cash $1,050 Equity $1,050 DECEMBER 2004 THE HONG KONG ACCOUNTANT 73

In the second instance, the bonds are converted by the bondholders into shares of the listed parent of the issuer. Under HKAS39, the bond is treated as in the first instance.

5 In the second instance, the bonds are converted by the bondholders into shares of the listed parent of the issuer. Under HKAS39, the bond is treated as in the first instance. With respect to the option, the issuer would recognise a gain on the derivative of $14 in the first year and a loss of $25 in the second year, because the option first falls in value from $39 to $25 and then rises in value to $50. On maturity, the bond liability of $1,000 and the derivative liability of $50 would be extinguished by the issuer purchasing treasury shares from the parent (say) for $1,050, for delivery to the bondholders. Similarly, the parent company will record an issue of shares for $1,050 in its individual entity accounts. The interesting question here, of course, is whether the gain of $14 and loss of $25 would be taxable/deductible? This would give a net deduction of $11, which together with the bond amortisation of $39 would result in additional deductions of $50. The Letters to the Editor Do you have any questions about the accountancy profession? Send your thoughts to the Editor, The Hong Kong Accountant, 20/F Sunning Plaza, 10 Hysan Avenue, Causeway Bay, Hong Kong. Fax: mike.grinter@thomson.com corresponding net credit of $50 would be recorded by the parent in Equity, in its entity accounts, which would not have any tax implications. This illustrates that the IRD would follow the accounting treatment at its own peril, because additional tax deductible expenses are created under HKAS39, where none exist if the transaction is examined from legal standpoint. This point needs to be clarified by the IRD: it would clearly be favourable for the IRD to seek to preserve the status quo by ruling in favour of the legal form of a genuine, commercial transaction. The transition HKAS39 will be applied prospectively. All accounting adjustments will be made from the beginning of 2005, not the start of the earliest presented, as would normally be the case. Thus financial assets and liabilities will be reclassified, hedging relationships reassessed and possibly designated and documented, Your full name and address must be included for verification. Letters may be edited for sense and style. and embedded derivatives will be identified and separated. The net result will be that an amount might be booked in Retained Earnings and in Equity. How will these amounts be treated for tax purposes? The IRD s view is that cases like Pearce v. Woodall-Duckham (51 TC 271) stand for the proposition that such adjustments are taxable in the year of change. Indeed, this is the approach that the IRD adopts when a taxpayer changes the basis of valuation of inventory. (Department Interpretation & Practice Note No. 1). However, this is not free from doubt. There is a school of thought that if an item of income is not picked up in the Income Statement, there is simply no provision that would bring it into the tax net. Taxpayers will therefore have to decide what filing positions they will take with respect to transitional adjustments. Certainly, at the very least, the amounts should be analysed into their components. For example, gains arising from available or sale assets that would normally be booked in Equity and therefore not taxed until they are realised, should not be taxed until they are realised, notwithstanding that they are included in the opening retained earnings. Similarly, any adjustments taken directly to the opening balance on Equity should not be taxed, until they are recycled to the Income Statement. KAUSHAL TIKKU IS A TAX PARTNER AND HEADS THE FINANCIAL SERVICES TAX GROUP AT PRICEWATERHOUSECOOPERS IN HONG KONG 74

Topics to be discussed. HKAS 32 & 39 and HKFRS 7 Part II 8 November 2006

Topics to be discussed. HKAS 32 & 39 and HKFRS 7 Part II 8 November 2006 HKAS 32 & 39 and HKFRS 7 Part II 8 November 2006 Nelson Lam 林智遠 CFA FCCA FCPA(Practising) MBA MSc BBA CPA(US) ACA 2005-06 Nelson 1 Topics to be discussed Recap on recognition and measurement (HKAS 39)