Hong Kong Tax Alert. 20 November Issue No. 17

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1 Hong Kong Tax Alert 20 November Issue No. 17 IRD gives guidance on the deductibility of specific provisions relevant to bank loans and the tax characterization of perpetual notes In the 2015 annual meeting with the Hong Kong Institute of Certified Public Accountants (HKICPA), the Inland Revenue Department (IRD) gave some guidance on: (i) (ii) the deductibility of specific provisions relevant to bank loans; and whether coupon payments on perpetual notes would be treated as being tax deductible interest expense or non-deductible after-tax distributions of profits by the issuer. This alert discusses the issues involved.

2 Deductibility of specific provisions relevant to bank loans Under the loan classification system of the Hong Kong Monetary Authority (HKMA), institutions such as banks in Hong Kong are required to classify loans into the following categories: Pass, Special Mention, Substandard, Doubtful and Loss. Whilst the classification of loans may be judgmental, the HKMA guidelines indicate that loans on which payments of interest and/or principal are overdue for more than three months and six months should generally be classified at least as substandard and doubtful, unless there are good reasons for a better classification (such as the fact that the loan is fully secured by good quality collateral). Some members of the HKICPA appeared to be under the impression that provisions for loans categorized as only being substandard under the HKMA loan classification system would not necessarily qualify for a tax deduction. The HKICPA asked whether the IRD would take into account the HKMA loan classification system in allowing tax deductions for non-performing categories of loans including substandard loans. The IRD replied that under section 16(1)(d) of the Inland Revenue Ordinance (IRO), only specific provisions for doubtful debts to the extent that they are estimated to the satisfaction of the assessor to have become bad during the basis period concerned would qualify for a tax deduction. Whether and to what extent a debt could be said to have become bad had to be decided upon consideration of all the relevant facts of a case. As such, the evidence required might vary from one case to another. In general, the relevant considerations and evidence included details of steps taken to recover the debt and the outcome of those steps; particulars of the collateral and its estimated value; the basis on which the provision was computed; and reasons why the debt was regarded as bad. The IRD clarified that provisions for substandard loans categorized under the HKMA loan classification system may or may not qualify for a tax deduction, depending on the facts and evidence concerned. The IRD further added that authorized banks may need to make a tax assessment of their provision for doubtful debts separate and distinct from that made for the purposes of the HKMA loan classification; the two sets of criteria and considerations not necessarily being in alignment. Perpetual notes being a hybrid instrument Many corporations raise funds by way of issuing perpetual notes with periodic coupon payments similar to a debt instrument with a fixed term. Whilst perhaps redeemable at a certain point of time at the option of the issuer, perpetual notes by definition have no fixed maturity date. This latter feature taken together with perhaps certain other features of a perpetual note would bestow on the note certain elements suggestive of an equity instrument. As such, perpetual notes are generally regarded in commercial terms as being a hybrid instrument of debt and equity. For Hong Kong tax purposes, the question of whether periodic coupon payments on a perpetual note would be regarded as an interest expense or an after-tax distribution of profits by the issuer is important. This is because while interest, subject to satisfying certain conditions, would be tax deductible, an after-tax distribution of profits would not. Similarly, the payments when received in the hands of the investors would also, for Hong Kong tax purposes, generally be characterized in a manner similar to the tax characterization applicable to the issuer. In response to the HKICPA s request for the IRD to issue a practice note to address the interest versus after-tax profit distribution characterization of such payments for tax deduction purposes, the IRD stated that such characterization would depend on whether, based on the overall features of a perpetual note, the instrument is regarded as debt or equity for tax purposes. In this regard, the IRD indicated that the starting point was to decide the nature of a perpetual note instrument according to its legal form rather than the accounting treatment or the underlying economic characteristics. Furthermore, the IRD noted they would also examine the prospectus, offering circular and information memorandum issued in connection with the instrument in order to determine the exact legal rights and obligations intended to be created between the issuer and the investors. In general, the IRD considered that a debt-like instrument would possess characteristics such as predetermined maturity, principal protection and no profit participation. However, where the instrument contained provisions for the writing down of the principal upon the occurrence of a trigger event and did not have a maturity date, such instrument was more akin to an equity instrument. 2

3 An appendix to this alert contains a full list of factors that the IRD considered as being relevant in determining whether a perpetual note should be classified as being debt or equity for tax purposes. The IRD stressed that the determination of the debt or equity issue had to be based on the overall analysis and not a mere counting of these factors. The IRD also noted that the OECD/G20 BEPS Project included an action plan to neutralize the effects of hybrid mismatch arrangements 1, e.g., under which the issuer may characterize the coupon payments as a tax deductible interest expense in one jurisdiction but the payments would be treated as non-taxable dividend income of the investors in other jurisdictions. The IRD added that when the work of the OECD in this area was finalized and consensus reached, the IRD would carefully map out the way forward and consider issuing a practice note on the topic if necessary. In the meantime, the IRD advised that prospective issuers might consider making use of its advance ruling service as a means of obtaining certainty for the tax treatment of a perpetual note. Commentary We welcome the IRD s clarification of the interaction between the regulatory provisions concerning a bank s doubtful loans and that for tax deduction purposes. As regards tax characterization of a perpetual note, the guidance given would be improved if the IRD could illustrate with examples how the relevant factors will apply to the analysis of certain typical terms of a perpetual note instrument. For instance, the IRD s reply did not explicitly address the relevance of a perpetual note possibly being redeemable at a certain point of time at the option of the issuer, or the relevance of the coupon rates on the note being stepped up in the future. In this regard, it is understood that a perpetual note with the above two specific features would in certain overseas jurisdictions generally be considered as suggesting that the instrument is more akin to debt than equity. An analysis of these two specific features and certain other features in the relevant overseas jurisdictions is summarized in the below table as regards a subordinated perpetual note being issued at par. Factors Features Analysis 1 Nature of interest acquired (equity interest or otherwise) 2 Voting rights 3 Obligation to repay the principal amount Under the relevant regulatory and company law of the overseas jurisdictions concerned, the interest acquired by the investors does not fall within the definition of a share and the investors are not reflected in the register of shareholders but instead in the register of debenture holders. No voting right. No fixed repayment date but a stepped-up feature is present (i.e. the rates of the coupon payments will be increased in the future where the note is not redeemed). 4 Payout The note bears fixed periodic coupon payments. Although the issuer has sole discretion to defer the coupon payments, any deferred payments are cumulative. 5 Ranking for repayment in the event of liquidation or dissolution In the event of liquidation or dissolution, the note ranks junior to the senior creditors of the issuer but equally with all other subordinated obligations of the issuer and ahead of the shareholders of the issuer. The features tend to support that the note is a debt instrument. The stepped-up feature would effectively create a de facto maturity date for the perpetual note. This is the case because a gradual stepup of coupon payments may result in a higher cost for the issuer to keep the perpetual note. This may in turn lead to the issuer exercising its call option to redeem Therefore, the stepped-up feature supports that the note is a debt instrument. 1. Action 2 of the Base Erosion and Profit Shifting (BEPS) action plan undertaken by the Organization for Economic Co-operation and Development (OECD) and G20 countries aims at developing recommendations with respect to domestic law provisions and treaty provisions to neutralize the effects of hybrid mismatch arrangements. On the above analysis, the perpetual note in this example would be regarded as debt by the relevant overseas jurisdictions. However, whether the same perpetual note would be similarly regarded as debt by the IRD is not certain. In this regard, clients should seek professional tax advice where necessary and consider whether an advance ruling is desirable. 3

4 Appendix Factors that the IRD would generally consider when determining the nature of a perpetual note: Factors Maturity date Source of payments Right to enforce payments Participation in management Status of advances in relation to regular corporate creditors Intent of the parties Identity or interest between creditor and shareholder Debt/equity ratio of taxpayer Ability to obtain credit from outside sources Use to which advances were put Acceptance of risk Analysis The absence of a maturity date would effectively subject the advances to an uncertain economic climate for an inordinate period and could weigh in favor of identifying the advances as equity. If the payments by the issuer were to come from net cash flow (after expenses and capital expenditures) and were effectively discretionary, the advances looked like equity. The lack of legitimate creditor safeguarded and the subordination of the repayment obligation to other creditors weighed in favor of characterizing the advances as equity. If the investors could actively participate in the investment or venture funded, the advances appeared more like equity. If the issuance document unequivocally subordinated any obligation of the issuer to repay to the other debts of the issuer, it demonstrated a characteristic of equity. If the issuer s intention was to create equity according to the laws of a jurisdiction and had been careful to retain discretion as to whether to make payments, it demonstrated the equity nature of the instruments. If advances were in proportion to equity ownership, an equity contribution was indicated. If the treatment of the advances as debt would cause the debt/equity ratio to become an untenable ratio, it supported the characterization of the advances as equity. If the evidence was that no third party lender would have loaned funds in the relevant amounts on the terms in the agreement (including the long and potentially perpetual terms, the subordination to other debts and the lack of creditors remedies), it supported the equity characteristics of the instruments. The use of the interest to make preferred return payments on the advance agreement and the lack of any connection to capital investments demonstrated debt-like characteristics. The question whether the funds were advanced with reasonable expectations of repayment regardless of the success of the venture or were placed at the risk of the business was another means by which to ascertain the intention of the parties. The long and conditional maturity dates, the subordination to other debt and other factors might evince the uncertainty of repayment of principal: it illuminated the equity characteristics of the advances. 4

5 Hong Kong office Agnes Chan, Managing Partner, Hong Kong & Macau 22/F, CITIC Tower, 1 Tim Mei Avenue, Central, Hong Kong Tel: / Fax: Principal tax contact Tracy Ho tracy.ho@hk.ey.com Hong Kong Tax partners Agnes Chan agnes.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 Grace Tang grace.tang@hk.ey.com Karina Wong karina.wong@hk.ey.com Jo An Yee jo-an.yee@hk.ey.com 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