Election to adopt fair value accounting for financial instruments for tax purposes was legislated News Flash Hong Kong Tax March 2019 Issue 2 In brief The prevailing accounting standards require entities in Hong Kong to account for financial instruments on a fair value basis with the revaluation gains or losses reported as income or losses in the year they arise. In Nice Cheer Investment Ltd. v Commissioner of Inland Revenue 1 (the Nice Cheer case), the Court of Final Appeal (CFA) decided that these accounting treatments should not be followed for taxation purposes. The Nice Cheer case established that the unrealised revaluation gains for marketable securities are not taxable at the time they are accounted for. On the other hand, the CFA also ruled in that case that unrealised revaluation losses may be deductible at the time of recognition in limited circumstances. This approach is sometimes referred to as the realisation basis. In the past few years, the Inland Revenue Department (IRD) allowed taxpayers to choose fair value basis as a concession despite the judgment in the Nice Cheer case. In order to formally address the concerns of taxpayers about the substantial costs involved and practical difficulties faced in re-computing their profits on a realisation basis for tax purpose, Inland Revenue (Amendment) (No. 2) Ordinance 2019 (the Ordinance) 2 was enacted on 1 March 2019 to provide for a legal basis of allowing taxpayers to opt for the fair value basis and aligning the tax and accounting treatments of financial instruments in certain circumstances. The Ordinance essentially allows taxpayers that have elected in writing to compute the assessable profit or allowable loss in respect of a financial instrument for tax purposes with reference to the amounts recognised in the profit or loss account, subject to the source rules and nature (i.e. capital vs revenue) of the recognised amounts. However, special treatments apply to a number of exceptional items, such as a debt security with an embedded derivative, an impairment loss of a debt instrument and a non-arm s length loan/debt, where the tax treatments do not follow the accounting treatments. While the legislative changes which allow taxpayers to choose between the fair value basis and the realisation basis to account for financial instruments for tax purposes will be welcomed by the business community, there are issues in the Ordinance that require further clarification or consideration by the government. These include (1) how the newly introduced conditions for an expected credit loss to be deductible interact with the current deduction provision of bad or doubtful debts in the Inland Revenue Ordinance (IRO) (i.e. section 16(1)(d)) and (2) the justification of deeming an impairment loss previously allowed to the transferor as a taxable trading receipt at the time of transfer under certain circumstances. Companies should carefully evaluate the pros and cons before making the generally irrevocable election for aligning the tax and accounting treatments of financial instruments.
In detail Background of the Ordinance Accounting treatment under international and Hong Kong accounting standards Fair value basis Effective from 1 January 2018, Hong Kong Financial Reporting Standard 9 (HKFRS 9) (the Hong Kong equivalent of IFRS 9) replaced the Hong Kong Accounting Standard 39 (HKAS 39). Like HKAS 39, HKFRS 9 requires Hong Kong reporting entities to account for financial instruments on a fair value basis and recognise unrealised revaluation gain or loss arising from these revaluations as income or losses in the year they arise, though HKFRS 9 introduces changes to the classification and measurement of debt and equity instruments. Tax treatment established by the Nice Cheer case Realisation basis The CFA handed down its judgement in the Nice Cheer case in 2013, and held that for marketable securities, unrealised revaluation gains are not taxable, whereas unrealised revaluation losses may be deductible in limited circumstances (i.e. the realisation basis). Before the Nice Cheer case, the assessing practice of the IRD was to follow the fair value accounting treatment of financial instruments for tax purposes i.e. taxing any unrealised revaluation gains or allowing any unrealised losses recognised in the financial statements at the time of recognition as long as they are revenue in nature and with a Hong Kong source. Subsequent to the Nice Cheer case, there is no legal basis for the IRD to continue to follow the fair value accounting treatment of financial instruments for tax purposes and legally speaking, all taxpayers should file their profits tax returns on a realisation basis. Interim administrative measures before the enactment of the Ordinance In view of the substantial costs incurred and practical difficulties faced by taxpayers in re-computing their profits on a realisation basis for tax purposes and upon the request of the financial industry, the IRD has adopted an interim administrative measure 3 since year of assessment 2013/14 under which taxpayers are allowed to choose to use either the fair value basis or realisation basis for profits tax filing purposes. The tax treatments introduced by the Ordinance Due to a lack of legal backing of the interim administrative measure, the Ordinance was enacted on 1 March 2019 to, among other tax measures, codify the IRD s practice of allowing taxpayers to align the tax and accounting treatments of financial instruments in certain circumstances. The relevant provisions on aligning the tax and accounting treatments of financial instruments in the Ordinance apply to a year of assessment for which the basis period begins on or after 1 January 2018. The general principle under the Ordinance Under the Ordinance, taxpayers who prepare their financial statements in accordance with HKFRS 9, IFRS 9 or a financial reporting standard adopted by a jurisdiction other than Hong Kong which is, in the Commissioner s opinion, equivalent to IFRS 9 4 can elect in writing to align the tax and accounting treatments of financial instruments. An election, once made, is irrevocable, unless an approval from the Commissioner to revoke the election is obtained on the basis that: (1) there are good commercial reasons for the revocation and (2) the avoidance of tax is not the main purpose, or one of the main purposes, for the revocation (e.g. in a merger or an acquisition where a company which has elected to adopt the fair value basis has become part of a group that adopts the realisation basis for tax filing purposes). The Ordinance also provides for the one-off tax adjustment that may be necessary in the election year (i.e. if changing from realisation basis to fair value basis) and revocation year (i.e. when changing back to realisation basis from fair value basis). Upon an election by a taxpayer, the tax-relevant amount in respect of a financial instrument will be the accounting-relevant amount in respect of that instrument, subject to a few exceptions. This means that the amounts recognised by the taxpayer in the profit or loss account in respect of the instrument during the basis period of a year of assessment will be brought into account for computing the assessable profit or allowable loss of the taxpayer for that year of assessment. The taxability or deductibility of the amounts recognised in the financial accounts, however, will still be subject to the source rules and the nature (i.e. capital vs revenue) of the recognised amounts. This general principle applies to a financial instrument that is measured at (1) fair value through profit or loss (FVPL), (2) amortised cost or (3) fair value through other comprehensive income (FVOCI) under HKFRS 9 or IFRS 9. Special treatment for certain items There are a few exceptions to the general principle of tax treatment following the accounting treatment for financial instruments. The exceptions are applicable to (1) an impairment loss of a debt instrument, (2) a financial liability that is measured at FVPL and with changes in the issuer s own credit risk, (3) an equity instrument that is measured at FVOCI, (4) a debt security with an embedded derivative to acquire shares or units in the issuer, (5) a preference share, (6) a non-arm's length loan/debt and (7) a hedging instrument. Please refer to the Appendix for a summary of the tax treatments of these items as stipulated in the Ordinance. 2 PwC
The takeaway While the legislative changes which allow taxpayers to choose between the fair value basis and the realisation basis to account for financial instruments for tax purposes will be welcomed by the business community, there are issues in the Ordinance that require further clarification or consideration by the government. These issues include (1) how the newly introduced conditions for an expected credit loss to be deductible interact with the current deduction provision of bad or doubtful debts in the IRO (i.e. section 16(1)(d)), and (2) the justification of deeming an impairment loss previously allowed to the transferor as a taxable trading receipt at the time of transfer under certain circumstances. Companies should carefully evaluate the pros and cons before making the generally irrevocable election for aligning the tax and accounting treatments of financial instruments. Endnotes 1. The CFA s judgment in the Nice Cheer case can be accessed via this link: http://legalref.judiciary.gov.hk/lrs/common/ju/ju_frame.jsp?dis=90096&currpage=t 2. The Inland Revenue (Amendment) (No. 2) Ordinance 2019 can be accessed via this link: https://www.gld.gov.hk/egazette/pdf/20192309/es1201923096.pdf 3. Please refer to the IRD s announcement on the interim administrative measure for the 2017/18 profits tax filing in this link: https://www.ird.gov.hk/eng/tax/bus_fva.htm 4. A Committee Stage Amendment (CSA) was made by the Administration to the bill originally gazetted to allow taxpayers adopting a local financial reporting standard that is equivalent to IFRS 9 to elect for the fair value basis. Please refer to this link for this and other CSAs to the bill: https://www.legco.gov.hk/yr18-19/english/counmtg/papers/cm20190220cb3-372-e.pdf 3 PwC
Appendix Summary of the tax treatments stipulated in the Ordinance for the items that are exceptions to the general principle of tax treatment following the accounting treatment for financial instruments: Financial instrument Debt instruments impairment loss Special treatment Expected credit loss recognised in respect of a debt instrument that is not creditimpaired is not deductible. Expected credit loss recognised in respect of a debt instrument that is creditimpaired (as defined in HKFRS 9 or IFRS 9) is deductible with certain conditions. As any cumulative gain or loss on effect of changes in issuer's own credit risk recognised in other comprehensive income (OCI) will not be recycled to the profit or loss (P/L) when the instrument is derecognised, such cumulative gain or loss will be brought into account for tax purpose upon derecognition of the instrument. The deeming provision - If a tax deduction for impairment loss/bad or doubtful debt was previously allowed in respect of a credit-impaired loan and the loan is subsequently transferred from one person (transferor) to another person (transferee), the amount of deduction previously allowed to the transferor will be deemed as a taxable trading receipt of the transferor accruing on the date of the transfer if all of the following conditions are met: the transferor is a financial institution; the transfer is not by way of a sale in the ordinary course of the transferor s business (e.g. pursuant to a merger or restructuring); and the transferor or the transferee is, or both of them are, not in the business of lending money in Hong Kong on the date of the transfer. Equity instruments measured at FVOCI Debt securities with an embedded derivative to acquire shares/units in the issuer As fair value changes in OCI will not be recycled to P/L when the instrument is derecognised, such fair value changes will be brought into account for tax purposes upon derecognition of the instrument. If the embedded derivative is recognised as an equity component in the financial accounts, the part of the interest, discount, premium or expense recognised by the issuer in respect of the debt security that is attributable to the embedded derivative is not deductible. Preference shares Any interest, discount, premium or expense recognised by the issuer is not deductible even if the preference shares are accounted for as debt instruments in the issuer s financial statements. Non arm s length loans/debts Actual profit, gain, loss, income or expense in respect of the loan/debt computed in accordance with the contractual terms of the loan/debt (rather than the amounts recognised in the financial accounts) will be brought into account for tax purposes. The transfer pricing rules (i.e. Rule 1 on the arm s length principle 1 ) may apply to adjust the taxable/deductible amount. Hedging instruments Any profit, gain, loss, income or expense recognised in respect of a hedging instrument must be disregarded if: the hedging instrument is designated, under a hedging arrangement in good faith, for the purpose of hedging against any risk associated with a hedged item; and the hedged item is on capital account. 1 Please refer to the discussion of transfer pricing Rule 1 in Hong Kong Tax News Flash, July 2018, Issue 9 via this link: https://www.pwchk.com/en/hk-tax-news/2018q3/hongkongtax-news-jul2018-9.pdf 4 PwC
For a deeper discussion of how this issue might affect your business, please contact: PwC s Corporate Tax Leaders based in Hong Kong Charles Lee China South and Hong Kong Tax Leader +852 2289 8899 charles.lee@cn.pwc.com Rex Ho Financial Services +852 2289 3026 rex.ho@hk.pwc.com Jeremy Ngai China South Tax Leader +852 2289 5616 jeremy.cm.ngai@hk.pwc.com Cecilia Lee Transfer Pricing +852 2289 5690 cecilia.sk.lee@hk.pwc.com Jeremy Choi Industrial Products +852 2289 3608 jeremy.choi@hk.pwc.com Jenny Tsao Corporate Tax and Consumer Markets +852 2289 3617 jenny.np.tsao@hk.pwc.com Kenneth Wong Tax Controversy +852 2289 3822 kenneth.wong@hk.pwc.com 5 PwC
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