News Flash Hong Kong Tax The latest IRD s views on various profits tax issues November 2013 Issue 12 In brief In the 2013 annual meeting between the Inland Revenue Department (IRD) and the Hong Kong Institute of Certified Public Accountants (HKICPA), the IRD expressed its views on a number of tax issues that are of interests to taxpayers. Some of the more important profits tax issues discussed in the meeting include: (1) source rule for brokerage commission income derived from electronic stock transactions; (2) deduction and taxation of group recharge of share-based payments; (3) deduction of research and development (R&D) expenditure; (4) taxation of royalties not otherwise chargeable to tax under the section 14 of the Hong Kong Inland Revenue Ordinance (IRO); (5) application of treaty to a foreign partnership; and (6) determination of the residence status of an overseas bank with a branch in Hong Kong in a treaty context. Companies with business operations in Hong Kong or doing business with Hong Kong should take into account the views expressed by the IRD in the meeting minutes in both the tax planning and tax filing processes for the effective management of their tax matters. In detail The IRD and HKICPA held their regular annual meeting in February this year to discuss and exchange views on various tax issues that were raised by the Institute and the Department respectively. The minutes for the meeting prepared by the IRD have recently been published. This News Flash summarises the IRD s views on a number of more important profits tax issues discussed during the meeting. For a full list of tax issues discussed in the meeting, please refer to the meeting minutes available on the HKICPA s website 1. Source of brokerage commission income for electronic stock transactions In the scenario where the orders of overseas customers were directly inputted and executed through an electronic link established by a stock broker with the electronic execution system of the Hong Kong Stock Exchange (HKSE) without any human intervention in Hong Kong, the IRD will regard the place of execution of the transactions as the source of the respective brokerage commission. As execution of the transactions only took place when there was a successful matching of the customers buy/sell orders and the matching was done at the HKSE on which the shares were listed, the respective brokerage commission income will be regarded as Hong Kong sourced. PwC s comment: This approach is consistent with the source rule for stock brokerage commission income established in the landmark case ING Baring Securities (Hong Kong) Limited v CIR, in which the Court of Final Appeal held that the source of stock brokerage commission income is determined by the place where the share transaction was executed. www.pwchk.com
Share based payment transactions Deduction of recharge by a group company Currently if a company (employing company) is recharged with stock options or share awards granted to its employees by another company (granting company) which acquired the shares from the market, the IRD s current assessing practice is the maximum deductible amount for the employing company is the lower of the amount recharged or the market value of the shares acquired at the date when the stock option/share award is exercised/vested less the amount of consideration given by the grantee/awardee, provided that certain specified conditions are satisfied. In this regard, the IRD clarified in the meeting that (1) the amount deductible by the employing company will still be determined by the above formula no matter whether the cost incurred by the granting company A to acquire the shares from the market is higher or lower than the recharged amount (provided that there is no indication that the recharge is grossly excessive in the latter case) and (2) where the market value of the shares at the date of exercise/vesting dropped below the amount recharged, a deduction claim of the amount recharged by the employing company may be considered by the IRD as excessive, even if the cost incurred by the granting company in acquiring the shares from the market is higher than the amount recharged and the market value of the shares at the date of exercise/vesting. According to the IRD, in scenario (2) above, a commercially realistic recharge agreement should safeguard the employing company s interests by allowing the amount of recharge to be adjusted according to the market conditions. PwC s comment: However, in practice, the granting company may need to acquire the shares from the market from time to time so as to maintain an inventory of shares for discharging the stock option/share award obligations when they are due. A commercially realistic recharge agreement that protects the granting company s interests may require its costs in respect of fulfilling the stock option/share award obligations be compensated by using a predetermined recharge amount which is the average market price over a period of time. The pre-determined recharge amount may be higher than the market value of the shares at the date of exercise/vesting in some cases. It is not clear from the meeting whether the IRD will allow deduction of the actual amount recharged if this is the case. Chargeability of the recharge received by the granting company The question of whether the recharge received by the granting company is subject to profits tax arises when the granting company is carrying on a business in Hong Kong. The IRD took the view that where the granting company discharged the stock option/share award obligations by issuing new shares, the recharge received will normally be considered as a capital receipt and not taxable. However, if the granting company discharged the obligations by acquiring shares from the market, the taxability of the recharge will depend on whether the granting company has been engaged in any trading of shares. The IRD will not normally regard the acquisition of shares from market by the granting company in satisfaction of its obligations as trading in shares. However, for a granting company that is itself carrying on a share dealing business, the IRD will look at the purposes for which the shares were acquired (i.e. whether the shares were acquired to form its own trading shares portfolio or solely for discharging its obligations under the stock option/share award scheme). The IRD also made a note that if a portion of the recharged amount constitutes service fee for intra-group services provided by the granting company, such fee should be chargeable to profits tax (assuming that the services were performed by the granting company in Hong Kong). Deduction of R&D expenditure Section 16B(1)(b) of the IRO provides that certain R&D expenditure is deductible despite its capital nature if the conditions specified in the section are satisfied. Based on the IRD s current interpretation of section 16B(1)(b), one of the conditions for the deduction is the expenditure must be incurred by the taxpayer in respect of activities undertaken by the taxpayer itself. In the meeting, the IRD further expressed its view on this issue in the context of (1) subcontracted R&D activities and (2) group R&D cost sharing arrangement. In the case where the R&D activities were carried out by the Mainland subsidiary for a Hong Kong company under the instruction and supervision of the Hong Kong company s employees sent to the Mainland, and the Hong Kong company reimbursed the Mainland subsidiary for the related R&D expenses (including staff cost and operating expenses), the IRD took the view that the Hong Kong company cannot claim a deduction of the R&D expenses paid to the Mainland subsidiary under section 16B(1)(b) due to the fact that the R&D activities were undertaken by the Mainland subsidiary (which is a separate legal entity) instead of the Hong Kong company. In the case of a group R&D cost sharing arrangement where a Hong Kong company sent its employees to the group s R&D centre to conduct R&D activities together with the employees of other group companies and where a portion of the costs of the group s R&D centre was allocated to the Hong Kong company, the Hong Kong company can claim a deduction under section 16B(1)(b) on the actual staff cost of the employees sent to the R&D centre but the R&D cost allocated to the Hong Kong company by the group is not deductible. PwC s comment: By limiting the deduction of R&D expenditure under section 16B(1)(b) to cases where the R&D activities were undertaken by the taxpayer itself, the IRD has taken a rather narrow interpretation of the section. Such interpretation has not been tested in court and has been disputed by some tax practitioners. Nevertheless, in the subcontracted R&D activities arrangement mentioned above, even though a deduction of the R&D expenses recharged and paid to the Mainland subsidiary will not be allowed, the Hong Kong company should be able to claim a deduction under section 16B(1)(b) on the staff costs of its employees who were sent to the Mainland and participated in the R&D activities carried out in the Mainland. 2 PwC
Application of section 15(1) to companies chargeable under section 14 Sections 15(1)(a)&(b) of the IRO deem the royalties received by or accrued to a person for the use or right to use of certain intellectual properties (IPs) in Hong Kong as taxable trading receipts where the sums would not otherwise be chargeable to tax under the normal charging section (i.e. section 14) of the IRO. As a matter of practice, sections 15(1)(a)&(b) have normally been applied to non-resident companies which do not carry on any business in Hong Kong. In the meeting, the IRD indicated that sections 15(1)(a)&(b) can also apply to a foreign company carrying on a business in Hong Kong. In the example discussed in the meeting, an IP was developed by a foreign company outside Hong Kong. Subsequently, the foreign company established a business presence in Hong Kong and received, among other income, royalties from licensing the IP to another person for use in Hong Kong. Based on the source rules for royalties derived from licensing of IP rights set out in Departmental Interpretation and Practice Notes (DIPN) No. 49, as the above IP was developed outside Hong Kong, the royalties received is with a non-hong Kong source and not taxable under section 14 despite the IP was used in Hong Kong. However, the IRD indicated that section 15(1)(a) or (b) is applicable in such situation to deem such royalties as taxable notwithstanding that the foreign company was chargeable to tax under section 14 in respect of its other income. In the IRD s view, sections 14 and 15(1) are not mutually exclusive and the latter serves to enlarge the scope of the former and bring into charge receipts which were not otherwise taxable. PwC s comment: Based on the IRD s interpretation of section 15(1) above and its narrow interpretation of section 16B(1)(b), a company that subcontracted the development of an IP to a group company, bore the R&D costs incurred for developing the IP through reimbursement arrangement with the group company, and derived royalty income from licensing the IP for use in Hong Kong will be placed in a unfair situation where the royalties so derived is subject to tax in Hong Kong while no deduction is allowed for the R&D expenses incurred. Application of treaty to a foreign partnership The issue discussed in the meeting is based on the following fact pattern: (1) a foreign partnership was established in a jurisdiction having a treaty with Hong Kong; (2) such partnership is not regarded as a taxable entity for income tax purpose (i.e. a fiscally transparent entity) in that jurisdiction; (3) the profits derived by the partnership are subject to tax in that jurisdiction in the names of its partners; (4) the same profits are also subject to profits tax in Hong Kong under the domestic tax laws of Hong Kong but are exempt or taxed at a reduced rate under the relevant Hong Kong treaty (e.g. due to lack of a permanent establishment in Hong Kong for business profits or a lower tax rate specified in the treaty for royalty income). The question was whether the IRD will accept the individual partners (instead of the partnership) as the applicants for treaty benefits under the relevant Hong Kong treaty although strictly speaking, the income was paid to the partnership instead of the individual partners. Following the OECD s approach on the application of treaty to partnerships, the IRD agreed that in such situation, the individual partners can apply for treaty benefits under the relevant Hong Kong treaty provided that all the following four conditions are satisfied: 1. The royalties article in the relevant treaty adopts the wording paid to a resident of the other Contracting Party ; 2. The foreign partnership is not considered as a resident of Hong Kong; 3. All partners are a resident of a jurisdiction that has a treaty with Hong Kong, although the partners need not to be a resident of the same treaty jurisdiction; and 4. The treaty jurisdiction where the partnership is established adopts a similar approach as Hong Kong. All of the above four tests have to be applied individually to each and every partner of the partnership. PwC s comment: Some treaty jurisdictions may require that the partnership be considered as a "person" as defined in Article 3 of the relevant treaty before the above "seethrough approach" can be adopted to allow the individual partners to apply for a treaty benefit on their share of the partnership's income. It is unclear from the minutes whether similar requirement will be imposed by the IRD. Residence of an overseas bank with a Hong Kong branch In the past, the IRD and the State Administration of Taxation of China (SAT) had held different views on determining the residence of an overseas bank with a branch in Hong Kong. In DIPN No. 44 (Revised) which provides guidance on the interpretation and application of the double tax arrangement between China and Hong Kong, the IRD took the view that if the Hong Kong branch of an overseas bank is managed in Hong Kong, the bank will be regarded as a resident of Hong Kong. However, the SAT has all along taken the view that the management or control of the bank instead of that of the branch in Hong Kong should be considered in deciding whether the overseas bank is normally managed or controlled in Hong Kong. In the meeting, the IRD advised that a consensus has now been reached with the SAT. In deciding whether an overseas bank is normally managed or controlled in Hong Kong, it has been agreed that the management or control of the bank as a whole should be considered. The relevant paragraph in DIPN No. 44 (Revised) will be updated accordingly 2. PwC s comment: The above change in the assessment of the residence status of an overseas bank with a Hong Kong branch is reasonable as it follows the approach adopted by the OECD and the international practice in general. Although DIPN No. 44 (Revised) is the IRD s interpretation of the Hong Kong-Mainland CDTA, it is expected that similar approach will be adopted for the other Hong Kong treaties. A confirmation from the IRD on this will be welcomed. 3 PwC
The takeaway Uncertainties as to how a provision in the domestic tax laws or a Hong Kong treaty should be interpreted and applied could adversely affect the effective management of a company's tax matters or give rise to disputes between taxpayers and the IRD. While taxpayers and tax practitioners may not fully agree to all the views expressed by the IRD in the meeting, the meeting minutes serve as a good reference of the IRD s stance on various profits tax issues. Companies with business operations in Hong Kong or doing business with Hong Kong should take into account the views expressed by the IRD in the meeting minutes in both of their tax planning and tax filing processes for the effective management of their tax matters. Endnotes 1. The minutes of the 2013 annual meeting between the IRD and HKICPA can be accessed via this link: http://www.hkicpa.org.hk/file/media/secti on5_membership/professional%20repr esentation/pdf-file/tax-b/24.pdf 2. The relevant paragraph, paragraph 27, of DIPN No.44 (Revised) has not yet been revised at the timing of writing. 4 PwC
Let s talk For a deeper discussion of how this issue might affect your business, please contact a member of PwC s Hong Kong Corporate Tax Team: Peter Yu +852 2289 3122 peter.sh.yu@hk.pwc.com Oscar Lau +852 2289 5603 oscar.lau@hk.pwc.com 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. 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 PwC s client service team or your other tax advisers. The materials contained in this publication were assembled on 1 November 2013 and were based on the law enforceable and information available at that time. This Hong Kong Tax News Flash is issued by the PwC s National Tax Policy Services 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 PwC s 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 +86 (10) 6533 3028 matthew.mui@cn.pwc.com Please visit PwC s websites at http://www.pwccn.com (China Home) or http://www.pwchk.com (Hong Kong Home) for practical insights and professional solutions to current and emerging business issues. 2013 PricewaterhouseCoopers Ltd. All rights reserved. PwC refers to the Hong Kong member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.