In this blog we will discuss some important topics such as hedge accounting, embedded derivatives and currency forward contract. After that we will discuss in detail the implementation of taxation system on the financial instruments and inherent gains. Under this topic we will go through the arguments of Inland Revenue department and decisions of court of first instance in these cases.   

Forward Contract in Currency

The loss or gain being raised from the currency forward contract obtained for the reason of enclosing the future remittance of machinery utilized as the capital asset is also capital in nature. While computing the devaluation allowance of machinery, this capital asset will be taken into account.

If for the reason of enclosing the trading stock’s purchase the forward contract of currency is required, then the nature of relevant loss or gain is revenue. In the same way, the loss or profit acquired on an interest rate contract to guard against rises in borrowing’s interest costs which is used to commerce the purchase of trading stock is revenue in term of nature.

Enclose Accounting

The therapy concerning the nature of loss or profit of enclosed item and the enclosing instrument would rely on the nature of enclosed item.

Let’s discuss an example, a set up company in HK is dealing in short futures contracts on metals on an offshore item exchange to enclose the sales prices of metals sold to customer in China Mainland while purchased in Australia. The selling and buying of the metals is proposed for assessment. The nature and locality of item follow that of repressed onshore deal will be considered by the Inland Revenue department.

Another is example is that where a craving dominated shares that are listed in Japan is held by a company. That company entered into a forward contract with the financial institution of Hong Kong. The purpose of that entering was to enclose against the variation of the yen’s value. It will be considered by the Inland Revenue department that, similar treatment of tax will be given to shares and forward contract in a way as forward contract was important part of an offshore investment.

Derivatives that are Embedded

Embedded derivative is a constituent of an instrument which is hybrid type. A non-derivative type host contract such as putting in bond options, putting options on preference shares are contained into it. It is considered by the Inland Revenue department that, the locality and nature of profit being raised from host contract and the embedded derivative should be the same every time.

Financial Instruments and Unrealized Gains Taxation

In the case of Nice Cheer Investment Ltd., T is a private start up business Hong Kong. The date of 31 March was adopted by it as closing date of its account. The trading of investment was its main activity. At reasonable value, the securities and stock were valued by T in accordance with Standard No. 39 (‘HKAS 39’) of Hong Kong Accounting Standard HKICPA and Standard of Accounting’s Statement Practice No. 24 (‘SSAP 24’) both the standard released by HKICPA. Under that standard either unrealized losses or gains being raised of trading’s revaluation securities were also maintained as losses or profits in the loss or profit account.

While computing the tax on profits, T:

  • At the end of year, requested the deduction of unrealized losses on trading securities; but
  • Not included the unrealized gains being raised from the trading securities’ revaluation for arrival at the assessable profits.


It was the view of evaluator that, unfulfilled losses and gains being raised from decreasing uphold listed securities held at the end of year should be incurred in computation of tax on profits for the assessment year in which:

  • The unfulfilled losses were stroked; and
  • The unfulfilled gains were attributed.

In accounts of T.

The question of law

Whether unfulfilled gains:

  • Attributed in account of loss and profit according to the common principles of commercial accounting; and
  • Being raised from the decreasing of investments on trading, being securities listed in Hong Kong, to their corresponding value at the balance date sheet.

Are accountable for the tax on profits.

Arguments of T

It was argued by T that:

  • The word ‘profit’ designated in the Section 14 (1) of Inland Revenue Ordinance does not mean national profits rather real profits.
  • The profits can be evaluated only, when they have been realized and earned. These cannot be expected or unrealized.
  • The attention should be on the word ‘profits’.

Arguments of Inland Revenue Department

While reporting the losses and profits, these must be reported with usual commercial accounting profits. In the computation of tax on profits, the remuneration must be altered to obey with the Inland Revenue ordinance. According to the persuading standards of accounting, financial statement of T has drawn up by him. T also ordered the holding gains being raised from declining of the listed securities. The evaluation of tax on profits on such declined profits was compatible with Inland Revenue ordinance. This case of the taxpayer T having Hong Kong incorporation was not a case in which profits tax on anticipated or national profits were charged. Basically, the tax succeeding accounting code was applied by the CIR. This principal is derived from the case of Secan.

Decision of Court of First Instance

It was consented by the Judge Anthony that, in assuring the losses and profits. The common commercial principles of accounting are important and useful. But the importance of these principles cannot be over-foregrounded. These Ordinary commercial principles are only applicable if there is no constitutional allowance suggestion otherwise. If there are some sort of the constitutional provisions that can be applied to different situations, then the explanation of the constitutional allowance and judge made rules in explanation have priority over common commercial principles of accounting. On proper and true construction of these, the meanings of terms ‘assessable profits’ and ‘profits’ mean true profits being raised out of real trading, business or professional activities between a party in Hong Kong and taxpayer. In the case of trade being carried out by a taxpayer having start up business Hong Kong, the meanings of trading activities are selling or buying of items including listing allowance or securities of services in a commercial transaction for the reward. The real profit is the profit that is allowable to the profits tax and this is in the sensation that, they have been accumulated, earned or assured, nonetheless if these have been obtained in cash; but national profits or book arising out of declining of trading stock is not included into it.

Listed securities were acquired by the T as its stock of trading. Some of that listed securities have not been vended yet. These securities appreciated in value. The changed value was documented as profits in financial statements of T according to the conquering standards of accounting. Still, these profits did not derive from or arise in actual trading transaction so were not actual profits. These inherent profits were not assessable to profits tax and were outside the acceptation of Section 14 (1) of Inland Revenue Ordinance. Due to this reason, the principles of accounting for assuring the profits are required to be altered to follow with the Section 14 (1). This is so that, the inherent profits being raised from inclination of listed securities in conferring with standard of accounting will have to be from profits tax computation. It is ordinary that for the companies to have 2 accounts set: one for shareholders of the companies showing their actual values as at balance date sheet in confirming with the Hong Kong Accounting Standard 39 and other for reasons of tax showing the actual profits allowable to losses for computation of loss’s preparation or profits tax.

Moreover, as stated by the Judge Lord Salmon in case of International Commercial Bank Ltd. it does not meant till profit has been accepted in cash, but means till it has been accumulated, earned or assured.

In the allowance of taxpayer having Hong Kong corporate formation for the claim of inherent losses and to pay the profits tax on inherent profits, there was no biasing. The point to be noted here is that, the CIR accepts as well judged practice, succeeding B.S.C. footwear Ltd, for in-trade-stock other than instruments of finance to be evaluated at market value or cost, whatever is lower among these. The CIR allows under Departmental Interpretation and Practice Notes 1 (Revised), medium and small-sized entities to evaluate their financial stock at the cost instead of adopting the Hong Kong Accounting System 39 in the requirements of their financial reporting. The adjustment is not constitutional. In fact, the CIR is charging on one group of taxpayer, the profits tax on expected profits and privileging the same tax from other groups of taxpayers. It was noted by the court that, in a tax statue thought here is no fairness but a tax jurisdiction should not be applicable so randomly as to produce these type of odd results.

In the United Kingdom case of Wernher (1955) the conclusion was drawn on the grounds of a very dissimilar tax jurisdiction. It was not applicable to the Hong Kong and should terminate to be estimated as regime for the hypothesis that there was a choice for man to trade with himself. In the case of Nice Cheer, the taxpayer did not do anything nor shifted them from itself in one capacity to other one.

The principle of the Secan case has not interpreted in right way by CIR without considering the acceptation of Section 14 (1) of Inland Revenue Ordinance thoroughly. The calculation of profits is a matter that the exemplar from United Kingdom has left to the professional accountants (1st point). From the confirmation it is different as to which profits should be chargeable to profits tax (2nd point). The first point was confirmed by that case of Secan. The profits on accounting in case of Secan did not include any type of national gains. That would require to be eliminated from chargeable profits.

The dispute of CIR on the position where the inherent gains of T obtained from declination of unsold securities of trading should be evaluated on the amount based on common principles of commercial accounting and zero alteration required by the Inland Revenue ordinance was false. The determination of CIR as well as the assessment of profits tax for the assessment year 2003 / 04 to 2005 / 06 were claimed.

The appeal of CIR was dismissed by the Court of appeal and it was held by it that, inherent gain concerning shares held for the purpose of trading was not evaluate able for tax.

The appeal of CIR was also dismissed by the court of final appeal and it held that:

  • For the preparation of its computations of tax, T was qualified to remove the remuneration of its inherent profits as not assessable to tax.
  • It is clear afar argument that, accounts fetched up concerning with the common commercial accounting principles must however be regulated for purposes of tax if they do obey to the latent taxation principle pronounced by the courts though these are not stated openly in the statue; and
  • In specific, commercial accounting principles must disintegrate to the key principles that tax is not allowed on the profits until they are perceived and that profits must not be expected.

According to the judgement of Lord Millett NPJ, the losses may or may not be expected. Though, an allowance for inherent loss may be chargeable for the purpose of tax if likely to be lasting and material. If this type of any allowance is made, the CIR cannot challenge it. If taxpayer having Hong Kong corporate formation is not able to write back an allowance which after sometime become unjustified, the accounts can be challenged by the CIR.


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