Inclusion of Expenses for Profit Tax in maintaining the Capacity of Profit Earning and related Specific Expenses to Profit Tax for Taxpayer Setting up a Business in HK


04 Jan

We will discuss some general deduction sections such as, maintenance of profit earning capacity and non-appropriation of profits. Then we will explore the implementation of profits tax policy on some specific expenses, loan interest and related expenses. We will understand these topics by discussing some case studies and evaluating the decisions of Hong Kong tax authorities in these cases.

Maintaining the Capacity of Profit Earning

In the case of Zeta Estates Ltd, it was observed that, the court of final appeal allowed the interest on the base that, the profit earning capacity of offshore incorporations HK was maintained by the loan of shareholder.

  

Profit not at Appropriation

Dividend’s distribution is not allowed to evaluation for tax. In the same way the transfer of funds or remuneration from one branch of HK company formation to its head office is not allowed to tax. Also, the interest paid by the branch of a commercial or non-commercial bank to its head office was held not to be allowed to tax. The reference for this statement is taken from the case of Banque Nationale de Paris Hong Kong Branch. But, as a common practice, the deduction of expenditures charged by an overseas head office is allowed by the Inland Revenue Department. This is the case if expenditures are on the basis of arm’s length.


Specific Expenditures

Some general rules for the deduction of the expenditures are set out by the Section 16 (1) of Inland Revenue Ordinance for any taxpayer having business or open company in Hong Kong. This Section also specify that only the number of expenditures are acceptable. These expenses that are allowable are listed in the Sections 16 (1) (a) to (h) of Inland Revenue Ordinance. Expenditures that are not falling inside these Sections should be supposed for deduction. Moreover, other than above Sectionsthe Inland Revenue ordinance also allows deduction for many different expenditures under Section 16 A to 16 G of Inland Revenue Ordinance. 

Debt Interest and other related Expenses

Following to the further conditions in the Section 16 (2) and 16 (2A) to 16 (2G) of Inland Revenue Ordinance, remuneration payable by a taxpayer setting up a business in HK by way of:

  • Stamp duties, fees for procurement, legal fees and other expenditures in the connection with such debiting; and
  • Interest on the any money debited by him/her for the reason of generating the accountable profits,

Are allowed to deduction for tax on profits under Section 16 1 (a) of Inland Revenue Ordinance.

Conditions under the Section 16 (2) of Inland Revenue Ordinance

If somehow the Section 16 (1) (a) of Inland Revenue Ordinance is satisfied, the deduction of tax will not be allowed for taxpayer who have open company in Hong Kong given that one of the conditions given below is satisfied:

  • An institution of finance debited the money in accordance with the Section 16 2 (a);
  • A public utility debited the money in accordance with the Section 16 (2) (b);
  • A person other than a foreign financial institution or local financial institution debited the money and the remuneration payable by the way of the interest are evaluate able to tax on profits in accordance with the Section 16 2 (c);
  • A financial institution or a foreign financial institution debited the money in accordance with the Section 16 2 (d);
  • The money has been debited exclusively or wholly to finance:
  • Borrower incurred the capital expenses on the allowance of:
  • An advised fixed asset under the Section 16 G (3); or
  • Plant or machinery that qualifies for the allowance of depreciation;
  • The plant or machinery for development and research, where the expenses may be deducted under the Section 16 B;
  • Any environmental-friendly mean of transport or machinery for the protection of environment under the Section 16 H (1), where the expenditures may be withdrawn under the Section 16 I.    
  • The borrower is not an affiliate of the lender;
  • The trading stock’s purchasing by the borrower, where the purchased trading stock is used by the borrower in the generation of profits that are evaluate able to tax on profits; and
  • Where the lender of money is also a trustee of an estate of trust or the corporation controlled and managed by that trustee, neither the corporation nor the trustee nor any beneficiary under that trust is the borrower or an affiliate of the borrower in accordance with the Section 16 2 (e);

OR

  • A corporation is the borrower of the remuneration and the deduction concerning the interest payable by it is claimed:
  • On money debited by the affiliated corporation of the borrower, where the money borrowed in the affiliated corporation’s hand arises wholly from the transaction of an issue by the affiliated corporation:
  • Of the already described instrument; or
  • Of the already described debentures,

In an amount not more than interest to be paid by the affiliated corporation to the holders of these instruments or debentures in accordance with the Section 16 2 f (iii).

  • On the debentures recorded on a stock exchange in the Hong Kong and recognized by the CIR; or
  • On the instruments (other than already described debentures):
  • Issued humble and in concerning of carrying on the marketed and business in Hong Kong or in an important center of finance outside the Hong Kong acknowledged by the CIR (prior to the amendment of 2004 Ordinance, it would be enough if the instrument of debt is able to market); or
  • Issued related to any arrangements or agreement, where the issue of any document, invitation or advertisement in respect of the arrangements or agreements has been acknowledged by the authorities, Future commissions, Securities and advertisements, document or invitation has been issued to the public in accordance with the Section 16 2 f (ii).

Tax deductions under the Sections 16 2 (c) to (e) above are further subject to Section 16 2(A), Section 16 2(B) and Section 16 2(C) of Inland Revenue Ordinance.

The lender is evaluated for tax under Section 16 2 (c) of Inland Revenue Ordinance. Following the implication of tax on interest, only the tax on profits will be applicable to the lender. If a person is unable to pass the conditions given below than he / she will be taxable on the income of interest under profits tax. These conditions are:

  • Section 14;
  • Section 15 1 (f), in case of corporation;
  • Section 15 1 (g), in case of an individual other than corporation; 
  • Section 15 1 (i), in case of an institution of finance.

In a case of D 58 / 01 it was observed that, the deduction of the interest paid to the HK company formation named as D was claimed by the taxpayer company. Company D investment was a joint venture company incorporated in the PRC that carried on the business in foreign. It was supposed by the taxpayer company that, the interest was chargeable to tax on profits in the hands of that company D, due to this reason the interest was a chargeable deduction to the taxpayer company by the favor of Section 16 2 (c). It was ruled by the Inland Revenue department that, the interest that was received by the company D was not evaluate able to tax as the business was not carried by the company in Hong Kong. Hence, the claim for such deduction was not allowed by the authority.


Secured Loan under Section 16 2A of Inland Revenue Ordinance

With the implementation from the date 25 June 2004, for the scenarios falling within:

  • Section 16 2 (c) (lender subject to the tax on profits on the interest);
  • Section 16 2 (d) (money debited from an institution of finance or a foreign institution of finance); or
  • Section 16 2 (e) (money debited for acquiring the plant or trading stock and machinery),

If the debiting (whether principal or interest) is secured, whether completely or in part, and, whether indirectly or directly, by a loan made or deposit by the affiliates of the borrower or borrower itself with or to:

  • The lender itself or his/her associate; or
  • An institute of finance or a foreign institute of finance or an affiliate of the institution,

And the interest on the loan or deposit is not evaluate able to the tax on profits under the Inland Revenue Ordinance, the deducted amount by the way of the interest on the debited money shall be decreased on such ground as is most appropriate and reasonable in the scenarios of the case.

Let’s consider an example, if the security is in a foreign country deposit with a foreign bank in such a way that, the income of interest on the deposit is not evaluate able to tax on profits, then the deduction of interest will be lessened. The reference for these statements is taken from the Example 3 and 4 of the departmental interpretation and practice notes 13A.

A key point to note here is that, before the 2004 Ordinance Amendment, Section 16 2 (d) of Inland Revenue Ordinance contained the allowance relating to a deposit being allowed as a security for a debt. The relevant part to the Section 16 (2A) of Inland Revenue Ordinance was removed by the 2004 Ordinance Amendment (with the effect from 25 June 2004) and it extended the prohibition of deduction of interest in case of the collateral deposit to Section 16 2 (c), (d), and (e). Another difference is that before the 2004 Amendment Ordinance, even though if the conditions of Section 16 2 (d) are fulfilled partly, for example, if the debt was secured partly through a deposit for which the income of interest is not subject to tax in Hong Kong, the complete amount of the expenses of interest is not deductible. In such circumstances, the deduction of part of the interest expenses is allowed by the 2004 Amendment Ordinance.

The departmental interpretation and practice notes 13 A was issued by the Inland Revenue Department in 2004. The purpose of its issuance was to explain the practice of IRD concerning the deductibility of these interest expenditures. The amount that will be disallowed, if in situation Section 16 2 (A) is not fulfilled as illustrated in the examples 5 to 10 in Departmental interpretation and practice notes 13A. For example, where the debt is protected partly by a bank deposit and partly by some other assets like shares or where the loan is protected by depositing in bank that is larger in amount than the debt. The allowable expenditures of interests will be divided.

The example related to that are given below:

  • Example # 5 of Departmental Interpretation and Practice Notes 13A
  • An amount of $1 Million was borrowed by the taxpayer F from a bank at interest rate of 5 percent. The debt was secured by a fixed deposit of amount $1 Million earning income of interest of 4 percent per annum. In that assessment year, tax free interest of amount $40,000 was earned from deposit by F and he paid an amount of $50, 000 interest on the debt. The net amount expenses on interest allowable for the deduction will be $50,000 - $40,000 = $10,000. A key point to note is that: before the 2004 Ordinance Amendment the complete amount of $50,000 was not allowable.

  • Example # 6 of Departmental Interpretation and Practice Notes 13A
  • The amount of $1 Million was secured by a deposit of amount $500,000 and some other shares which were also benefit of $500,000. The amount deposited generated the interest that was tax-free and of amount $20,000. The overall allowable interest is of amount $50,000 - $20,000 = $30,000.
  •  
  • Example # 7 of Departmental Interpretation and Practice Notes 13A
  • $1 Million loan in example # 5 was secured by a deposit of amount $2 Million. The deposited amount generated the interest that was tax-free and of amount $80,000. The amount of interest on expenditures evaluate able for the deduction will be lessened by amount $40,000. It is calculated as follow.

 

  • Example # 8 of Departmental Interpretation and Practice Notes 13A



     The accountable interest is to be lessened by:


The worth of the shares used as security may change from time to time depending upon the circumstances. Due to the reason of this calculation, a reasonable ground of averaging, such as by reference to the balances of month-end, will be acquired.

  • Example # 9 of Departmental Interpretation and Practice Notes 13A
  • A deposit of amount $2 Million was utilized to protect a loan of amount $1 Million. This amount was used for financing non-offshore business activities while, another loan of amount $1.5 Million used for the offshore businesses’ financing. The deposit generated tax-free interest of amount $80,000. The interest included on the loan for onshore business was of amount $50,000 and the interest incurred on the loan for offshore business was of amount $80,000.

The interest that is allowable is to be lessened by:


  • Example # 10 of Departmental Interpretation and Practice Notes 13A
  • The two loans discussed in the example # 9 were protected by the deposit of amount $4 Million. This thing produced the interest that was tax-free of amount $160,000. There was no security other than that, the two loans that were secured by the deposit were of amount $2.5 Million and $4 Million respectively. Out of this part, the actual portion that is attributable to the non-offshore loan is of amount $1 Million and $2.5 Million respectively for both loans.

The attributable interest is to be lessened by:



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