In this blog we will discuss the implementation of the Hong Kong tax policy on expenses related to profit tax calculation of taxpayer business. These include tax treatment on expenses such as, tax on apportionment of expenses, apportionment of interest, investment portfolios, compensation for breach of contracts upon termination of the business, accommodated revenue expenses, restoration costs, shared-based payments and keyman insurance policy. A detailed describing of these expenses will be provided along with their involvement in tax computation.

Tax Treatment on Different type of Expenses

Division of the Expenditures

It is provided by the IRR 2A that where any expenditure or outgoing is experienced for offshore company registration in Hong Kong:

  • Not exclusively and completely in the generation of profits that are chargeable; or
  • Partly in the generation of profits that are not offshore and partly in the generation of the profits that are offshore.

A division shall be made on a suitable ground.

No ground of division was specified by the IRR 2A, in the case of off/onshore profit, the base should be the most suitable to the actions of profession, trade or concerned business. In the case of expenditures not exclusively and completely experienced in the generation of profits that are chargeable, the grounds of division should be the most suitable and reasonable in the scenarios of the case.

Division of Interest

Where a loan lent by a taxpayer starting a small business in Hong Kong, is utilized to capitalize partly or wholly non-chargeable remuneration for generating assets, that are interest free to an affiliated company, that assets or shares held as investment for long-term to produce non-onshore profits, the interest on the loan is partly or completely disallowed. Where it is not possible to recognize which part of the debt is used specifically to finance the non-evaluate able income generating assets, an ordinarily adopted approach by the Inland Revenue department is to division on the following ground:

The board of review has accepted this approach. The reference for this statement is taken from the case D 68/87.

Investment Case

As long as more suitable and practical ground is not available, a required portion of the management, general and clerical expenditures attributable to the management and supervision of an investment case should not be allowed. The sums not allowed should be a percentage of the total cost of securities and investments, not overreaching:

  • 1% * 1/8 of the investment’s cost where for resale, the investments are held; or   
  • 1% * 1/2 of the investment’s cost in other cases. The reference for these statements is taken from the IRR 2C.

If the assessor supposes that the investment is not large sufficiently then no regulation must be made.

Reimbursement for Violation of Contracts upon Termination of Business

In the case of Overseas Textile Ltd, it was observed that, the business was terminated by the taxpayer company. It had to pay the reimbursement for its collapse in order to complete the particular weaving and spinning contract. A remuneration paid to avoid the possible law suit after termination of business was not made for the reasons of trade.

Prepaid Revenue Expenditures (Departmental Interpretation and Practice Notes 40)

In following the case of Secan, it was issued by the departmental interpretation and practice notes 40 to deal with the revenue expenditures that are remunerated in proceed of the periods to which it relate. The practice is applicable to any accommodation that is made during the ground period of a taxpayer for the assessment year 2002/03 and the following years.

It is stated under the old practice, by the DIPN 40 that, a deduction may be allowed to a taxpayer rendering Hong Kong company formation services, for the complete sum of an accommodated expenditure in the year of payment even if the remuneration related to more than one accounting year and was charged to and expended over to the loss and profit accounts for a number of years.

Under the reconsidered application:

  • It is not allowed to a taxpayer having business such as start up business Hong Kong, to claim an exclusion for the overall amount of an accommodated expenditure in the year of payment if any portion of the expenditure is postponed to a following period or year. A withdrawal for a specific year is only given for that part of the accommodated expenditure that is evaluated to the loss and profit account of that year, given that the accounts are produced concerning the pertinent accounting standards.
  • It would be accepted by the accounting treatment of an accommodated expenditure as correct if it observes with the pertinent statement of standard accounting practice proceeded by the HKICPA or Hong Kong Institute of Certified Public Accounting and is not non-consistent with any allowance of the Inland Revenue Ordinance.

Due to this reason, under the practice notes 40 and on the jurisdiction of Secan, if the practice of evaluating the whole amount is adopted by the taxpayer for an accommodated expenditure to the loss and profit account for the term in which the expenditure in experienced, the complete remuneration can be withdrawable in the related assessment year without the requirement for postponing some parts of the expenditure to future years (given this practice is according to the accepted standards of accounting of Hong Kong Institute of Certified Public Accounting).

Let’s discuss an example, an expenditure of amount $30,000 covering the 3 years to 31 March 2014 was remunerated in the year ended on the date 31 March 2012. In concerning with the accounting policy of company, the complete amount of $30,000 was evaluated in the loss or profit account for the year terminated on date 31 March 2012. The date of 31 March is adopted by the company as its period of accounting. The complete remuneration of amount $30,000 will be withdrawable in calculating the accountable profits for the assessment year 2011 / 12 if the policy of accounting is according to the accepted standards of accounting of Hong Kong Institute of Certified Public Accounting.

Restoration Payments

Under the rules of a debt agreement a taxpayer who is starting a small business in Hong Kong, it may be required by the lender of properties to restore the condition of the properties back to their native condition at the termination of the lease. It is required by the related principles of accounting from lessee to accumulate the restoration cost as an extra cost of the earlier modernization. The cost of restoration is to be given based on the best approximate costs of restoring the properties to their native state. The reference for this statement is taken from the HKAS 37.

According to the Inland Revenue Department (TB 19), where a debt exceeds more than 1 year, that debt will be treated as capital asset. The restoration costs when experienced will treated as portion of the capital investment of obtaining the lease. As the costs that are approximated for restoration are allowance and no original expense has been experienced, the allowance or estimate does not charter for allowance of commercial building. Due to the reason discussed above, the restoration costs experienced at the termination of the lease are still principal expense and hence are prevented from withdrawal under Section 17 (1) (c) of Inland Revenue Ordinance. The reference for this statement is taken from the TB19.

Payments on a Share-Base

Shares may be given by an employer to employees or an individual taxpayer providing Hong Kong company formation services as a compensation. The associated expenditure experienced by the employer is withdrawable to the extent that it is experienced in the generation of evaluate able profits. The reference for this statement is taken from the Section 16 (1) of Inland Revenue Ordinance. The treatments of accounting for shared base payments (‘SBP’) is governed by the Hong Kong Financial Reporting standard 2 (‘HKFRS 2’) and is effectual for the financial terms commencing on or after 1 January 2005. The introduction of Hong Kong Financial Reporting Standard 2 has built treatments of controversial tax on the withdrawal of shared-based payments in the accounts.

It remained the stance of the Inland Revenue Department that, shared-based payments acknowledged in respect of the share award responsibility or stock option fulfilled by providing new shares are not withdrawable. Where the responsibilities are met by accessing shares from the market, the expenses experienced in the accessing are evaluate able deductions when the conferring conditions of the share award or stock option have been contended.

Responsibilities of share award or stock option are discharged sometimes by agreements of discharge between group companies, i.e., an employing organization is recharged for shares accessed or issued by another group organization. The reason that why issue on recharge are most questionable is because there are various views between the practitioner of tax and the Inland Revenue Department. Having reconsidered the problems and with a view of settling the extended disputes, it was announced by the Inland Revenue Department on 6 March 2012 that, it has determined to adopt the positions given below for arrangement of recharge with agreement of written recharge:

  • Recreate in relation to the both new problem of the shares as well as accession of the shares from the market by a group organization can be permissible.
  • The schedule of withdrawal is the point of conferring of share award or point of exercise of stock option.
  • The amount of withdrawal claimed must not be immoderate. For example, it should not be in excess than the open market value of the shares accessed at the date when the stock share / option award is conferred / exercised less the value or amount of supposition given by the awardee / grantee for the grant or / and exercise of the award / option, according to the case.
  • Where any alternative shares / award shares are cancelled or forfeited subsequently, any deduction allowed previously should be responded as a receipt of trading and offered for the assessment.     

Where it is doubted that any shared-based options transactions are gone through for the reasons of tax avoidance, the Inland Revenue Department may explore into the transactions in detail and may invoke the allowances of the Inland Revenue Ordinance, where suitable to counteract the benefits of tax obtained.

Insurance Policy of Keyman (KIP)

There is no lawful definition of the term ‘keyman insurance policy’. Generally, according to the Inland Revenue Department this term has the features as discussed below. An insurance policy taken out by an employer insuring against the loss of profits being raised from sickness, death or injury of a key or crucial employee. The employer is the beneficiary. In the case of policy of a life insurance, it is as a term insurance, covering the employee’s life within the meaning of the policy, with no benefits other than that. The term does not go beyond the term of usefulness of the employee to employer. The reason of taking out the insurance is basically to reimburse the employer for trading income’s loss that may result from the overlooking of the service of crucial employee in case his sickness, death or injury.

The premium is withdrawable that is paid by the employer on policy. The proceeds or transactions as being the compensation for loss of profits, are taxable as receipts of trading of the employer.

If it is required by the employer under the law to pay reimbursement to employee on his / her death or injury, etc., and the employer attains a policy of insurance to cover these type of lawful obligations (for example, workers’ reimbursement under the Employment Ordinance), these installments are evaluate able, as being the normal expenditures of the business. This type of policy is not a keyman policy. The transactions are not evaluate able. There are different certain scenarios under which the installments of insurance paid on the policy are partially or completely not deductible.

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