Relevant to TX-HKG and ATX-HKG
Although certain dates referred to in this article are not necessarily contemporaneous, the underlying principles and concepts remain relevant for current candidates and therefore continue to be examinable.
From a tax perspective, whether an interest cost can be claimed as a deduction against a taxpayer’s taxable income will primarily depend on the ‘use’ of the borrowed money, including ‘how’ the money is used and ‘to what extent’. As a general rule, if the borrowed money is used for a non-income producing purpose, the related interest will normally not be tax deductible. Unfortunately, the opposite situation does not necessarily guarantee a tax deduction. Subject to the provisions of the tax law, even if the borrowed money is used for an income-producing purpose, the related interest will not necessarily be tax deductible. There are a series of other conditions required to be satisfied before a tax deduction is allowed.
This article is relevant to candidates preparing to sit TX-HKG and ATX-HKG. It aims to explain, in layman terms as far as possible, the Hong Kong tax rules and practice surrounding the claims for interest deductions by corporate taxpayers. This article should be read in conjunction with the technical article on ‘the pitfalls of interest deduction claims by individual taxpayers’. Different scenarios will be used to illustrate the different possible uses of the borrowed money from which interest arises and the impact of this on the availability of a tax deduction for corporate taxpayers in respect of the interest expense. Where applicable, references will be made to mistakes frequently made by candidates. This article will not follow the sequence of the tax law provisions or break down the topic based on the three types of taxes in Hong Kong; instead, it will present some commonly found scenarios involving the use of borrowed money by corporate taxpayers. Moreover, unless necessary, relevant tax law and rules will not be replicated in great detail and thus candidates are recommended to read this article in conjunction with the relevant tax law and reference materials. The aim of this article is to aid candidates preparing to sit the HKG tax exams to master the practical and integrated usage of the respective tax laws and rules under different circumstances. TX-HKG candidates should focus on the treatment of interest costs in tax computations and the legal reasoning behind this treatment. ATX-HKG candidates should aim to master and digest (rather than merely memorise) the relevant tax principles, rationale and concepts, in order to be able to demonstrate the ability to explain, discuss, comment and apply these in different scenarios in the exam.
All legislative references in this article are to the Inland Revenue Ordinance.
In Hong Kong, a corporation may borrow money to fund general business operations which could include the payment of operating expenses and the purchase of inventory or capital assets. Some corporations borrow money to make investments, such as trading in securities, establishing new subsidiaries or providing intra-group financing. The tax law in Hong Kong regarding the deduction of interest is not straightforward, and requires both an in-depth understanding of the law and a clear mind to integrate income tax principles with expense deduction rules. In a scenario, the question of whether or not the interest costs will be deductible may warrant a careful analysis of the purpose of the borrowing as follows:
1. Use of borrowing to fund business operations
A common use of borrowing by corporations is to fund business operations. For simplicity, in the scenarios that follow it should be assumed that the corporations are not public utility companies or financial institutions, and that they are not borrowing money via the issue of debentures or other marketable instruments. This article does not intend to address interest deductibility rules in these situations.
(a) Borrowing used to purchase inventory
A corporation may borrow money to purchase inventory or it may purchase inventory on credit terms with a supplier and in both cases, interest will be incurred. Interest deductibility for profits tax purposes is governed by sections 16(1), (1)(a), (2) and (2A) to (2CD). Primarily, the interest must first satisfy the general deduction rule under s16(1), being an expense incurred in the production of assessable profits. The deduction rule for interest is further extended by s16(1)(a) which requires the ‘borrowing’ to be used for the purpose of producing the assessable profits. In order to determine whether interest on borrowings used to purchase inventory is deductible, the first consideration is therefore whether or not the inventory purchased is used in the production of assessable profits. In other words, whether the income generated from the sale of the inventory will be chargeable to profits tax in Hong Kong. If the sales income is not subject to profits tax in Hong Kong due to being offshore-sourced or exempt, the interest expense will not be deductible. If, however, the income generated on the sale of the inventory is assessable to profits tax in Hong Kong, then the general deduction rule is satisfied. This in itself, however, does not necessarily mean that the interest will be deductible. In addition, one of the following conditions for deductibility must also be met:
(i) If the money is borrowed from a financial institution under s16(2)(d) then provided that the borrowing is not secured by another loan or deposit that derives interest income which is not taxable in Hong Kong (the secured loan test under s16(2A)), and the borrowing is not part of an arrangement such that the interest payment ultimately flows back to the borrowing corporation or its associates (the interest flow-back test under s16(2B)) the interest will be deductible. If the secured loan test and interest flow-back test are not satisfied, a tax deduction for the interest cost will be denied or restricted to a lower amount. Candidates are advised to consult the technical article on ‘the pitfalls of interest deduction claims by individual taxpayers’ to recap the restrictions imposed on the extent of deductions for interest expenses satisfying s16(2)(c), (d), (e) and (f).
(ii) If the money is borrowed from a non-financial institution (for example, an associate of the corporation) and the interest received by the lender is subject to tax in Hong Kong, then provided that the secured loan test and the interest flow-back test mentioned in (1)(a)(i) above are both satisfied, the interest will be deductible under s16(2)(c). The interest received by the lender will be subject to tax in Hong Kong if the lender is carrying on business in Hong Kong and the interest is Hong Kong-sourced (the provision of credit test); or the lender is deemed as carrying on a money-lending business in Hong Kong.
(iii) If the borrowed money is used wholly and exclusively to purchase trading stock or plant and machinery for the purpose of producing chargeable profits in Hong Kong and the lender is not an associate (as defined under s(3)), then provided that the secured loan test and the interest flow-back test mentioned in (1)(a)(i) above are both satisfied, the interest will be deductible under s16(2)(e).
A typical example in which none of the above conditions are satisfied is when a corporation borrows money from an overseas associate which is not subject to tax in Hong Kong. In this case, there is no tax deduction for the interest expense.
When money is borrowed from a lender who is not an associate of the corporation, and the money is borrowed wholly and exclusively to finance the purchase of inventory for the purpose of producing chargeable profits in Hong Kong, the interest will be deductible under (1)(a)(iii) above.
When inventory is purchased on credit terms with a supplier and the income from the sale of the inventory is chargeable to profits tax in Hong Kong, in order to determine whether the interest is deductible it is also necessary to consider whether any of the conditions listed in (1)(a)(i), (ii) and (iii) above are met. If the supplier is not associated with the corporation, the interest may be deductible under condition (1)(a)(iii) above. If the supplier is an associate of the corporation, the interest may still be deductible under condition (1)(a)(ii) above if the supplier is subject to Hong Kong tax on the interest income it receives from the corporation. If, however, the supplier is an associate of the corporation and is not subject to Hong Kong tax, there is a risk that the interest payable will not be deductible. However, a possible argument exists if the interest paid on the credit agreement is effectively part of the contractual terms of the purchase such that it forms part of the purchase cost of the inventory. Depending on the evidence available, it may be possible to argue that the interest is not ‘interest on money borrowed’ and should be tax deductible as part of the purchase cost. In this case, the interest will be deductible under s16(1).
(b) Borrowing used to pay operating expenses
Sometimes corporations borrow money to finance general operating expenses such as rent and rates, utilities, consumables and professional fees. The borrowing could be in the form of a bank overdraft or an advance or loan from shareholders or associates. In the case of a bank overdraft, interest will be incurred and will be payable to the bank. To determine whether the interest is deductible for tax purposes, the general deduction rule must first be satisfied, that is whether or not the borrowing is used for the production of assessable profits. In the circumstances, if the operations of the corporation are carried out in the production of profits assessable to tax in Hong Kong, the borrowing used to finance the operation will be regarded as satisfying the general deduction rule. When considering whether the borrowing is used ‘in the production of profits’, in practice it is not necessary to demonstrate a direct connection to assessable profits. It would be sufficient for the money to be used in the ‘ordinary course of carrying on a business’ from which assessable profits are derived, such as for the payment of rent and rates. After satisfying the general deduction rule, the next step is to determine whether either of the conditions (1)(a)(i) or (ii) above are met. If the money is borrowed from a bank, condition (1)(a)(i) needs to be satisfied otherwise the deduction will be denied or restricted. If the money is borrowed from an associate, condition (1)(a)(ii) needs to be satisfied otherwise the deduction will also be denied or restricted.
(c) Borrowing used to purchase capital assets
When money is borrowed to finance the acquisition of capital assets such as office furniture, equipment or properties, the interest charged on the borrowing may either be capitalised or expensed in accordance with applicable accounting principles. Note that following the Secan case, it is generally the practice of the IRD to follow the accounting treatment for tax purposes. Where interest is capitalised, tax law in Hong Kong allows for the total capitalised cost to qualify for tax depreciation allowances under s40. In scenarios where the interest is expensed, candidates often make the mistake of jumping to the conclusion that the interest is not deductible because it was incurred to acquire a capital asset and so is capital in nature. It is worth noting that interest should have a connection with the ‘loan’ rather than the ‘asset’. Interest arises from a borrowing. Whether interest is incurred for a purpose that satisfies the general deduction rule will depend on how the borrowed money is used. When the borrowed money is used to acquire a capital asset, the test is extended to look at how the capital asset is used. Where the loan is used in the ordinary course of business to acquire a capital asset which is used for the purpose of producing assessable profits, it is generally accepted that the interest incurred on that loan satisfies the general deduction rule. For this purpose, it will suffice if the assets are being ‘put into use’ or are ‘intended to be used’ for producing assessable profits. The assets do not need to be ‘already used’ for the purpose of producing assessable profits. With the general deduction rule being satisfied, conditions (1)(a)(i), (ii) and (iii) above need to be assessed, in order to determine whether or not, and to what extent, a tax deduction will be available for the interest incurred.
If money is borrowed to acquire a property for use as an office or as accommodation for staff, the use of the property would satisfy the general deduction rule of being incurred ‘for the purpose of producing assessable profits’. For these purposes, the definition of staff includes directors and a deduction is available regardless of whether or not rent is charged. However, if the property is used by a shareholder or associate of the corporation, it would only qualify as being ‘for the purpose of producing assessable profits’ if rent is charged and the corporation is assessed to Hong Kong tax on the rental income. Otherwise, the related interest cost and other expenses for such a property will not be tax deductible.
2. Use of borrowing for investment purposes
(a) Borrowing used to buy securities and/or foreign currencies
It is not uncommon for a corporation to use borrowed money to engage in the trading of securities or foreign currencies. The related interest cost on the money borrowed will be tax deductible if the general deduction rule is satisfied as well as either of the above conditions (1)(a)(i) or (ii) depending on the identity of the lender. In order to satisfy the general deduction rule, any profits arising from the trading of the securities or foreign currencies must be assessed to Hong Kong tax. If the buying and selling of securities or foreign currencies constitutes a trade pursuant to s14(1) and the profits arising are sourced in Hong Kong, then the general deduction rule would be satisfied as the profits would be assessed to Hong Kong tax. The general source rule would need to be applied.
In certain circumstances, a corporation may acquire securities with the intention of holding them for long-term investment purposes rather than for trading. This could include acquiring shares in subsidiaries or associates. In assessing whether the interest on money borrowed for such an investment satisfies the general deduction rule, consideration must be given as to what type of income (or return) the corporation would expect to earn from its investment. In the case of holding securities, the corporation would expect to generate dividend income. Under Hong Kong tax law, dividend income distributed by companies chargeable to tax in Hong Kong is specifically exempt from tax in the hands of the investors under s26 and dividends distributed by companies outside of Hong Kong are generally accepted as offshore-sourced and therefore not taxable. As such, any borrowed money used to acquire long-term investments in securities would therefore not satisfy the general deduction rule of being ‘for the purpose of producing assessable profits’. As a result, the related interest cost on the borrowing will not be tax deductible.
(b) Borrowing used to establish a new subsidiary
A corporation may borrow money to establish a new subsidiary. Despite the minimal costs associated with the incorporation of new companies in Hong Kong, funding would normally be required to be injected into the new subsidiary to finance its operations. When a corporation borrows money for this purpose, interest is incurred. In order to determine whether the interest is deductible, the general deduction rule must be satisfied, as well as either of the conditions (1)(a)(i) or (ii) above. First it is necessary to identify the form of the funds injected into the subsidiary. In general, the funds may be injected in the form of equity or a loan, as follows:
Assuming that the interest income earned from the money loaned to the subsidiary is taxable in Hong Kong, the general deduction rule is satisfied. If either of conditions (1)(a)(i) or (a)(ii) are met, the interest expense on the money borrowed to finance the subsidiary loan will be deductible. A typical example of when an interest deduction would be denied is when a corporation borrows money from an offshore non-financial institution (eg an offshore associate) and then on-lends the borrowed money to its subsidiary.
In the event that the corporation frequently borrows and on-lends within the group to such an extent that the IRD accepts that the corporation is carrying on an intra-group financing business, there is a possibility under the new legislation in s15(1)(ia) and (la), effective 1 April 2016, that the related interest expense will be tax deductible. This situation is elaborated under scenario (2)(c) below. Note that the corporation is not eligible for the new deduction rule if the borrowing and lending of money from and to group companies is an isolated transaction and not as part of an intra-group financing business.
(c) Borrowing used to provide intra-group financing
With effect from 1 April 2016, new legislation was enacted to determine the chargeability of interest income and the deductibility of the related interest expense arising through or from an intra-group financing business. If a corporation performs corporate treasury functions within a group of companies (including borrowing money from one associate and on-lending the money to another), the corporation may be accepted by the IRD as carrying on an ‘intra-group financing business’. There is no statutory definition of an ‘intra-group financing business’ but the IRD generally makes reference to the number and size of transactions in determining whether an intra-group financing business is taking place. Departmental Interpretation and Practice Note (DIPN) 52 states that generally the IRD would accept that a corporation is carrying on an intra-group financing business if it has no less than four borrowing or lending transactions each month, with each of the transactions exceeding HK$250,000 and borrowing or lending transactions are with no less than four associated corporations in the relevant basis period.
Chargeability of interest income – Under the new tax law in s15(1)(ia) and (la), interest income arising through or from the activities of an intra-group financing business will be deemed as a taxable trading receipt, regardless of the application of the provisions of either the credit test or the operation test as discussed above. The normal corporate income tax rate will apply. However, if the corporation is performing the corporate treasury function to the extent that it qualifies as a ‘qualified corporate treasury centre’ (QCTC) under s14(D)(2), the relevant qualified profit will be eligible to be taxed at a concessional rate under s14(D)(1) which is 50% of the corporate tax rate, ie 8.25%. Note that the corporation must make an irrevocable election to be a QCTC, and its central management and control as well as all substantial activities must be carried out in Hong Kong under ss14(D)(5) and (6).
Deductibility of interest expense – Under the new tax law, a tax deduction will be allowed for the interest incurred on the related borrowing to finance the intra-group financing business only if all of the following conditions under s16(2)(g) are met:
(i) interest is incurred by the corporation in the ordinary course of its intra-group financing business
(ii) interest is incurred on money borrowed from a non-Hong Kong associated corporation
(iii) interest in the hands of the lender has been or will be taxed overseas at a rate greater than or equal to 16.5% (or 8.25% if the interest-paying corporation is a QCTC), and
(iv) interest is received by the lender as the beneficial owner and is not passed on to any other person under any contractual or legal obligation, unless the interest is obliged to be passed on under a genuine arrangement at arm’s length (eg due to genuine security on the loan or sub-participation). This beneficial ownership requirement is to prevent an interest deduction being given to a lender which is a conduit, agent or administrator acting on behalf of other interested parties.
Condition (2)(c)(iii) above will not be regarded as satisfied if the interest has been reduced to nil or negative by direct expenses or the offset of losses. In the event that condition (2)(c)(iii) above is partially failed, apportionment is possible to restrict the interest deduction to the qualifying portion under ss(2CA) and (2CB). Moreover, if the IRD considers that the main purpose of the intra-group financing transaction is to utilise a loss for the avoidance of tax, the interest deduction will be denied under ss16(2CC) and (2CD).
Note that the new tax law on interest deductions for intra-group financing businesses is only an additional channel for securing a tax deduction on top of the other conditions in (1)(a)(i), (ii) and (iii) mentioned above. Having that said, it is worth noting that the new deduction rule only applies to intra-group financing businesses. Therefore, if the corporation incurs interest on money borrowed from an offshore lender and on-lends the same money to another borrower to generate interest income, it is still possible that an interest deduction will be denied if none of the conditions in (1)(a)(i), (ii) or(iii) are satisfied, and the act of borrowing and lending is not accepted as an intra-group financing business by the IRD, hence not satisfying condition (2)(c)(i) above.
(d) Borrowing used to buy properties for lease or resale
A corporation may borrow money to acquire a property to lease out for use by tenants in order to earn rental income. Usually a property held for this purpose would be accepted as a capital asset unless there is evidence to prove otherwise. In determining whether or not the interest expense is deductible, the general deduction rule of being ‘for the purpose of producing assessable profits’ must be satisfied. When the property is situated in Hong Kong, the lease income derived is therefore of Hong Kong source. As property owner, the corporation is assessable to both property tax under s5(1) and profits tax under s14(1), although corporations subject to such double taxation may apply for exemption from property tax under s5(2)(a) or to offset the property tax paid against the profits tax payable under s25. Under the tax law in Hong Kong, the interest cost would not be eligible for any tax deduction under property tax, but could possibly be deductible under profits tax given that the general deduction rule is satisfied, subject to the satisfaction of further conditions in (1)(a)(i) or (ii) mentioned above.
Alternatively, a corporation may borrow money to acquire properties with the intention of disposing of them for a profit. Assuming that the act of buying and selling properties constitutes a ‘trade’ or ‘an adventure in the nature of trade’, the profit arising from the sale would be assessable to profits tax. As a result, the related interest cost on money borrowed would satisfy the general deduction rule. If any of the conditions in (1)(a)(i), (ii) or (iii) are satisfied, a tax deduction will be allowed (or restricted as the case may be).
To recap, interest deductibility for profits tax purposes is primarily governed by sections 16(1), (1)(a), (2) and (2A) to (2CD). Despite the fact that section coding is not required in the TX-HKG or ATX-HKG exams, given the nature of this topic, it is recommended that candidates study the relevant sections of the legislation on interest deductibility in depth. In addition to the legislation, candidates may also find Departmental Interpretation and Practice Notes useful sources to consult in relation to how the law is interpreted and applied by the IRD in practice.
References
(1) Sections 5(1), 5(2)(a), 14(1), 15 (1)(ia) and (la), 14D, 14E, 14F, 16(1), 16(1)(a), 16(2), 16(2A) – (2CD), 16(3), 25, 26 and 40 of the Inland Revenue Ordinance, Chapter 112
(2) DIPN 52 (2016), ‘Taxation of corporate treasury activity’
(3) Secan Ltd and Another v CIR (20000 5 HKTC 266
(4) CIR v Orion Caribbean Ltd (in voluntary liquidation) (1997) 4 HKTC 432
Written by members of the TX-HKG and ATX-HKG examining teams