Relevant to Papers F6 (HKG) and P6 (HKG)
Interest expenses or finance costs are a common expenditure item for both individuals and corporations. Broadly speaking, interest costs are the consideration for the use of money acquired in the form of borrowing. An individual who borrows to acquire a property pays interest on the borrowing. A corporation which draws down on credit lines to finance its operations also pays interest on the amount borrowed. The payment of ‘interest’ does not arise on its own, but is dependent on the ‘use’ of the borrowing.
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 is not necessarily tax deductible.
This article is relevant to candidates preparing to sit Paper F6 (HKG) and Paper P6 (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 individual taxpayers. Relevant rules applicable to corporate taxpayers will be addressed in a separate article. 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 in respect of the interest expense. Where applicable, references will be made to mistakes frequently made by candidates and relevant ACCA Examiners’ Reports. 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 individual 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 papers to master the practical and integrated usage of the respective tax laws and rules under different circumstances. Paper F6 (HKG) candidates should focus on the treatment of interest costs in tax computations (including profits tax, salaries tax, and personal assessment) and the legal reasoning behind this treatment. Paper P6 (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, it is very common for a taxpayer to obtain a loan to finance a property acquisition. A property may be acquired for the taxpayer to live in themselves; or to be rented out by the taxpayer; or as a speculative investment. Some taxpayers may borrow money to make personal investments such as buying securities, or to on-lend the money to others at a margin. Taxpayers looking to start their own businesses may need to borrow, while those who are already running a business may require to borrow to finance further business needs. 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 for property acquisition
A property, referred to as real property here, is usually considered to be a capital asset, but this is not always the case. For a property dealer, a property is acquired with the primary intention of reselling it for a profit, and thus is considered to be trading stock or inventory. A profit arising from the sale of trading stock is subject to profits tax provided that the profit is sourced in Hong Kong.
On the other hand, if the property is treated as a capital asset, the profit arising from the sale is a capital profit and not subject to profits tax, pursuant to the specific exclusion under s14. It is therefore critical to identify whether the property in a question is held as a trading asset (a revenue asset) or a capital asset. If the property in question has been acquired by a loan on which interest is incurred, the deductibility of the loan interest will also be affected by whether the property is considered to be trading or capital in nature.
(a) Borrowing used to acquire a property for trading
An act of ‘buy-low-sell-high’ with a profit-making motive is likely to constitute a ‘trade’. Where a property is acquired with the primary or obvious intention of resale at a profit, the property is considered to be trading stock and the profit is taxable. In some cases where the ‘trading’ intention is not obvious, the act of buying and selling the property must be analysed under the ‘badges of trade’ in order to ascertain whether a ‘trade’ or ‘an adventure in the nature of a trade’ exists. Pursuant to the two-limb test under s14, if the ‘buy-sell’ act constitutes a ‘trade’, the first limb of s14 is satisfied. If the profit earned from this ‘trade’ is sourced in Hong Kong (analysed by reference to the contract effected test), the second limb of s14 is also satisfied. Section 14 would then apply to impose profits tax on the profit arising from the sale of property, but not property tax or salaries tax. An individual taxpayer would be taxed at 15% whilst a corporate taxpayer would be taxed at 16.5%.
If the acquisition of the ‘traded’ property is financed by a loan, interest will be incurred. Since profit from the sale of the property will be chargeable to profits tax, it is necessary to ascertain whether the interest is deductible against the taxable profit. 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 chargeable profits. Furthermore, s16(2) contains six conditions (contained within s16(2)(a) to s16(2)(f)), any one of which must also be met for a deduction in respect of the interest to be allowed. There are restrictions imposed on the extent of the deductions allowed for interest expenses satisfying ss16(2)(c), (d) (e) and (f) and these restrictions, varying from 0% to 100%, are contained under ss16(2A), (2B) and (2C). The relevant law and rules are not detailed here, but candidates’ attention is drawn to some of the tricky points as follows:
Figure 1: Section 16(2A) is applicable: The interest expense deduction available to the borrower is restricted to $4 ($10 – $6)
* Interest income of $6 received by B is not taxable in Hong Kong, either because B is an individual or the deposit/second loan is provided outside Hong Kong
Figure 2: Section 16(2A) not applicable; but s16(2B) may apply if A or B is an associate of the borrower
* Loan/deposit is not designated as security for the $100 loan to the borrower
Where interest on a loan satisfies all of the conditions under ss16(1), (1)(a), (2), and (2A)/(2B)/(2C), it will be tax deductible against the taxable profits arising from the sale of the ‘traded’ property.
(b) Borrowing used to acquire a property for personal enjoyment
Unless a property is acquired and used as a trading asset (as discussed in (1)(a) above), it is generally considered to be a capital asset. When a loan is obtained to acquire a property as a capital asset, candidates often make the mistake of jumping to the conclusion that the related interest expense is capital expenditure and not deductible. This common error has been mentioned in the Paper P6 (HKG) Examiners’ Report for the December 2013 sitting as well as in earlier diets. As discussed above, interest arises from a ‘borrowing’. Whether interest is incurred for a purpose that satisfies the tax 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. That is, in the case of a property acquisition, it is the ‘purpose’ or ‘usage’ of the property that determines the tax deductibility of the loan interest.
When a property is acquired by an individual taxpayer (whether solely in the individual’s name, or jointly with others) and the property is used by the taxpayer as his own residence, the property is used for personal enjoyment. The usage is domestic and private in nature, rather than for income-producing purposes. When the acquisition is financed by a loan and interest is incurred, the interest is also of a private nature. In the event that the individual taxpayer earns employment income subject to salaries tax, and applies his employment income to repay the loan (with interest), the question arises as to whether the interest can be deducted against the taxable employment income. Pursuant to s9, any expense/outgoing may be allowed as a deduction against the assessable income if the expense/outgoing is incurred ‘wholly, exclusively and necessarily in the production of the assessable income’, and the expense/outgoing is not of a domestic, private or capital nature. As the related loan interest is domestic and private in nature, it is not incurred in the production of assessable income and will not be deductible. Even if the taxpayer performs his employment services at his residence (e.g. he uses the property as a home office), an interest deduction will not be allowed for the reason that the ‘wholly, exclusively and necessarily’ test is not satisfied. Fortunately, a concessionary deduction by way of ‘home loan interest’ is available to a taxpayer if the stipulated conditions are satisfied (see s26E(1) and DIPN 35). The maximum deduction per annum is $100,000 (based on the prevailing law applicable to the June and December 2014 sittings), and each taxpayer is eligible for such a deduction for a maximum of 15 years in total, which may or may not be consecutive. In summary, the fundamental pre-requisite is that the property must be used by the taxpayer as his principal place of residence in Hong Kong. If, however, the property has been occupied free-of-charge by the taxpayer’s family members only (for example, by a taxpayer’s parents) and has not been occupied by the taxpayer as his principal residence, no home loan interest deduction would be allowed.
There are a few points of caution to bear in mind when considering a home loan interest claim:
(c) Borrowing used to acquire a property for income generation purposes
Broadly speaking, an individual acquiring and holding a capital asset such as a property may put the asset to one of three types of use:
(1) to earn a profit from disposing of it (ie for trading purposes)
(2) to use or consume it himself (ie for personal enjoyment), or
(3) to yield income from holding it or leasing it out (ie for income generation purposes).
As far as a property is concerned, an income-generating property may include :
(i) a property that is leased out for use by tenants, as a result of which the owner earns rental income (including lease premiums and other consideration for the use of the property from the tenant), and
(ii) a property that is used by the individual owner who runs a sole proprietorship business from the property. These two income generation purposes will now each be considered in more depth:
(i) The property is leased out
Where a property is leased out, the lease income and other consideration received by the property owner (called the ‘assessable value’) will be assessable to property tax pursuant to s5. Allowable against such assessable value are tax deductions which, however, are restricted only to the rates paid by the owner and a 20% statutory allowance. The balance of assessable value after deducting rates and the statutory allowance is termed the ‘net assessable value’. When an individual landlord incurs interest on a loan obtained to finance the acquisition of the leased property, such interest would not be deductible for property tax purposes; even though the lease income is assessed to property tax, and the property is acquired with the funds on which interest is incurred.
Fortunately, personal assessment provides a possible way for an individual landlord to claim a tax deduction for interest incurred on money borrowed for the purpose of producing the net assessable value which is included in the total income assessable under personal assessment (s42(1)). However, in order to be deductible in this way, the interest must not have already been deducted under profits tax. It is believed that this condition serves to avoid a double deduction, and does not necessarily impose the deduction conditions under s16(2) on interest deductions under personal assessment. Candidates can often become confused when considering the conditions for interest deductions under profits tax and personal assessment; and, in the past, have mistakenly applied the s16(2) conditions to interest claimed against the net assessable value under personal assessment.
As previously mentioned, in order to be eligible for electing for personal assessment, the taxpayer must be either a temporary or permanent resident of Hong Kong; depending on the residency status of the taxpayer and/or his extent of stay in Hong Kong. Note that this residency condition is relevant in determining the eligibility for electing for personal assessment, but is not relevant in determining the taxability of property income. Therefore, a foreigner who obtains a loan to buy a Hong Kong property which is leased for rental would still be required to pay property tax in Hong Kong without any deduction for the interest incurred, and would be unable to elect for personal assessment if he is not a permanent or temporary resident of Hong Kong.
Another common mistake made by candidates is to wrongly describe the interest claimed under personal assessment as ‘home loan interest’ (please see 'Related links' to the Paper P6 (HKG) Examiners’ Reports for the June 2013 and June 2012 sittings, and the Paper F6 (HKG) Examiners’ Report for the December 2011 sitting). Candidates should ensure that they are clear about the distinction between the two types of loan interest deduction: Home loan interest refers to interest incurred on a taxpayer’s residence and is claimed as a concessionary deduction against the ‘net assessable income’ under salaries tax or ‘net total income’ under personal assessment; whereas interest incurred on a leased property is claimed against the ‘aggregated total income’ under personal assessment only and there is no specific ‘name’ for this interest deduction claim. Moreover, the home loan interest deduction is subject to a statutory maximum of $100,000, whereas the interest deduction for a leased property is limited to the amount of net assessable value included under personal assessment.
(ii) The individual owner runs a sole proprietorship business from the property
When a property is acquired by an individual owner who runs his sole proprietorship business from the property, the property is also regarded as being acquired and held for the purposes of generating business profits. If interest is incurred on a loan obtained to finance the property acquisition, this interest will be regarded as a business expense/outgoings deductible against the business profits. If the business profits are chargeable to profits tax under s14, the interest will have satisfied the general deduction rule under ss16(1) and s16(1)(a), and could be tax deductible if the extended conditions under ss16(2) and s16(2)(A)/(B)/(C) are also satisfied. Please refer to paragraph (1)(a) above for the potential pitfalls to watch out for when considering a deduction claim against profits tax.
In the event that part of the property used by the sole proprietorship business has been rented out to tenants, and the rental income has been included as business profits, it is possible that the rental income would be assessed to both profits tax and property tax, both in the name of the sole proprietor. This is referred to as ‘double taxation’ and gives rise to an excessive tax burden on an individual taxpayer. Section 25 provides for a relief whereby the amount of property tax ‘paid’ by a taxpayer can be used to offset against (ie be deducted from) the amount of profits tax ‘payable’. Any positive balance of profits tax after deducting the property tax would be payable by the sole proprietor; whereas any negative balance would represent an overpayment of tax which would be refunded to the sole proprietor. However, in reference to this issue, candidates should be alert to the following:
2. Use of borrowing for investment purposes
An individual taxpayer may also borrow money to finance his personal investments. Some taxpayers may need money to start up their own businesses (either sole proprietorship, partnership or corporation) or to fund further business needs of their existing businesses; while others may need money to finance other personal investments (eg securities, foreign currencies, or commodities). Some individual taxpayers may borrow money to on-lend it to others at a marked-up interest rate. In each of these scenarios, interest incurred by a taxpayer may or may not be tax deductible against his income, depending on the ‘purpose’ of the borrowing and the statutory deduction rules.
(a) Borrowing used to fund a new or existing business
(i) Sole-properietorship/partnership business
Where an individual starts up his own sole-proprietorship business, he may borrow to fund the start-up capital to be used to (for example) lease and renovate the office/shop, buy inventory and hire staff etc. It is common that a loan is taken out by a taxpayer in his capacity as a sole proprietor such that interest incurred on the loan is treated as a business expense. Provided that the income earned by the sole proprietorship business is assessable to profits tax, interest on the borrowing used to finance the business operations will satisfy the general deduction rules under ss16(1) and (1)(a). If the extended conditions under ss16(2) and (2A)/(2B)/(2C) are also satisfied, interest will be deductible against the business profits. Again, candidates should refer to paragraph 1 (a) above which details the potential pitfalls of claiming interest deductions against profits tax.
Caution is required to distinguish the above situation from a loan obtained by an individual taxpayer which is then loaned on by him to his business with interest. It is uncommon to find this situation with a sole-proprietorship business. However, it is common in a partnership situation, whereby one of the partners extends a loan to the partnership and charges interest. If the lending partner borrows to finance his loan to the partnership, the interest incurred by him will not be deductible even if he receives interest from the partnership on the loan extended. This is because the interest income he receives from the partnership will not be assessable to Hong Kong tax, either because the interest does not fall within any scope of charge under salaries tax, property tax or profits tax; or due to the fact that the interest represents an appropriation of profits made by the partnership. The only exception to this rule is where the loan to the partnership is made by the lending partner in the ordinary course of running a money-lending business in Hong Kong as, in this case, profits tax would be payable on the interest income earned. If interest income earned from the partnership is not taxable, interest incurred by the partner on the money borrowed to finance his loan to the partnership is not deductible. On the other hand, interest paid by the partnership to the lending partner would be treated as an appropriation of profits and not tax deductible under ss17(1)(c) and (2).
(ii) Incorporated business
Where an individual taxpayer establishes his business through an incorporated entity, he will be a shareholder of the incorporated entity which carries on the business. An incorporated entity is an independent legal entity separate from its shareholder(s) (ie the individual taxpayer). If the shareholder borrows money to fund the operational needs of the incorporated entity, interest on the borrowing incurred by the shareholder will generally not be deductible, unless he himself is running a money-lending business. This remains the case regardless of whether the shareholder extends the money borrowed to the incorporated entity in the form of equity or a loan, as follows:
Equity
When an individual taxpayer borrows money to acquire shares in an incorporated entity, or injects the borrowed money as equity into an existing incorporated entity, he is applying the money borrowed as a capital investment. This scenario assumes that the individual taxpayer intends to hold his shareholding as a long-term investment rather than for short-term trading purposes. As a shareholder, the expected return on his investment is the dividend income from the incorporated entity, as and when after-tax profits are distributed. Dividends received from a corporation subject to tax in Hong Kong are specifically exempt from profits tax, pursuant to s26. As a consequence of this, any interest incurred by the shareholder on the money borrowed to finance his shareholding will not be deductible. On this technical point, candidates should take care to note that the reason that the shareholder is not allowed the interest deduction is because the borrowed money is used to produce dividend income which is not chargeable to profits tax. It is not sufficient (and is, in fact, strictly speaking incorrect) to state that the shareholder is not allowed the interest deduction because the borrowed money is used to acquire shares which are capital assets (please refer to the Paper P6 (HKG) Examiner’s Report for the December 2011 sitting for further on this point).
Loan
If an individual shareholder borrows and extends the money as a loan to an incorporated entity, interest incurred by the shareholder will not be deductible, regardless of whether the extended loan is interest-bearing or not. Similar to the scenario described in (2)(a)(i) above, even if interest is charged to the incorporated entity, the shareholder cannot claim a deduction for any interest expense since the borrowed money is used to generate interest income which is not assessable to any tax in Hong Kong. This scenario assumes that the shareholder is not running a money-lending business.
(b) Borrowing used for funding ad-hoc personal investments
An individual taxpayer may borrow money to acquire ad-hoc personal investments, such as securities, foreign currencies or commodities. Where interest is incurred on the borrowing, the taxpayer may or may not be able to claim an interest deduction, depending on whether or not the income earned from the investments is assessed to Hong Kong tax. Based on the general rule, income earned from capital investments held for long-term purposes would not be taxable, while income earned from short-term or revenue investments held for trading purposes would be chargeable to profits tax. In the former case, any interest incurred on the borrowing would not be deductible as the money borrowed is applied to produce capital income that is not taxable. In the latter case, where the buying and selling of securities, foreign currencies, commodities or other investments are regarded as constituting a trade, the trading income would be taxable and the related interest costs would be deductible provided that the conditions contained in ss16(1), (1)(a), (2), and (2A)/(2B)/(2C) are all satisfied.
The issue of whether or not the buying and selling of securities (including foreign currencies, commodities or other similar investments) will amount to a trade in a given scenario is not an easy and straightforward question. Technically, the ‘intention’ of a taxpayer would need to be examined from different perspectives, including a consideration of the ‘badges of trade’ factors. By reference to the prevailing practice of the IRD and related Board of Review decisions, an individual taxpayer trading in listed securities (including foreign currencies and others) without heavy and systematic conduct of activity would generally not be regarded as carrying on a ‘trade’, but rather as carrying on a speculative activity, akin to gambling. However, candidates should be careful to note that there is no one conclusive factor in ascertaining whether or not a trade exists and every case must be determined on its own merit.
(c) Borrowing used for on-lending at a margin
An individual taxpayer who wishes to make a loan to others may finance the loan by borrowing himself and thus incur interest costs. If the taxpayer does not charge interest on the loan extended to others, there is no income arising from the lending activity. The interest cost incurred by the taxpayer on the borrowing would, therefore, not be eligible for any tax deduction.
In the event that interest is charged on the loan extended to others, the individual taxpayer will earn interest income. On the assumption that the taxpayer only extends the loan on an ad-hoc basis rather than as part of regular money-lending activities, the act of lending is generally not regarded as a ‘trade’, and thus no tax liability would arise on the interest income received. Similar to the situation where an interest-free loan is extended, any interest incurred on the underlying borrowing will not be tax deductible. However, if the taxpayer is carrying on a regular activity of money borrowing and on-lending with the intention of earning a margin from the interest rate differential, he is likely to be regarded as carrying on a ‘trade’ or ‘money-lending business’. Whether or not the taxpayer is duly registered as a money-lender is not relevant for tax assessment purposes. If a trade or business is carried on, the interest income earned from the on-lending would be assessable to profits tax under s14 if it is sourced in Hong Kong. Any interest incurred by a taxpayer on a borrowing obtained to finance the on-lending trade/business would be potentially tax deductible, provided that the deduction conditions under ss16(1), (1)(a), (2) and (2A)/(2B)/(2C) are all satisfied.
3. Use of borrowing for personal consumption and other purposes
It is not uncommon for an individual taxpayer to borrow to finance his own personal consumption needs, such as daily consumption, tax payment, settlement of bills, etc. If the individual taxpayer incurs interest on the funds borrowed, it is most likely that the interest is private in nature and thus not tax deductible. Based on the general rule, for interest to be tax deductible, the interest cost should have a nexus to the production of assessable income earned by the same taxpayer, such as lease income arising from a property acquired with borrowed money, or assessable profits from a trade/business financed by the borrowed money. The only exception to this ‘symmetry’ is the ‘home loan interest’ deduction which is a concessionary deduction granted to a taxpayer who borrows to finance his place of residence in Hong Kong. Therefore, with the exception of ‘home loan interest’, any interest incurred to finance private expenditure, which is not for an income producing purpose, will not be eligible for any tax deduction.
Written by members of the Paper F6 (HKG) and Paper P6 (HKG) examining teams