Hong Kong SAR
Expenses that are incurred for producing profits chargeable to tax and that are not capital in nature are generally tax deductible. In addition, special tax relief is available for certain capital expenditure. There are special rules for deduction of certain expenses (e.g. interest expenses).
Accounting treatments are usually followed in determining the assessable profits, except when there is an explicit rule in the IRO. Accrued expenses recognised in the profit and loss account in accordance with GAAP are usually deductible if they are incurred for producing profits chargeable/subject to Hong Kong profits tax and are not capital in nature.
Expense items for which a tax adjustment is necessary in determining the amount of taxable profits from the accounting profits include: tax depreciation allowance vs. accounting depreciation, expenses that are capital in nature, general provisions that are non-deductible, and non-deductible interest expenses on borrowings used to finance non-income producing assets.
Set out below are the Hong Kong profits tax treatments of some common expense items.
Tax depreciation of fixed assets
Tax depreciation allowances/deductions are available for capital expenditure incurred on the construction of buildings or structures and in the provision of machinery and plant for trade or business purposes, as follows:
- Industrial buildings and structures: An initial allowance of 20%, in addition to an annual allowance of 4%, of the cost of construction or cost of purchase from a developer is granted for an industrial building or structure occupied for the purpose of a qualifying trade. Provision is made for balancing allowance or charge in the year of assessment in which the building is disposed of to adjust the written-down value of the building to the disposal price. Balancing charges are restricted to the total of initial and annual allowances previously given.
- Commercial buildings and structures: An annual allowance of 4% of the capital expenditure incurred on the construction is applicable. A balancing allowance or charge applies upon disposal. Balancing charges are restricted to the total annual allowances previously given.
- Plant and machinery: An initial allowance of 60% of the capital expenditure on plant and machinery is given for the year of assessment during the basis period in which the expenditure is incurred. An annual allowance is also given for depreciation at three prescribed rates on the reducing value of each of the three depreciation rate ‘pools’. The three prescribed rates are 10%, 20%, and 30%, and the reducing value of each of the three depreciation rate pools is original cost less initial and annual allowances and sales proceeds. Provision is made for balancing charges when plant and machinery within one of the three depreciation rate pools is sold or disposed of and the reducing value of that pool is less than the sale price, which is capped at the original amount incurred in the pool. In addition, balancing allowances or charges may be applicable upon cessation of business. Otherwise, sales proceeds are deducted in calculating the reducing value on which the annual allowance is calculated.
Book depreciation is adjusted for tax purposes in accordance with the above depreciation allowances granted under the IRO.
Cost of acquisition of goodwill/amortisation of goodwill is not deductible as it is capital in nature.
Organisational and start-up expenses
In general, company formation/start-up expenses that are incurred before the commencement of a trade, profession, or business and that are for the establishment of the overall income producing structure are capital in nature and not tax deductible.
Research & development (R&D)
An R&D tax deduction regime was introduced in Hong Kong SAR that applies to qualifying expenditure incurred or qualifying payment made on or after 1 April 2018. Under the new R&D tax deduction regime, there are two types of qualifying R&D expenditure, namely Type A expenditure and Type B expenditure. Subject to certain conditions, Type A expenditure (R&D expenditure other than Type B expenditure) will be granted a 100% normal deduction. Type B expenditure will be entitled to a 300% deduction for the first HKD 2 million of the expenditure and a 200% deduction for the remaining amount, without any limit on the amount eligible for the 200% deduction.
There is no thin capitalisation rule in Hong Kong SAR. However, except in some specified circumstances (e.g. interest expenses paid to an overseas associated corporation by a corporation carrying on an intra-group financing business in Hong Kong SAR where certain conditions are met), interest expenses paid to an overseas recipient other than a financial institution (whether a related or unrelated party) are generally not deductible if the overseas recipient is not subject to Hong Kong profits tax on the interest income. In addition, deduction of interest expense is subject to stringent and complicated rules that are designed to guard against loan arrangements with an intention to avoid Hong Kong profits tax.
In general, a bad or doubtful debt incurred in any trade, profession, or business, proved to the satisfaction of the Hong Kong Inland Revenue Department (HKIRD) to have become bad during the basis period for a year of assessment, is deductible. The deduction is limited to debts that were included as a trading receipt in ascertaining the taxpayer’s assessable profits or debts in respect of money lent in the ordinary course of a money-lending business in Hong Kong SAR.
If a taxpayer has elected to adopt the fair value basis to account for its financial instruments for profits tax filing purposes, a special deduction rule instead of the above general rule applies. Under the special rule, an impairment loss recognised in respect of a financial instrument that represents a trading debt or a debt in respect of money lent in the ordinary course of a money lending business in Hong Kong SAR is deductible only if it is credit-impaired.
If any bad debt, doubtful debt, or impairment loss that has previously been allowed as a deduction is ultimately recovered, it will be treated as taxable profits of the basis period in which it is recovered.
A deduction is allowed for cash donations to approved charities made in the basis period for a year of assessment if the aggregate of such donations is not less than HKD 100. The deduction is limited to 35% of the assessable profits of the year of assessment.
A deduction is allowed for regular/ordinary contributions to a mandatory provident fund scheme or recognised occupational retirement scheme made by an employer in respect of an employee to the extent that the contributions do not exceed 15% of the employee's total emoluments for the period to which the contributions relate.
Special payments, other than the ordinary contributions to a mandatory provident fund scheme or recognised occupational retirement scheme, are capital in nature but can be deducted evenly over a five-year period under a specific provision of the IRO.
There are also specific rules for deduction of provisions for contributions to a mandatory provident fund scheme or recognised occupational retirement scheme.
Payments for directors
Director fees or other remunerations paid by a corporation to its directors are generally deductible under the normal deduction rule. Nevertheless, no deduction is allowed on salaries or other remunerations paid to a sole proprietor or any partners or partners’ spouses of a partnership business.
Generally speaking, general provisions for expenses are not deductible, whereas specific provisions are deductible if the HKIRD is satisfied that the amount has been incurred (i.e. the taxpayer has a legal/contractual obligation to pay such amount in the future) and that the provision represents a reasonably accurate estimate of the future liability.
There are special deduction rules for expenditures incurred:
- for refurbishment of a building or structure, other than a domestic building or structure
- on environmental protection installation and machinery
- on environment-friendly vehicles
- on machinery or plant used specifically and directly for any manufacturing process, computer hardware (other than that which is an integral part of machinery or plant), computer software, and computer systems (collectively known as prescribed fixed assets)
- for registering trademarks, designs, or patents used in the production of taxable profits, and
- on the purchase of patent/know-how rights and specified IP rights (i.e. copyrights, registered trademarks, registered designs, protected layout-design [topography] rights in respect of integrated circuits, protected plant variety rights, or performer’s economic rights), provided certain specified conditions are met.
Fines and penalties
Fines and penalties are generally not deductible, as the HKIRD does not consider them to be expenses incurred for producing profits chargeable/subject to tax.
Taxes paid on corporate profits are generally not deductible for the purpose of calculating the assessable profits. The HKIRD may consider a foreign tax that is not calculated by reference to profits as deductible under the general deduction provision.
Where foreign taxes were charged on (i) interest income or gains from the sale of a certificate of deposit or bill of exchange that are deemed to be subject to profits tax in Hong Kong SAR or (ii) a certain percentage of gross income without deduction for outgoings and expenses (e.g. WHTs on royalties and service fees), and the same income is also subject to profits tax in Hong Kong SAR, a deduction is allowed for foreign taxes of substantially the same nature of Hong Kong profits tax paid in respect of the same income in the following situations:
- For Hong Kong residents, deduction is allowed for the foreign taxes that are not paid in a jurisdiction having a CDTA with Hong Kong SAR, provided that the taxpayer had taken all reasonable steps to minimise the foreign tax paid. In the case where such foreign taxes are paid in a CDTA jurisdiction, a Hong Kong resident can only claim a tax credit for the foreign taxes paid on the relevant income.
- For non-Hong Kong residents, deduction is allowed for the foreign taxes paid in another jurisdiction, provided that the taxpayer had taken all foreign tax minimisation steps (i) in the jurisdiction where the income is received or receivable (i.e. source jurisdiction) and (ii) in the residence jurisdiction of that person, including any double tax relief available. If relief of the amount of foreign taxes paid in the source jurisdiction is available in the residence jurisdiction of the non-resident person after taking all the foreign tax minimisation steps, the deduction in Hong Kong SAR will be limited to the portion of foreign taxes that are not entitled to relief in the residence jurisdiction.
Net operating and capital losses
Net operating losses incurred in an accounting year can be carried forward indefinitely to offset future profits of the business. A corporation carrying on more than one business may have losses in one business offset profits of the others, with any balance being carried forward. However, losses sustained from the sale of equity interests outside Hong Kong SAR (where the proceeds are received in Hong Kong SAR, and where the gain would have been taxable had a gain been derived from the transaction) may only be set off against the taxpayer’s assessable profits derived in the current or subsequent years of assessment from specified foreign-sourced income that is chargeable to profits tax under the refined FSIE regime. Net operating losses cannot be carried backward.
Capital losses are not tax deductible.
Payments to foreign affiliates
Royalties and service fees paid/payable by a Hong Kong corporation to foreign affiliates are deductible, provided they are incurred for the production of profits chargeable/subject to tax. There is no special restriction on the deductibility of these payments.
In general, interest payable by a Hong Kong corporation to a foreign affiliate is not deductible if the recipient is not chargeable/subject to Hong Kong profits tax on the interest income received (except where either the payer or the recipient is a financial institution as defined in the tax law). Interest expenses on money borrowed from a non-Hong Kong associated corporation by a corporation in the ordinary course of its intra-group financing business carried on in Hong Kong SAR are deductible, provided that certain specified conditions are met.