A look at the proposed research and development tax deduction regime
The bill proposing an enhanced tax deduction for research and development (R&D) expenditure in Hong Kong was gazetted on 20 April. Subject to certain conditions, there will be a 300 percent tax deduction for the first HK$2 million of qualifying R&D expenditure incurred by enterprises and a 200 percent tax deduction for the remaining amount, without limit. R&D expenditure that does not qualify for the enhanced deduction may continue to enjoy a normal 100 percent tax deduction subject to fulfilment of the specified conditions. Once the bill is enacted into law, the new R&D tax deduction regime will take retrospective effect for expenditure incurred or payment made on or after 1 April 2018.
The current tax deduction for R&D expenditure
The current tax deduction for R&D expenditure is provided in section 16B of the Inland Revenue Ordinance. Under this, R&D expenditure incurred by a taxpayer related to its trade, profession or business (including capital expenditure on plant or machinery but excluding capital expenditure on land or buildings or in acquiring any rights in, or arising out, of R&D) can be fully deducted (i.e. a 100 percent tax deduction) in the year of assessment in which the expenditure is incurred, subject to certain conditions.
Based on the Inland Revenue Department’s (IRD) interpretation, in order to qualify for the deduction, the R&D expenditure must either be:
1. Incurred in respect of in-house R&D activities undertaken by the taxpayer itself; or
2. A payment made to an approved research institute (i.e. for subcontracted R&D activities).
For a cost-sharing arrangement within a group, the IRD’s view is that only the actual staff costs of the employees of the Hong Kong taxpayer participating in the R&D activities, instead of the full amount of the R&D costs allocated to the Hong Kong taxpayer, can qualify for the deduction.
For R&D expenditure incurred by a taxpayer outside Hong Kong (i.e. expenditure on R&D activities carried outside Hong Kong), an apportionment of the expenditure is required if the taxpayer’s trade, profession or business is carried on partly in and partly outside Hong Kong (i.e. where only part of the taxpayer’s pro ts are taxable in Hong Kong).
The proposed enhanced R&D tax deduction regime
To encourage more enterprises to invest in R&D in Hong Kong and promote local R&D activities, the government proposed in the 2017 Policy Address to introduce an enhanced tax deduction for R&D expenditure. The Inland Revenue (Amendment) (No.3) Bill 2018 (the Bill), which was gazetted on 20 April, set out the details of the proposed normal and enhanced tax deduction for R&D expenditure in Hong Kong. Once the bill is enacted into law, the new regime will take retrospective effect for qualifying expenditure incurred or qualifying payment made on or after 1 April 2018.
With the introduction of the enhanced R&D deduction, section 16B is revamped and a new schedule (i.e. Schedule 45) is introduced to specify the details for the deduction of R&D expenditure. As specified in Schedule 45, there are two types of tax deductible R&D expenditure, namely Type A expenditure (which qualifies for a 100 percent tax deduction) and Type B expenditure (which qualifies for enhanced tax deduction of 300 percent for the first HK$2 million and 200 percent for the remaining amount). One point that is worth to note is if any rights generated from the R&D activity are not, or will not be, fully vested in the taxpayer, no deduction (both Type A and Type B expenditures) will be granted. This requirement is not clearly specified in the existing section 16B.
Compared with other countries that also offer tax incentives for R&D activities, some features of the proposed regime in Hong Kong are more competitive whereas the others are less attractive. Taking Mainland China as an example, the current rates of enhanced tax deduction for qualifying R&D expenditure are only 175 percent (for qualified small- and medium-sized technological enterprises) or 150 percent (for other enterprises), which are lower than the 300/200 percent enhanced deduction rates in Hong Kong. On the other hand, while payments made for subcontracted R&D activities are generally not eligible for enhanced deduction in Hong Kong (unless the subcontractor is a designated local research institution), 80 percent of the expenditure incurred for R&D activities subcontracted to a related or unrelated party (either an organization or individual) is eligible for enhanced tax deduction in the Mainland China provided that the R&D activities are conducted by a local party in Mainland China.
Certain receipts in relation to R&D deemed as taxable trading receipts In order to maintain tax symmetry, the following provisions (which are originally in section 16B) are retained in Schedule 45, with modifications to reflect the proposed enhanced R&D tax deduction:
- Proceeds from sale of plant or machinery used for an R&D activity where the capital expenditure on such plant or machinery has been allowed as a deduction under section 16B, with the deemed taxable amount limited to the amount of deduction previously allowed; and
- Proceeds from sale of any rights generated from one or more R&D activities for which the expenditure have been allowed as a deduction under section 16B, with the deemed taxable amount limited to the amount of deduction previously allowed.
The Bill also introduces provisions that deem the following receipts as taxable Hong Kong sourced trading receipts:
- Royalties received for the use, or the right to use, outside Hong Kong of any intellectual property or know-how generated from any R&D activity in respect of which a R&D deduction is allowable under section 16B; and
- Sums received for imparting or undertaking to impart knowledge directly or indirectly connected to the use outside Hong Kong of any intellectual property or know-how generated from any R&D activity in respect of which a R&D deduction is allowable under section 16B.
Assessment of eligibility for the R&D tax deduction
For the purpose of assessing a claim or an advance ruling application made in relation to a deduction for R&D expenditure under section 16B, the Bill proposes to empower the Commissioner of Inland Revenue (CIR) to seek advice from the Commissioner for Innovation and Technology (CIT) in ascertaining whether (1) an activity falls within the scope of R&D activities qualifying for the tax deduction and (2) the expenditure should be regarded as incurred in relation to an R&D activity qualifying for the tax deduction. The CIR may disclose to the CIT any details which he considers necessary for the purpose of such consultation. The final decision on whether a deduction should be allowed for the R&D expenditure concerned will be made by the CIR.
While the Bill represents a significant move of the Government in the right direction for promoting local R&D activities in Hong Kong, the proposed enhanced R&D tax deduction regime is considerably complex as it specifies numerous conditions for enjoying the enhanced deduction, introduces various deeming provisions that treat certain receipts in relation to R&D that would otherwise not subject to pro ts tax as taxable trading receipts and includes anti-avoidance provisions to safeguard against abuse of the tax deductions (both normal and enhanced) for R&D expenditure.
Hong Kong companies that are engaging in or planning to engage in R&D activities in and/or outside Hong Kong should review their R&D activity arrangements in light of the proposed regime and assess how to best structure their R&D activities for bene ting from the enhanced R&D tax deduction in Hong Kong.
This article was originally published in PwC's Hong Kong Tax News Flash (April 2018)