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Why specific anti-tax avoidance provision may make tax deductions on purchase costs of intellectual property rights difficult

September 2018


Jo An Yee, Patrick Kwong and Kathy Kun look at why section 16EC(4)(b) of the Inland Revenue Ordinance attracts controversy



The Inland Revenue (Amendment) (No. 2) Bill 2018 has recently been enacted to grant tax deductions for three new types of intellectual property rights (IPRs), namely (i) performer’s economic right; (ii) protected layout-design (topography) right; and (iii) protected plant variety right. These new tax deductions work within the existing regime comprising two main provisions of the Inland Revenue Ordinance (IRO), namely:

  • Section 16E, which is not affected by the new law, and grants a 100 percent tax write-off in the year of purchase for costs of patent rights and rights to know-how where specified conditions are satisfied; and
  • Section 16EA, which after the enactment of the new law effective from Year of Assessment 2018/19, will extend its coverage from registered trademarks, copyrights, and registered designs to include the three new types of IPRs detailed above. Under section 16EA, tax deductions for capital expenditure incurred on the purchase of such IPRs will generally be spread over five successive years in equal instalments, beginning in the year of purchase.

Tax deductions otherwise granted under both sections 16E and 16EA will however be denied when the specific anti-avoidance provisions contained in section 16EC apply. Of all the specific anti-avoidance provisions in section 16EC, the one that has attracted the most controversy from tax professionals is contained in section 16EC(4)(b).

The controversial section

Under section 16EC(4)(b), no tax deduction will be allowed under sections 16E or 16EA if the relevant IPR is wholly- or principally-used outside Hong Kong by a person other than the taxpayer under the term of a license (regardless of whether royalties are charged).

Section 16EC(4)(b) is in fact modelled on section 39E(1)(b)(i) of the IRO. The latter section has been controversially invoked by the Inland Revenue Department (IRD) to deny tax depreciation allowances on capital expenditure incurred by Hong Kong taxpayers in respect of plant or machinery provided on a rent-free basis by such taxpayers. Typically, these recipients of rent-free capital goods are contract manufacturers of the taxpayers based in Mainland China pursuant to import processing arrangements. Such denial will occur regardless of whether the profits derived by the taxpayers from the trading of goods manufactured under the import processing arrangements are fully tax-chargeable in Hong Kong.

Similar to section 39E(1)(b)(i), the controversies arising from the application of section 16EC(4)(b) are that it could affect many normal business arrangements that are not tax driven or structured with a view to avoiding tax. The following is one such typical example.

Example

A Hong Kong company purchases, from a third party, a layout-design (topography) right for certain integrated circuits (IC Right) for HK$8 million with the IC Right protected under the law of Mainland China. Furthermore, the company then procures an unrelated contract manufacturer in Mainland China under import processing arrangement to produce goods on behalf of the company, and in the process allows the contract manufacturer to use the IC Right royalty free. If the goods incorporating the IC Right were then sold by the company to customers in Hong Kong, the profits derived would generally be fully taxable in Hong Kong being Hong Kong-sourced income.

The tax position taken by the IRD

In the above example, the IRD would consider that the Hong Kong company has effectively granted the contract manufacturer in Mainland China (being a person other than the Hong Kong company as the taxpayer) a license for the use of the IC Right wholly or principally outside Hong Kong. As such, under section 16EC(4)(b), the IRD will deny the Hong Kong company’s claim for a tax deduction of the purchase cost of the IC Right of HK$8 million. This would be the case even though the profits derived by the Hong Kong company from the trading of the goods manufactured by the contract manufacturer in Mainland China were fully chargeable tax in Hong Kong.

Lobbying efforts to remove or amend section 16EC(4)(b)

When the new law was a legislative bill, a number of professional bodies made submissions to the Bills Committee formed to scrutinize the bill that section 16EC(4)(b) should be removed or amended such that tax deductions would not be denied in situations as illustrated by the above example.

In response, the government indicated that section 16EC(4)(b) was first introduced into the IRO in 2011 when section 16EA was originally enacted, and that this legislative exercise only sought to extend the coverage of section 16EA to include the three new types of IPRs, the terms of section 16EC(4)(b) being unaffected by the bill. As such, the government considered that this legislation was not an appropriate platform for examining the issue of whether section 16EC(4)(b) should be removed or amended.

Nonetheless, the government also indicated that in the light of potential economic integration arising within the Greater Bay Area, the Secretary for Financial Services and the Treasury was re-examining both the section 16EC(4)(b) and section 39E(1)(b)(i) issues as raised by the submissions.

The scope of the secretary’s re-examination would include exploring feasible options to address the concerns raised by the submissions, while also enabling Hong Kong to comply with the principles of tax symmetry and transfer pricing.

Principles of tax symmetry and transfer pricing referred to by the government

Tax symmetry

Using the above example for illustration, for tax symmetry the issue is whether the granting of the use of the IC Right by the taxpayer to the contract manufacturer royalty-free is for the purpose of generating (i) the manufacturing profits of the contract manufacturer in Mainland China which are not chargeable to tax in Hong Kong; or (ii) the trading profits of the taxpayer which are fully chargeable to tax in Hong Kong.

If the argument in (i) prevails, the principle of tax symmetry would require the IRD to disallow the tax deduction for the purchase cost of the IC Right under section 16EC(4)(b). Whereas if the argument in (ii) prevails, there may be no reason for applying section 16EC(4)(b) to disallow the tax deduction otherwise obtainable by the taxpayer under section 16EA.

Transfer pricing

Regarding transfer pricing, the issue is whether the taxpayer in the above example should charge the contract manufacturer royalties for the use of the IC Right, given that (i) the IC Right is used by the contract manufacturer solely for the production of goods for the account of the taxpayer; and (ii) any royalties so charged would likely be re-charged by contract manufacturer back to the taxpayer by way of a corresponding equivalent increase in the price of the goods charged by the contract manufacturer.

The concerns of the government are that if royalties have to be charged under the principle of transfer pricing, such royalty income of the taxpayer would normally be non-taxable, being sourced offshore Hong Kong given that the IC Right in question would be used in Mainland China. As such, the purchase cost of the IC Right would also need to be disallowed under the principle of tax symmetry referred to above.

In addition, the government is also apparently concerned that if tax deduction under section 16EA for the purchase cost of an IPR is granted in Hong Kong in situations like the above example, Hong Kong could be accused by overseas tax authorities of encouraging Hong Kong taxpayers not to charge their overseas contract manufacturers royalties. By so doing, Hong Kong taxpayers could then be argued to be avoiding their overseas withholding tax liabilities in respect of what would otherwise have been their royalty income, potentially undermining the taxing rights of the overseas tax authorities.

Commentary

In a recent case ATG v The Comptroller of Income Tax (CIT) [2011], heard by the Singapore Income Tax Board of Review, the tribunal ruled that plant and machinery consigned by a Singapore taxpayer to their contract manufacturers located outside of Singapore was for the purpose of generating the trading profits of the taxpayer which were taxable in Singapore, rather than generating the manufacturing profits of the contract manufacturers which were not taxable in Singapore.

Understandably, following the case, the Inland Revenue Authority of Singapore has since agreed to grant tax depreciation allowances to Singapore taxpayers in respect of plant and machinery consigned by Singapore taxpayers to their contract manufacturers located outside of Singapore.

The outcome of this case lends support therefore to the argument that in the above example, the taxpayer’s grant of the right to use the IC Right to the contract manufacturer is for the purpose of generating the trading profits of the taxpayer which are taxable in Hong Kong, rather than generating the non-Hong Kong taxable manufacturing profits of the contract manufacturer in Mainland China.

Thus, it appears that if Hong Kong is to follow the Singapore approach, section 16EC(4)(b) could be removed or suitably amended such that the tax deduction otherwise obtainable under section 16EA would not be denied, whilst at the same time not affecting Hong Kong’s desire to comply with the principle of tax symmetry.

Regarding the principle of transfer pricing, the issue appears to be academic given that any royalties charged by the taxpayer to the contract manufacturer in the above example would likely be offset by a corresponding increase in the prices of goods charged by the contract manufacturer to the taxpayer. In other words, it is unlikely that there would be any net additional payment or receipt between the taxpayer and the contract manufacturer – regardless of whether royalties are charged or not. The respective net profits or losses of the two parties in each jurisdiction would remain the same.

Nonetheless, the issue may still be whether such a single payment between the taxpayer and the contract manufacturer could or should be “unbundled” to the two constituent elements discussed. That is, to identify the income source and overseas  withholding tax liabilities of the “royalty income element” of the taxpayer “embedded” in the payment.

In this regard, there are views that, unlike an offsetting of two separate and distinct transactions, such an unbundling of the payment may not be warranted, given that the use of the IC Right in the example is an integral part of the single transaction relating to the supply of goods.

In addition, some tax practitioners in Hong Kong are of the view that, for Hong Kong tax purposes, the source of the “royalty income element” of the payment, if any exists, could also be regarded as being located in Hong Kong, given that it stemmed from part of the operations undertaken in Hong Kong by the taxpayer for securing the supply of goods traded in Hong Kong.

Also unlike granting tax incentives to attract geographically mobile businesses to Hong Kong, the decision of whether to grant a tax deduction for the purchase cost of an IPR used outside Hong Kong pursuant to a contract manufacturing arrangement, is purely a matter of how Hong Kong interprets and administers its own tax law.

As such, there would be no question of Hong Kong engaging in harmful tax practices by its application and interpretation of section 16EC(4)(b). Nor could the taxing rights of overseas tax authorities be undermined if the royalty income, actual or imputed, could be regarded as being sourced in the overseas jurisdictions concerned based on their own domestic tax laws.

Further to such views, granting a tax deduction under sections 16E or 16EA for the purchase cost of an IPR used outside Hong Kong pursuant to a contract manufacturing arrangement would not be against the principles of tax symmetry and transfer pricing.


Now that the new law has been enacted, taxpayers await with keen interest how the Secretary for Financial Services and the Treasury will take the above into consideration when he explores feasible options to resolve the controversial issues surrounding sections 16EC(4)(b) and 39E(1)(b).  


Jo An Yee is Tax Partner, Patrick Kwong is Executive Director and Kathy Kun is Tax Senior Manager at EY Tax Services