News Flash

Hong Kong Tax

The revised DIPN 42 provides

detailed guidance on the election for
financial instruments assessed on fair
value basis for tax purposes
June 22, 2020
Issue 10

In brief
On June 12, 2020, the Inland Revenue Department (IRD) published a revised Departmental Interpretation
Practice Notes No. 42 on Taxation of Financial Instruments and Foreign Exchange Differences 1 (the revised
DIPN). The revised DIPN was updated to reflect mainly the legislative changes brought about by the Inland
Revenue (Amendment) (No. 2) Ordinance 20192 (the Ordinance), which was enacted to allow taxpayers to
align the tax treatment of financial instruments with the commercial accounting principles, i.e. Hong Kong
Financial Reporting Standards (HKFRS) 9.

This news flash summaries the salient points in the revised DIPN concerning the adoption of fair value basis
for tax purposes. For a more detailed background of the Ordinance and the specific tax treatment of a financial
asset or liability, please refer to our Hong Kong Tax News Flash, March 2019, Issue 23.

In detail
Basis of assessable profits
Previously, the use of fair value accounting as a basis to compute and ascertain taxable profits was accepted
by the IRD as an interim administrative measure to alleviate taxpayers’ burden in recomputing their profits on a
realisation basis as laid down in the judgement of the Court of Final Appeal in Nice Cheer case4. Now, the
Ordinance was enacted to provide a legal basis for taxpayers to make a generally irrevocable written election
to adopt the fair value accounting for financial instruments for tax purposes, i.e., to align the tax treatment with
the ordinary commercial accounting principles.

Following the legislative amendments, the IRD published the revised DIPN to provide a detailed guidance to
taxpayers on how the new amendments apply in practice.

Tax assessment on fair value basis

• The option to elect for assessment on fair value basis is available to a taxpayer only if the taxpayer
prepares financial statements in accordance with a specified financial reporting standard, i.e., either
HKFRS 9, International Financial Reporting Standards (IFRS) 9 or a standard that is equivalent to IFRS 9.
Whether a standard is equivalent to IFRS 9 is a matter of fact and degree. In case the standard is not fully
identical to IFRS 9, adjustments have to be made to reconcile the accounting difference, e.g. generally
acceptable accounting principles (GAAP) to IFRS difference.

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• In general, where such election is made, the tax treatment of financial instruments will align with the accounting treatment,
i.e., tax relevant amount equals accounting relevant amount. The timing in recognition of profit, gain, loss, income or
expense under HKFRS 9 will normally be followed for tax purpose. In short, upon election for fair value basis, both realised
and unrealised profits or losses on a financial instrument will be taken into account when computing the taxable profits.

• Once the election to adopt fair value basis is made in a particular year of assessment, it is generally irrevocable. The same
basis should be applied for all subsequent years of assessment unless there is a good commercial reason and the
revocation is not driven by a tax avoidance motive, for example, to conform with the group’s tax reporting policy after a
business merger or acquisition.

• The revised DIPN elucidates the interaction between the newly enacted provisions with other provisions in the Inland
Revenue Ordinance. Those assessing practices on the source principle, the nature of a transaction (capital or revenue), all
deeming provisions and deduction rules in the previous version of the DIPN 42 continue to be applicable as set out in the
Appendix 2 to the revised DIPN.

• Particularly for the newly introduced conditions for tax deduction on an expected credit loss, the revised DIPN explained that
the application of section 18K(3) is not subject to the deduction rule for bad debts under section 16(1)(d). An impairment
loss is allowable for deduction if the specific conditions in section 18K(3)(a) or (b) can be satisfied and is credit-impaired at
the end of the year. That said, evidence to prove that a trade receivable is credit-impaired may be of a similar nature to that
of under section 16(1)(d).

• Echoing with our Hong Kong Tax News Flash, March 2019, Issue 23, the IRD has explained, in the revised DIPN, the
conditions of deeming an impairment loss previously allowed to the transferor (being a financial institution) as a taxable
trading receipt at the time of transfer. Subject to section 18K(6), where a credit-impaired loan is transferred to the transferee
(which is not in the business of money lending in Hong Kong) not by way of sale and the loss allowance is transferred to the
transferee upon the transfer, the IRD would consider that the loss allowance is not effectively written off by the transferor
and the impairment loss, being previously allowed to the transferor, would be clawed back.

The takeaway
We welcome the issuance of revised DIPN as it provides extensive explanations on the tax treatments of various financial
instruments accorded by the Ordinance with comprehensive examples.

The revised DIPN makes it clear that the option to elect for assessment under fair value basis is only available when the
financial statements are prepared in accordance with a specified standard that is fully identical to IFRS 9. For companies that
delay the adoption of HKFRS 9 (e.g. insurers) but wishing to adopt for a fair value basis for taxation purposes, they may still be
able to file the profits tax return for year of assessment 2019/20 on a fair value basis due to the temporary extension of interim
administrative measure announced by the IRD. Going forward, companies should take note of the revised DIPN and assess
carefully the costs and benefits of whether to adopt realisation basis or fair value basis for tax assessment purposes given the
election to adopt fair value basis is generally irrevocable.

Endnotes
1. The revised DIPN can be accessed via this link:
https://www.ird.gov.hk/eng/pdf/dipn42.pdf

2. The Ordinance can be accessed via this link:

https://www.gld.gov.hk/egazette/pdf/20192309/es1201923096.pdf

3. The Hong Kong Tax News Flash, March 2019, Issue 2 can be accessed via this link:
https://www.pwchk.com/en/hk-tax-news/2019q1/hongkongtax-news-mar2019-2.pdf

4. The Court of Final Appeal (CFA) handed down its judgment in the Nice Cheer Investment Ltd. v CIR on 12 November 2013. The CFA
dismissed the Commissioner’s appeal and upheld the decisions of the lower courts that unrealised revaluation profits recognised in
accounts prepared in accordance with the prevailing accounting standards are not taxable while unrealised losses of the taxpayer in this
case are deductible. A copy of the CFA’s judgement can be accessed via this link:
https://www.info.gov.hk/bor/en/docs/v28s_FACV_23_2012.pdf

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News Flash
Hong Kong Tax

Let’s talk
For a deeper discussion of how this impacts your business, please contact:

PwC’s Corporate Tax Leaders based in Hong Kong

Charles Lee Jeremy Ngai Jeremy Choi

+852 2289 8899 +852 2289 5616 +852 2289 3608
charles.lee@cn.pwc.com jeremy.cm.ngai@hk.pwc.com jeremy.choi@hk.pwc.com

Rex Ho Cecilia Lee Jenny Tsao

+852 2289 3026 +852 2289 5690 +852 2289 3617
rex.ho@hk.pwc.com cecilia.sk.lee@hk.pwc.com jenny.np.tsao@hk.pwc.com

Kenneth Wong
+852 2289 3822
kenneth.wong@hk.pwc.com

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Administrative Region, Macao Special Administrative Region and Taiwan Region.
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June 22, 2020 and were based on the law enforceable and information available at that time.
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long.ma@cn.pwc.com
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