THE HONG KONG POLYTECHNIC UNIVERSITY

AF3210 HONG KONG TAX FRAMEWORK

Unit 8 – Profits Tax (2): Calculation of Assessable Profits 1

Coverage
1 Accounting profits vs assessable profits
2 Capital vs revenue receipts
3 Capital vs revenue expenditure
4 General deduction rule: Section 16(1)
5 Specific deduction rule – Interest expense
6 Other specific deductible items under Section 16(1)

Learning Outcomes
After completing this unit, you should be able to:
• distinguish assessable profit versus accounting profit
• explain the principles distinguishing capital and revenue items
• identify capital receipts and revenue receipts
• identify capital expenditures and revenue expenditures
• explain the general deduction rule under section 16(1)
• determine the deductibility of expense under profits tax

1 ACCOUNTING PROFITS VS ASSESSABLE PROFITS

• Accounting Profits = Revenue – Expenses

• Based on generally accepted accounting principles
• In the Court of Final Appeal in CIR v Secan Ltd & Anor (2000)
– “Both profits and losses must be ascertained in accordance with the
ordinary principles of commercial accounting as modified to conform to
the Ordinance.”
• “Profits before taxation” in the financial statements is the starting point for
the calculation of assessable profit, subject to adjustments which are
required either under general rules or specific provisions of IRO

Profits before taxation per account

Add: Non-deductible expenses
Accounting depreciation
Taxable items not reflected in account

Less: Non-taxable income

Depreciation allowance
Deductible items not reflected in account

= Assessable profits

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2 CAPITAL VS REVENUE RECEIPTS

• Section 14(1) excludes profits arising from the sale of capital assets
• General test: Fixed capital vs Circulating capital test
- i.e. receipts are capital in nature if connected with fixed capital (fixed
assets) of the business but revenue in nature if connected with
circulating capital (current assets)
- Fixed capital is what a person turns to profit by keeping it in his
possession; circulating capital is what a person makes a profit of by
parting with it and letting it change masters, i.e. for resale purpose

• Relevant case decisions:

(1) Nature of asset lost
- Compensation received for loss of trading stock is of revenue nature
while compensation for loss of capital asset is of capital nature
[Green v J Gliksten & Son Ltd (1929)]

(2) Permanent or temporary loss

- Compensation received for permanent loss/destruction of a fixed
asset is a capital receipt [Glenboig Union Fireclay Co Ltd v CIR
(1922)]
- Compensation received for temporary loss of use of a capital asset,
or payment for loss of profits is a revenue receipt [Burmah Steam
Ship Co Ltd v CIR (1930)]

(3) Cancellation of contracts

- Compensation received for cancellation of a trading contract or one
of a number of agency contracts is a revenue receipt [Kelsall
Parsons & Co v CIR (1938)]
- Compensation received for cancellation of the only contract leading
to the cessation of business is a capital receipt [Barr Crombie & Co
Ltd v CIR (1945)]

3 CAPITAL VS REVENUE EXPENDITURE

• Section 17(1)(c) disallows any expenditure of a capital nature or any loss or

withdrawal of capital
• Section 17(1)(d) disallows the cost of any improvements
• General test: Fixed capital vs Circulating capital test
• Other tests:
(1) Once and for all test
“capital expenditure is a thing that is going to be spent once and for all,
and income (revenue) expenditure is a thing that is going to recur every
year.” [Vallambrosa Rubber Co Ltd v Farmer (1910)]

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 (2) Enduring benefit test
“when an expenditure is made, not only once and for all, but with a
view to bringing into existence an asset or an advantage for the
enduring benefit of a trade, there is a very good reason for treating such
an expenditure as properly attributable not to revenue but to capital.”
[Atherton v British Insulated & Helsby Cables Ltd (1926)]

• Relevant case decisions:

(1) Acquisition of business
– Cost of taking over a business is capital in nature [John Smith and
Son v Moore (1921)]

(2) Replacement of asset

– Expenses incurred in erecting a new structure ‘in its entirety’, or the
replacement of an entirety so that a new capital asset is created are
capital in nature [O’Grady v Bullcroft Main Collieries Ltd (1932)]
– Cost of removing and replacing a part of an entire asset is revenue
expenditure [Samuel Jones & Co (Devonvale) Ltd v CIR (1951)]

(3) Acquisition repairs

– Cost of initial repairs to improve a newly acquired asset to put it
into a usable condition is capital in nature [The Law Shipping Co.
Ltd v CIR (1923)]
– Cost of initial repairs to remedy normal wear and tear of a newly
acquired asset which is in working order is revenue in nature
[Odeon Associated Theatres Ltd v Jones (1971)]

(4) Dismissal of employee

– Payment to get rid of an unsatisfactory director is a normal revenue
expense [Mitchell v BW Noble Ltd (1927)]
– Payment to a retiring director for agreeing not to compete with the
company is capital expenditure as it would increase the company’s
goodwill by buying off potential competitors [Associated Portland
Cement Manufacturers Ltd v Kerr (1946)]

4 GENERAL DEDUCTION RULE – SECTION 16(1)

• Section 16(1): there shall be deducted all outgoings and expenses to the
extent to which they are incurred during the basis period for that year of
assessment in the production of profits chargeable to profits tax for any
period

• “to the extent”

- allow that part of expenditure related to the production of chargeable
profits only
- apportionment is permitted but only when reasonable, identifiable and
substantiable

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 • “incurred”
- not confined to a cash payment
- has a definite commitment or legal liability to pay
- excludes contingent liabilities

Banque Nationale de Paris Hong Kong Branch v CIR (1985)

- interest charged by the bank’s head office to the HK branch was
disallowed because:
- head office and branch was one and the same legal entity; no definite
liability for the HK branch to pay to the head office
- interest charge is only “notional expense”, not “incurred”

CIR v Secan Ltd & Anor. (2000)

- taxpayers constructed residential units for sale
- for units not yet sold, the interest expense paid during the construction
period was capitalized as “cost of property development for sale”, which
is an asset item put in the statement of financial position, but not as an
expense item put in the income statement
- expense not yet charged to the income statement, but recorded as an
asset according to the accounting principles is not regarded as “incurred”
- accounting principles followed unless they are inconsistent with the
IRO; interest so capitalized is not deductible till the stock is sold (when
the interest expense will be charged to the income statement)

• “in the production of chargeable profits”

- expenses must be made for the purpose of earning the profits
- necessary to look at the real intention for the expenses incurred
- not enough if only made in the course of the trade (e.g. fines and
penalties)
- expenses incurred in the production of non-taxable profits (e.g. capital
receipts or offshore profits) not allowable

CIR v Swire Pacific Ltd (1979)

- taxpayer going to cease business and would merge with another
company in a few months’ time
- workers went on strike and payments were made to end the strike in
order to get the workers back to work so that business continued
- expenses incurred “with a view to producing assessable profits” (i.e.
with the expectation of generating assessable profits) are deductible

CIR v Cosmotron Manufacturing Co. Ltd (1997)

- taxpayer ceased business and made severance payments according to
Employment Ordinance
- payments represented a discharge of statutory obligations incurred in the
running of the business, was already accrued as a cost of employing the
staff
- deductible even though the liability was only crystallised at the time of
cessation of the business

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5 SPECIFIC DEDUCTION RULE – INTEREST EXPENSE

5.1 Section 16(1)(a)

• Interest on money borrowed is deductible if:
1) for the purpose of producing chargeable profits;
2) satisfy any conditions under section 16(2); and
3) subject to the limitations in section 16(2A), (2B) and (2C)
• Also includes relating expenses such as legal fees, procuration fees and
stamp duty in connection with the borrowing

5.2 Section 16(2) – the conditions referred to in Section 16(1)(a)

(a) Money is borrowed by a financial institution

- “financial institution” is an authorised institution within the meaning
of section 2 of the Banking Ordinance, e.g. licensed bank and
deposit-taking company, including any associated corporation of
such an authorised institution
- there is no limitation on deduction

(b) Money is borrowed by a public utility company

- i.e. HK Electric, China Light & Power, and HK & China Gas
- interest not exceeding the rate specified by the Financial Secretary

(c) Money is borrowed from a person other than a financial institution

- interest received by the lender is chargeable to tax in Hong Kong

(d) Money is borrowed from a financial institution (local or overseas)

(e) Money is borrowed wholly and exclusively to finance

(i) capital expenditure on the provision of
- machinery or plant qualifying for depreciation allowance;
- machinery or plant for research and development;
- prescribed fixed asset;
- environmental protection machinery or environment-friendly
vehicle; or
(ii) the purchase of trading stock
and the lender is not an associate of the borrower

(f) Money is borrowed by a corporation by way of

(i) debentures (債權證) listed on a stock exchange in Hong Kong or
other stock exchange recognised by the CIR, or
(ii) other instruments (債務票據) issued
- bona fide in the course of carrying on business and is marketed
in Hong Kong or other major financial centre approved by the
CIR (e.g. New York, London, Singapore, Luxemburg, etc.); or
- pursuant to the authorization of the Securities and Futures
Commission under section 105 of the Securities and Futures
Ordinance

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 Where money is borrowed from an associated corporation which raises
the proceeds from such an issue, deduction is limited to the amount
payable by the associated corporation to debentures/ instruments holders

Summary of the conditions in section 16(2)

Sections Applicable situations Conditions
16(2)(a) Borrower is a financial Nil
institution
16(2)(b) Borrower is a public utility • Interest rate not exceeding a
company specified rate
16(2)(c) Lender is not a financial • Interest received is taxable in
institution Hong Kong;
• Subject to limitations under
S.16(2A) and (2B)

16(2)(d) Lender is a financial institution - Subject to limitations under

S.16(2A) and (2B)

16(2)(e) Purpose is for acquiring trading - Lender is not an associate;

stock or plant and machinery etc. - Subject to limitations under
S.16(2A) and (2B)
16(2)(f) Through issue of debenture or - Listed in recognized stock
other instruments exchange / marketed in
recognized financial centre;
- Subject to limitation under
S.16(2C)

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 The Inland Revenue (Amendment) (No. 2) Ordinance 2016 was
gazetted on 3 June 2016. It amended the Inland Revenue Ordinance
to give profits tax concession to qualifying corporate treasury
centres; to make provisions for profits tax purposes regarding
interests on money borrowed from or lent to associated corporations;
Lecturer’s and to treat regulatory capital securities as debt securities.
notes
Under the Amendment Ordinance, section 16(2)(g) was added under
which any corporation which carries on in Hong Kong a business of
borrowing of money from and lending of money to its associated
corporations can claim a tax deduction for interest paid to a non-
Hong Kong associated corporation provided that the following
conditions are satisfied:
(1) the money is borrowed in the ordinary course of that business;
(2) the lender is subject to tax overseas which is similar to Hong
Kong profits tax at a rate not lower than that in Hong Kong; and
(3) the lender’s right to use and enjoy that interest is not
constrained by a contractual or legal obligation to pass that
interest to any other person.

The claim for deduction will be subject to certain restrictions (interest

diversion test and loss shifting test). Details of these will be dealt
with in an advanced taxation course.

5.3 Sections 16(2A), (2B) and (2C) – Limitations on deduction

• Secured loan test – Section 16(2A)

- Applicable to a loan under section 16(2)(c), (d) or (e)
- Restriction on interest expense deduction applies if:
o the loan is secured by a deposit or a loan made by the borrower or its
associate with/to the lender, a financial institution, an overseas
financial institution, or its respective associate, and
o the interest on such deposit/loan is not taxable in Hong Kong
- Deduction is to be reduced by an amount calculated on the most
reasonable and appropriate basis, having regard to the amount of interest
income arising from the deposit/loan

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 Illustration
Source: DIPN No. 13A

Borrowings Securities (Collateral) Deduction Interest

Case reduced
Interest Interest allowed
Loan Deposit Shares by
expense income*
1 1,000,000 50,000 1,000,000 - 40,000 40,000 10,000
2 1,000,000 50,000 500,000 500,000 20,000 20,000 30,000
3 1,000,000 50,000 2,000,000 - 80,000 40,000 10,000
(80,000 x
1m / 2m)
4 1,000,000 50,000 1,000,000 500,000 40,000 26,667 23,333
(40,000 x
1m /1.5m )

* Assume that interest income on deposit is not taxable because it is sourced outside Hong Kong

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 • Interest flow-back test – Section 16(2B) and (2C)
- Applicable to a loan under section 16(2)(c), (d) or (e), and debentures/
instruments under section 16(2)(f)
- Restriction on interest expense deduction applies if there is an
arrangement in place whereby interest payment is ultimately paid back
to the borrower (issuer) or a connected person, except that:
o interest income is taxable in Hong Kong;
o interest is payable to financial institution, public body, member of
recognised retirement scheme, body corporate owned by
Government, etc. (“excepted persons”); or
o in the case of debenture/debt instrument, the connected person is a
market maker holding securities in the ordinary course of business
(section 16(2G))

Note: Loan sub-participation: an arrangement under which a person who

buys the equitable right of the loan from the original lender will has the
right to receive the principal repayment and interest payment. The legal
owner is still the original lender.

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 - Partial deduction is allowed if only part of the interest payment flows
back to the borrower or to a connected person
- Apportionment will be made by reference to the portion of loan assigned
to or sub-participated by the borrower or connected person that
generates the interest flow-back, and the length of time in which such
arrangement is in place

Illustration

Debenture listed on Singapore stock exchange: $10,000,000

Interest expense (per year): $1,000,000
Debenture held by an associate: $8,000,000

Interest disallowed: $1,000,000 x 8/10 = $800,000

Allowable interest: $1,000,000 - $800,000 = $200,000

If the associate only held the debenture for 6 months, interest to be

disallowed will be time-apportioned: $800,000 x 6/12 = $400,000.

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 • “Associate” – Depending on whether the borrower is an individual,
partnership or a corporation, an associate includes the parents, spouse,
child, brother or sister (whole or half blood, adopted or step), partner,
shareholder, director, “associated corporation” of the borrower

• “Associated corporation” (AC) –

- a corporation over which the person has control;
- a corporation which has control over the person; or
- a corporation which is under the control of the same person as the
borrower

Borrower AC Controlling Co.

Control Control Control

AC Borrower Borrower AC

“Control” means the power of a person to ensure that the affairs of the
corporation are conducted in accordance with its wishes, may be by
holding of shares or possessing voting power, or through power
conferred by the articles of association

• Person connected with the borrower –

- an associated corporation of the borrower
- a person (other than a corporation)
o who controls the borrower;
o who is controlled by the borrower; or
o who is under the control of the same person as the borrower

6 OTHER SPECIFIC DEDUCTIBLE ITEMS UNDER SECTION 16(1)

6.1 Section 16(1)(b) - Rent

• Deduction of rent paid in respect of land or buildings occupied for
producing chargeable profits
• For rent paid to a taxpayer’s spouse or by a partnership to any partner or his
spouse, deduction is restricted to the assessable value of the property

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6.2 Foreign Tax

6.2.1 Section 16(1)(c) - Foreign Tax Paid on Interest-type Income

• Deduction allowed for foreign tax paid in respect of interest income, gains
or profits from sale of certificate of deposit or bill of exchange, etc. (deemed
to be taxable under section 15(1)(f), (g), (i), (ia), (ib), (j), (k), (l), (la) or
(lb)), where the foreign tax is substantially the same nature as Hong Kong
profits tax
• Effective from the year of assessment 2018/19, deduction does not apply if
tax is paid in a DTA territory and a Hong Kong resident will be allowed a
tax credit under section 50 in accordance with the DTA (section 16(2J))

6.2.2 Section 16(1)(ca) – Foreign Tax Paid on Other Types of Income

• Newly enacted in June 2021
• Effective from the year of assessment 2021/22, for foreign taxes which is of
substantially the same nature as Hong Kong profits tax and is charged on a
gross income basis on other types of income (i.e. without deduction of
expenses, such as royalties, licensing fees, management or service fees), a
Hong Kong resident may:
- deduct foreign tax if paid in a non-DTA territory, or
- be allowed a tax credit if paid in a DTA territory

6.2.3 Other Foreign Taxes and Duties

• Other foreign taxes and duties which are not calculated by reference to
profits or income (e.g. goods and services tax, value added tax) can be
deducted under section 16(1) as per DIPN No. 28 (revised July 2019)

6.3 Section 16(1)(d) - Bad Debts

• Debts incurred in any trade proved to the satisfaction of assessor to have
become bad during the year (proof: recovery actions have been taken to
chase the debts but in vain), provided that the debts are:
- previously included as taxable trading receipts, or
- in respect of money lent in the ordinary course of a money lending
business carried on in Hong Kong (proof of a money lending business
includes: money lender license, organised set-up, frequency of similar
transactions, scope of activities mentioned in the Memorandum and
Article of Association, etc.)
• Subsequent recovery of bad debts previously allowed for deduction is
taxable in the year of recovery
• General provision, which is ascertained based on rough estimation without
sufficient documentary evidence, is not regarded as “incurred”
• Specific provision for doubtful debts, which is ascertained based on detailed
rules and supporting documents, is regarded as “incurred” because the
provision amounts to an accrued liability, whether legal or practical, and is
an accurate measured liability

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6.4 Section 16(1)(e) - Repairs
• Expenditure incurred in the repair of any premises, plant, machinery,
implement, utensil or article employed in the production of chargeable
profits
• Should not be improvements on the assets nor an entirety of the asset

6.5 Section 16(1)(f) - Replacement

• Expenditure incurred in the replacement of any implement, utensil or article
employed in the production of chargeable profits
• Under IRR 2, “implement, utensil or article” includes kitchen utensils, loose
tools, soft furnishing (such as curtains and carpets) and medical instruments
• Initial purchase not allowed and also not entitled to depreciation allowances

6.6 Section 16(1)(g) - Registration

• Sum expended for the registration of trade mark, design or patent used in the
production of chargeable profits
• Effective from the year of assessment 2018/19, deduction extended to plant
variety right

Reading
Wong & Wong: ¶6-3500 – 6-3720, 6-4600 – 6-5260, 6-6120
Ho & Mak: Chapter 17-19
DIPN No. 13A and 28

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