Inland Revenue Department
Hong Kong
DEPARTMENTAL INTERPRETATION AND PRACTICE NOTES NO. 22 (REVISED)
COMPUTATION OF ASSESSABLE PROFITS FROM
CINEMATOGRAPH FILMS, PATENTS, TRADEMARKS, ETC.
These notes are issued for the information and guidance of taxpayers and their authorised representatives. They have no binding force and do not affect a person’s right of objection and appeal to the Commissioner, the Board of Review or the Courts.
These notes replace those issued in July 2003.
LAU MAK Yee-ming, Alice Commissioner of Inland Revenue
January 2005
Our web site : www.ird.gov.hk
DEPARTMENTAL INTERPRETATION AND PRACTICE NOTES
No. 22 (REVISED)
CONTENT
Paragraph
Introduction
1
Amendments to section 21A
Inland Revenue (Amendment)(No.4) Ordinance 1993
5
How the 1993 amendments addressed the situation
8
Revenue (No.2) Ordinance 2003
11
The Inland Revenue (Amendment) Ordinance 2004
12
Application of section 21A
15
Advance rulings
21
INTRODUCTION
Section 21A, along with a number of other provisions, was introduced by the Inland Revenue (Amendment) Ordinance 1971 to implement recommendations of the Second Inland Revenue Review Committee. The purpose of introducing the section and related section 15(1)(a) and (b) was to ensure that certain sums which arise from or in connection with business activity in Hong Kong are chargeable to tax here and to prescribe the percentage to be taken as assessable profits. The relevant categories of receipts are specified in section 15(1)(a) and (b), and in broad terms they cover royalties and licence fees for the use of or right to use in Hong Kong certain industrial and intellectual property. More particularly, the receipts comprise sums, not otherwise taxable, received by or accrued to a person from the exhibition or use in Hong Kong of cinema or television film or tape, any sound recording, or any advertising material connected with such items [section 15(1)(a)] and for the use of or right to use in Hong Kong any patent, design, trademark, copyright material, secret process or formula or similar property, or for imparting or undertaking to impart knowledge connected with such items [section 15(1)(b)]. 2. Initially, section 21A provided that the assessable profits of a person in respect of a sum deemed by section 15(1)(a) or (b) to be a receipt arising in or derived from Hong Kong from a trade, profession or business carried on in Hong Kong, were taken to be 10% of that sum, in all cases. However, subsequent amendments to the section, resulting from the enactment of the Inland Revenue (Amendment)(No. 4) Ordinance 1993 and the Revenue (No. 2) Ordinance 2003, altered that position. These amendments are further discussed in paragraphs 5 to 11 below. 3. Following the enactment of the Inland Revenue (Amendment) Ordinance 2004, a further deeming section i.e. section 15(1)(ba) was introduced and section 21A was correspondingly expanded to cover receipts under section 15(1)(ba). The method of computing assessable profits under section 21A, however, remains unchanged. 4. The purpose of introducing section 15(1)(ba) is to bring into charge sums, not otherwise taxable, received by or accrued to a person for the use of or right to use outside Hong Kong any patent, design, trademark, copyright material, secret process or formula or other property of a similar nature, or for
imparting or undertaking to impart knowledge connected with such items, which are deductible in ascertaining the assessable profits of a person for the purpose of Profits Tax. These amendments are further discussed in paragraphs 12 to 14 below.
AMENDMENTS TO SECTION 21A Inland Revenue (Amendment)(No. 4) Ordinance 1993 5. The 1993 amendments were introduced to counter attempts made by a number of Hong Kong companies to exploit section 21A by entering into arrangements with overseas associates. 6. Typically, a section 21A “scheme” involved a Hong Kong company making use of a trademark it had developed “in-house”. Whilst it retained ownership of the trademark, it did not incur any deductible expense in respect of its use. The usual approach was for the Hong Kong company to enter into a “sale and licence back” arrangement with a subsidiary incorporated offshore (e.g. in the British Virgin Islands). The Hong Kong company transferred ownership of property of a kind referred to in section 15(1)(a) or (b) to the offshore subsidiary which then granted back to the Hong Kong company, for a substantial royalty or fee, the right to continue to use the property in Hong Kong. The objective for tax purposes was for the Hong Kong business to obtain a deduction under section 16(1) of the Ordinance, for the full amount of the royalty or fee paid, with the offshore subsidiary being taxed under section 21A on only 10% of the sums it received. In other words, funds remained within the group, but a 90% deduction was created in respect of the royalties or fees involved. 7. Although the general anti-avoidance provision of the Ordinance, section 61A, can be invoked, and indeed has been used, to strike down schemes directed at exploiting section 21A, it will be a time-consuming and expensive exercise to argue its application in every case. In order to provide certainty to both Taxpayers and the Revenue, and in accordance with the Government’s commitment to close avenues for avoidance, the Financial Secretary proposed in his March 1993 Budget Speech that section 21A should be amended.
2
How the 1993 amendments addressed the situation 8. Exploitation of the section arose because relevant sums were generally fully deductible to the payer, whereas in the hands of the recipient, by virtue of then section 21A (which contained no reference to the relationship of the parties involved), only 10% was treated as assessable profits. The fact that it was a relatively simple matter for a Hong Kong group to incorporate a subsidiary outside Hong Kong and to ensure that the subsidiary did not carry on business in Hong Kong was also pertinent. 9. The amendments addressed the situation by providing that where a payment was derived from an associate, the general position was that 100% of the amount of the payment (i.e. no deduction for expenses), rather than 10% of it, would be treated as assessable profits. 10. However, the straightforward application of the 100% rate would be restrictive, in the sense that if the 100% rate were to apply to all payments to associates, it could have an adverse bearing on the importation of technology into Hong Kong by multinational groups. In the absence of any indication that section 21A had been exploited by multinationals in respect of technology developed overseas, a provision was added to exclude the relevant payments from the application of the 100% rate under a certain circumstance. By virtue of the proviso to section 21A(1)(a), the relevant amendment provided that the 100% rate would not apply in respect of any sum derived from an associate “where the Commissioner is satisfied that no person carrying on a trade, profession or business in Hong Kong has at any time wholly or partly owned the property in respect of which the sum is paid”. In such cases, and also where a relevant sum was derived from a person who was not an associate, the 10% rate would continue to apply. Revenue (No. 2) Ordinance 2003 11. The 2003 amendments were proposed in the Financial Secretary’s March 2003 Budget Speech and enacted in July 2003. The amendments have the effect of increasing the assessable profits deeming rate from 10% to 30% for payments which come within the scope of section 21A and are not subject to the 100% rate. The new rate of 30% applies to sums received or accrued on or after 1 April 2003. However, if the sum accrues before that date but is received on or after that date, the old rate of 10% would still apply.
3
The Inland Revenue (Amendment) Ordinance 2004 12. In view of an unfavourable court decision, a new section 15(1)(ba) was enacted in 2004 to enable this Department to continue a long-standing and hitherto widely accepted assessing practice in respect of royalty payments. This new section deems as the recipient’s chargeable profits sums for the use of or right to use outside Hong Kong any of the intellectual properties enumerated in section 15(1)(b), which are deductible expenses in ascertaining a person’s chargeable profits. The section does not apply to sums received or accrued before 25 June 2004. 13. The need of the 2004 amendments stemmed from the Court of Final Appeal decision in CIR v. Emerson Radio Corporation [1999] 5 HKTC 122. The decision was inconsistent with this Department’s interpretation of section 15(1)(b) held since its enactment in 1971. Prior to the Emerson case, this Department had all along taken the view that an intellectual property right was “used in Hong Kong” for the purpose of section 15(1)(b) if the payer carried on a business in Hong Kong and used the property right to produce chargeable profits, irrespective of where the goods concerned were manufactured or sold. The Court of Final Appeal however held in Emerson that only royalties relating to goods manufactured in Hong Kong could be chargeable to tax under section 15(1)(b) and royalties paid in respect of goods manufactured outside Hong Kong were not chargeable. Given that most of our manufacturing base has been relocated outside Hong Kong, the decision might lead to a significant loss of revenue in terms of Profits Tax because the royalty payment would be tax deductible on the part of the payer but tax exempt in the hands of the non-resident recipient. 14. The new section 15(1)(ba) therefore maintains a tax symmetry to avoid possible loss of revenue and is consistent with the original legislative intent of section 15(1)(b). It is noted that similar provisions for royalty payments are adopted by other jurisdictions to protect revenue. The 2004 amendments also expanded the scope of section 21A such that it does not only apply to sums deemed to be taxable under section 15(1)(a) and (b) but also those under section 15(1)(ba).
4
APPLICATION OF SECTION 21A 15. Generally, payments to which section 21A applies are derived by non-residents. Where this is the case, section 20B of the Ordinance provides for the assessment and collection of the tax due. Departmental Interpretation and Practice Notes No. 17 discusses the relevant provisions and, in particular, the taxation responsibilities of persons in Hong Kong who may be chargeable to Profits Tax on behalf of such non-residents. 16. As far as the payer is concerned, the amendments made in 1993, 2003 and 2004 to section 21A have not affected the deductibility of royalty payments etc. The issue of deductibility continues to be determined in accordance with the terms of section 16(1) of the Ordinance. 17. With regard to section 21A, in considering whether the assessable profits in respect of a relevant sum should be taken to be the lower rate (i.e. 10% or 30%, as the case may be) or 100%, the first question to be determined is, of course, whether the sum was derived from an associate. The term “associate” is defined widely in section 21A(3) in order to prevent circumvention of the provisions by the interposition of third parties. For the purpose of ascertaining whether a sum was derived from an associate, regard must also be had to section 21A(2), which covers the situation where a sum is derived from or by a trustee of a trust estate or a corporation controlled by such a trustee. In such cases, the sum is deemed to have been derived from, or by, as the case may be, each of the trustee, the corporation and the beneficiary under the trust. 18. The provisions concerning associates, and the related definitions in section 21A(3) of “associated corporation”, “beneficiary under the trust”, “control”, “principal officer” and “relative”, are along similar lines to those contained in sections 16E and 39E of the Ordinance. 19. Where, having regard to the relevant provisions of section 21A, it is concluded that a sum was not derived from an associate, the lower rate is applied to the sum in order to determine the assessable profits. However, where the sum has been derived from an associate, 100% must be treated as assessable unless “the Commissioner is satisfied that no person carrying on a trade, profession or business in Hong Kong has at any time wholly or partly
5
owned the property in respect of which the sum is paid”. In this regard, the Department accepts that “owned” refers to direct ownership. For example, although a shareholder is a proportionate owner of a company, the shareholder does not own the assets of the company – they are owned by the company itself as a separate and independent legal entity. 20. If a sum is to be paid to an associate and either the person responsible for making the payment or the recipient considers that the ownership history of the relevant property is such that the Commissioner would be “satisfied” in terms of the proviso referred to above, confirmation may be obtained by way of an advance ruling from the Commissioner as to whether the lower rate is applicable. It should, however, be noted that rulings will not be provided in respect of hypothetical situations.
ADVANCE RULINGS 21. In addition to providing the information and documents listed in paragraph 15 of Departmental Interpretation and Practice Notes No. 31 (“Advance Rulings”), a request for an advance ruling concerning the application of section 21A should comply with the following requirements (a) The request must be signed by the person responsible for making the payment (“the payer”), the person who owns the relevant property (“the taxpayer”), or by the authorised representative of either party. (b) A copy of the agreement under which the taxpayer acquired the property and a statement of the reasons for acquisition should be submitted. (c)
A copy of the agreement under which the payment is to be made should be submitted.
(d) If the property is not wholly owned by the taxpayer, details should be provided of other owners, their respective interests in the property and, if an associate, the nature of the relationship with the taxpayer.
6
(e)
A statement should be provided of the full ownership history of the property. If for some reason it is not possible to provide a full history of the ownership, an explanation should be provided with the application. In any event, where a previous owner was, or is, an associate of the taxpayer, details should be included of the nature of the relationship.
(f)
A declaration, signed by both parties, is required to the effect that, to the best of the knowledge of the taxpayer and the payer, no person carrying on a trade, profession or business in Hong Kong has at any time wholly or partly owned the relevant property.
22. Given the nature of the property involved, cases with a complicated history of ownership should be the exception rather than the rule. The current owner obviously should know the details of the party, if any, from whom the property had been purchased. In many cases, relevant property would have been developed by the current owner and, as such, there would not be a previous owner. 23. Generally where the information referred to above is provided, it should be sufficient to allow a ruling to be made. In such cases, it will be issued in letter form signed by the Commissioner or an authorised officer. In some cases, however, it may be necessary for the Department to seek further information from the taxpayer or a third party before a ruling can be given. 24. A case by case approach will be adopted by the Department in relation to the issue of rulings. Accordingly, a ruling given in one case should not be regarded as requiring the Department to issue a like ruling in a subsequent similar case.
7
