Hong Kong Tax Alert: 10 October 2013
Deductibility of payments for sub-contracted research and development
This alert discusses the views recently expressed by the Inland Revenue Department (IRD) as regards the deductibility of expenditure incurred on research and development (R&D) activities undertaken by a subsidiary for a parent; and in a group cost sharing arrangement.
Given the IRD’s interpretation of the relevant legislative provisions explained in this alert, the scope for a tax deduction for expenditure incurred on sub-contracted out R&D activities appears to be very limited.
With a view to enhancing the deductibility of relevant expenditure, clients who have incurred or will incur significant costs in respect of sub-contracted out R&D activities should review their tax position and consider the scope for amending their R&D arrangements where these involve group companies.
The issues involved are complicated and clients should seek professional tax advice where necessary.
Legislative provisions in respect of R&D expenditure
R&D expenditure, normally incurred with a view to developing new products and improving existing production methods, is generally regarded as being capital in nature. As such, R&D expenditure is disallowed under section 17(1)(c) of the Inland Revenue Ordinance (IRO). Nonetheless, section 16B (1) of the IRO specifically provides for a tax deduction for certain R&D expenditure and reads as follows:
“Notwithstanding anything in section 17, in ascertaining the profits from any trade, profession or business in respect of which a person is chargeable to tax …there shall… be deducted the following payments made, and expenditure incurred, by such person…namely –
(a) Payment to
(i) An approved research institute for research and development related to that trade, profession or business
(ii) An approved research institute, the object of which is the undertaking of research and development related to the class of trade, profession or business to which that trade, profession or business belongs
(b) Expenditure on research and development related to that trade, profession or business …”
In the 2011 annual meeting between representatives of the IRD and the Hong Kong Institute of Certified Public Accountants (HKICPA), a question was raised on how section 16B(1) quoted above should be interpreted. In particular, the HKICPA sought the IRD’s view on whether a person could claim a deduction under limb (b) of section 16B(1) in respect of R&D expenditure incurred by way of appointing a service provider to carry out the relevant R&D activities. The scenario posed by the HKICPA was that the service provider was not an approved research institute specified under limb (a) of section 16B(1), but performed the R&D activities for the person under instructions and guidelines provided by the person.
In reply, the IRD adopted a narrow interpretation of section 16B(1) such that only expenditure incurred on in-house R&D activities undertaken by the person themselves qualify for the tax deduction. As a result, because the scenario outlined by the HKICPA involved R&D activities which were sub-contracted out, and the service provider was not an approved research institute, the IRD indicated that the R&D expenditure would not be tax deductible under section 16B(1).
Nonetheless, the IRD added that where a minor part of the R&D activities was sub-contracted out, e.g. certain laboratory tests, the overall R&D activities might still be regarded as being undertaken by the person themselves – the issue being a matter of fact and degree.