Hong Kong Tax Alert: 31 October 2013
Whether a discount on a note was in the nature of interest and were the notes “marketed”?
The scenario posed by the HKICPA involved a note with a face value of $100 on maturity being originally issued at a discounted price of $90.
The HKICPA apparently took the view that while the discount of $10 (i.e., $100 - $90) was compensation paid by the note issuer for its time use of the money involved, and therefore a revenue expense incurred by the issuer, the discount was not technically interest for the purposes of sections 16(1) and 16(2) of the IRO. The technical position taken by the HKICPA was that the discount, unlike interest, was not ascertained by reference to the sum of money due (i.e., the discount of $10 was not ascertained by reference to the $100 owed by the note issuer to the holder on maturity).
In this regard, the HKICPA also referred to the stated position of the UK Revenue of not treating such discount as interest for the purposes of applying interest withholding tax in the UK.
In reply, the IRD advised that in general terms, “interest” was the return or consideration or compensation for the use or retention by one person of a sum of money belonging to, or owed to another person. The IRD added that what constituted interest was a question of legal substance and not terminology.
The IRD further advised that the UK Revenue’s practice referred to by the HKICPA only related to withholding tax. The UK Revenue in fact treated discount as interest for corporation tax purposes.
The IRD noted that in the scenario posed, there was a debt, i.e., the note. The issue price was the sum of money by reference to which the payment, be it called interest or not, was to be ascertained. Furthermore, the sum was due to the person who was entitled to receive the face value of the note on maturity.
The IRD therefore took the view that such a discount was in the nature of interest. The IRD also noted that to be tax deductible under section 16(1) of the IRO, the note proceeds had to be employed to generate profits which were chargeable to tax in Hong Kong. In addition, because the discount was in the nature of interest, the note issuer would need to meet the restrictive conditions for deduction of interest specified in section 16(2) in order to claim a the deduction for the discount.
The IRD also commented on one of the restrictive conditions for deduction of interest most relevant to note issuers specified in section 16(2), namely section 16(2)(f) of the IRO.
Under section 16(2)(f), interest on notes, other than debentures listed on a Hong Kong or recognized overseas stock exchange, would be deductible if the notes are issued bona fide and in the course of carrying on business and “marketed” in Hong Kong or in a major recognized financial centre outside Hong Kong.
The HKICPA however expressed concern as regards what constituted notes being “marketed” for the purposes of section 16(2)(f). The HKICPA noted that DIPN 13A indicates that in determining whether notes are marketed, the IRD would consider a long list of factors, e.g., whether road-shows or meetings with potential investors are undertaken by an issuer before the issuance of the notes and whether the notes are rated by reputable credit rating agencies etc. The HKICPA commented that where a placement of notes was limited to a couple of institutional investors, the marketing efforts might be insignificant and did not feature many of the factors specified in DIPN 13A.
In response, the IRD considered that the requirement in section 16(2)(f) that the relevant notes be “marketed” could not be problematic to taxpayers since the provision, which was anti-avoidance in nature, was targeted at round-robin schemes. The IRD added that it would not be a problem if the notes themselves were marketable instruments.
Clients should note the IRD’s latest views on the above issues and review their tax positions accordingly. For example, the IRD’s change in approach to determining the tax residence of an overseas bank with a branch in Hong Kong may necessitate a review of whether the jurisdiction of which the overseas bank as a whole is a tax resident has a CDTA with mainland China which offers tax benefits similar to those under the HK-mainland China CDTA.
The IRD’s stated applicable source rules for brokerage commission in respect of transactions executed electronically and for interest earned on overseas listed bonds may affect the year-end tax provisioning position of clients.
To be welcomed is the IRD’s position that section 16(2)(f), being an anti-avoidance provision, primarily targets round-robin schemes. As such, section 16(2)(f) should not affect a genuine private placement of notes which does not require significant marketing efforts.
All issues discussed in this alert are complicated matters and clients should seek professional tax advice where appropriate.