Determining the source of interest income could be a complicated matter in many circumstances.

This alert discusses the views recently expressed by the Inland Revenue Department (IRD) in regard to the application of the “provision of credit” test for determining the source of interest income on bonds acquired in the secondary market, on assigned loans, and in respect of certain offsetting transactions.

The IRD has in practice for a long time applied the “provision of credit” test for determining the source of interest income earned in respect of a simple loan of money by taxpayers not carrying on a business of money lending.

The “provision of credit” refers to the place where the loan proceeds were first made available to the borrower.

As an example, under the “provision of credit” test, where a lender first credits the loan proceeds of a simple loan of money to a bank account maintained outside Hong Kong by the borrower, the interest income earned by the lender would be accepted as non-taxable offshore income in Hong Kong. This would be the case regardless of the place where the loan agreement was entered into, or where the borrower subsequently used the loan proceeds etc.

A simple loan of money generally refers to a person lending their own surplus funds to a borrower, i.e., the loan does not involve the person first borrowing the money to on-lend. Where the loan is not a simple loan of money but involves a borrowing and on-lending of the money, the applicable test for determining the source of interest income would generally be the “operations test” instead.

The “operations test” would look at all the relevant operations of the person, including the person’s operations for the borrowing and on-lending of the money.

While the “provision of credit” test may look simple, its application to determine the source of interest income on bonds purchased by a person in the secondary market may not be that straightforward. The following diagram illustrates the issues involved.

In response to the question posed above, the IRD has previously indicated that where the bond purchaser and similarly any subsequent bond purchasers are not trading in bonds, each of these bond purchasers is effectively only substituting for the original bond subscriber. As such, the source of interest income on the bonds earned by the each of these subsequent bond purchasers would still be governed by the location of the “provision of credit” of the original bond issue.

In the above example, the interest income earned by the subsequent bond purchaser would therefore be accepted as non-taxable offshore income by virtue of the subscriber first making available the subscription proceeds of the bonds to the issuer outside Hong Kong. This would be the case regardless of the location where the subscriber received the consideration for the sale of the bonds from the subsequent bond purchaser.

Where a subsequent bond purchaser carries on a business of buying and selling of bonds, interest on bonds would however be regarded as forming part of the profits from the bond trading business. As such, the “operations test”, i.e., looking at the place where the relevant profit generating activities took place, including the place of acquisition of the bonds, instead of the “provision of credit” test would apply to determine the source of the interest income.

Similarly, in his 2012 annual meeting with representatives of Hong Kong Institute Certified Public Accountants (HKICPA) held earlier this year, the Commissioner of Inland Revenue (CIR) further indicated that where a loan of money is assigned by the original lender to an assignee, the interest income of the assignee in respect of the assigned loan would still generally be governed by the location of the “provision of credit” of the original loan. This would apply to the situation where the assignee does not carry on a business of borrowing and lending of money or other financing business.

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