Hong Kong Tax Alert: 26 October 2012
Source of interest income on loans where no fund movements are involved
Clients should seek professional tax advice where necessary.
In their 2012 annual meeting with the CIR, representatives of the HKICPA also posed a question on the source of interest income on loans created as a result of an offsetting transaction not involving any fund movements. The question posed is depicted in the following diagrams.
Company X originally made a loan of $100 (Loan 1) to Company Z. Subsequently, Loan 1 was extinguished as a result of an offsetting transaction. Under the offsetting transaction, a new company, Company Y then owed Company X $100 (Loan 2) and Company Z now owed Company Y $100 (Loan 3). The question asked was: what is the source rule for determining the interest income on Loan 2 and Loan 3?
In reply, the CIR noted that the above offsetting transaction was not a straightforward loan transaction and may even raise the question of whether Loan 2 and Loan 3 were real loans. In this regard, the CIR noted that there were no fund movements in respect of Loan 2 and Loan 3, and Company Y was in effect indebted to Company X in respect of a sum previously lent to Company Z. The CIR also considered that the legal effect and consequences of such new “loan” arrangements were not clear.
Given the circumstances, the CIR took the view that in any event the “provision of credit” test would not be applicable. Instead, given the complexity of the offsetting transaction, the CIR considered that the “operations test” should be applied.
The CIR noted that under the “operations test”, all the relevant facts would have to be taken into account in order to determine the source of the interest income on Loan 2 and Loan 3. These factors would include the nature of business carried on by the parties involved, how the transactions were in fact carried out, and what were the contractual terms of the loans etc.
The above situations illustrate that determining the source of interest income could be a complicated matter in many circumstances. Clients should seek professional tax advice where necessary.