Interpretation of relevant law and practice and the presentation of evidence are key to tax dispute.
A recent decision D32/12 of the Board of Review (BOR) involved a taxpayer disputing that income derived from certain derivative contracts including equity-linked notes, gains on the disposal of overseas and locally listed securities, and revaluation gains in respect of available-for-sale securities, were taxable in Hong Kong.
The non-taxable claims were made on the basis that the income was either offshore sourced, capital in nature, or represented an unrealized profit.
The BOR held that the revaluation gains in respect of available-for-sale securities were unrealized profits not chargeable to tax in Hong Kong. However, based on the BOR’s interpretation of the applicable law, or on the grounds that the taxpayer did not produce any creditable or persuasive evidence, the BOR dismissed the taxpayer’s non-taxable claims in respect of other items.
Tax dispute is by its nature a complicated matter and clients should seek professional tax advice where necessary.
For the relevant years of assessment, the taxpayer carried on an investment holding business in Hong Kong. The Commissioner of Inland Revenue (CIR) determined that gains derived by the taxpayer from transactions in certain securities and derivative contracts, including equity-linked notes (ELNs), were chargeable to Profits Tax in Hong Kong. Not satisfied with the CIR’s determination, the taxpayer appealed to the BOR.
We summarize below the BOR’s decision on the main issues of the case.
Income derived from ELNs and other derivative contracts
The following example illustrates the terms and features of the ELNs in question:
An ELN with a nominal value of HK$3,000,000 was issued at a discount at HK$2,900,000 on 1 April 2013 by an overseas bank with a branch in Hong Kong. The maturity date of the ELN is 30 June 2013. The underlying shares to which the ELN is linked is Company A’s listed shares and the strike price is HK$100.
If the closing price of Company A’s listed shares on the maturity date is HK$110 (i.e., above the strike price of HK$100), the holder will receive HK$3,000,000, being the nominal sum of the ELN. As a result, the holder will get a return of HK$100,000 (i.e., HK$3,000,000 – HK$2,900,000) on the ELN.
However, if the closing price of Company A’s listed shares on the maturity date is HK$90 (i.e., below the strike price of HK$100), the holder will not receive the nominal value of the ELN in cash. Instead, the holder will receive 30,000 units of Company A’s listed shares valued at the strike price of HK$100 each (i.e., HK$3,000,000 / HK$100) from the bank in settlement of the ELN. As a result, the holder will suffer a loss of HK$200,000 on the ELN since the true market value of the shares on the maturity date will only be HK$2,700,000 (i.e., 30,000 units x HK$90).
In respect of one of its ELNs with the above illustrated terms, the taxpayer obtained a return of HK$100,000 because the closing price of the underlying shares on the maturity date of the ELN exceeded the strike price.
The taxpayer contended that the return of HK$100,000 was in the nature of interest and the source rule for determining the taxability of the “interest” income on the ELN should be the “provision of credit” test. The taxpayer argued that since the monies were first made available to the bank outside Hong Kong, the “interest” of HK$100,000 should be non-taxable offshore income under the “provision of credit” test. The taxpayer contended that this was the case regardless that it was the Hong Kong branch of the overseas bank that sold the ELN to the taxpayer.
The BOR however accepted the counter-argument of the CIR that given the terms of the ELN, it could not be said that the taxpayer was advancing a sum of money to the bank in return for interest income. The BOR considered that the return claimed as “interest” was earned by way of the taxpayer concluding a contract with the bank in Hong Kong for the purchase of the ELN. As such, the BOR held that the return on the ELN was sourced in Hong Kong and, therefore, chargeable to tax in Hong Kong.
Apparently, the CIR’s approach to the issue in dispute was a departure from his previously stated position. In this regard, the CIR has previously stated that an ELN of this nature would normally be regarded as a “certificate of deposit” (i.e., a loan arrangement). In such case, to the extent that the holder of the ELN is not dealing in ELNs, the CIR has indicated that the “provision of credit” test would be the applicable source rule for determining the return on such ELNs. As regards persons who purchase ELNs for dealing and not investment purposes, the CIR has indicated that the “operations” test should apply1. Under the “operations” test the place where the relevant contracts were effected would be one important factor to be considered when determining the source of the relevant return.
Whilst under his previously stated position, the CIR could adopt the “operations” test to assess the claimed “interest” income on the ELN to tax in Hong Kong if he considered the taxpayer was dealing in the ELNs and not making an investment, the CIR did not adopt such an approach in this case. Instead, the CIR challenged at the BOR that the ELN was not a loan arrangement at all and argued that the return on the ELN should be onshore taxable income based on the “contract effected” test.
Similarly, the BOR held that this “contract effected” test should be the applicable source rule for determining the taxability of the gains accruing to the taxpayer from trading other derivative contracts such as OTC barrier call options. However, for its offshore claim in respect of these derivative contracts, the taxpayer only presented certain confirmations and statements issued by the bank (which operated a branch in Hong Kong) as evidence. In the circumstances, the BOR found that the taxpayer had failed to discharge its burden of proof that the relevant derivative contracts were effected outside Hong Kong. Hence, the BOR also dismissed the taxpayer’s non-taxable claim for the relevant income.
Gains from the disposal of presumably locally listed shares acquired from ELNs
The taxpayer had received the underlying shares linked to certain other ELNs that it had purchased. Subsequently, the taxpayer disposed of the shares so acquired and argued that the gains on the disposal should be non-taxable capital gains under section 14 of the Inland Revenue Ordinance (IRO). The taxpayer contended that when it purchased the relevant ELNs, it chose the underlying shares carefully, targeting blue chip stocks which the taxpayer intended to hold for the long-term.
While accepting the evidence of the two witnesses of taxpayer in this regard, the BOR however held that the intention of the taxpayer at the time it acquired the ELNs was not relevant for determining its intention towards the underlying shares. This was presumably because the ELN contracts did not necessarily result in the taxpayer acquiring the underlying shares and that the taxpayer, by entering into the ELN contracts, did not normally even want to receive the underlying shares.
The BOR held that the relevant time for determining the taxpayer’s intention towards the underlying shares was the maturity date of the ELNs when the shares were received. Since the taxpayer presented no evidence as regards its intention at the date of maturity of the ELNs, the BOR dismissed the taxpayer’s appeal on this issue.
The BOR’s decision on this point is also in line with the classic trading-versus-investment case Simmons v IRC in that “… normally the question to be asked is whether this intention [trading versus investment] existed at the time of the acquisition of the asset.”
Gains on trading of offshore securities
The taxpayer also claimed that trading gains on certain offshore securities were non-taxable offshore income since the securities were traded on overseas stock exchanges. However, the taxpayer presented no evidence of how and by what means the offshore securities were traded on the claimed overseas stock exchanges. The only evidence presented by the taxpayer was that the securities were denominated in US dollars and were physically kept in an overseas branch of the bank.
On this issue the BOR accepted the argument of the CIR that theoretically it was possible for the Hong Kong branch of the bank to buy and sell the relevant shares on behalf of the taxpayer from or to its other clients in Hong Kong, thereby making the transactions onshore. The BOR was not persuaded that the evidence presented by the taxpayer was sufficient to discharge its burden of proof that the transactions were effected through the overseas stock exchanges. Hence, the BOR also dismissed the taxpayer’s appeal on this issue.
The CIR’s approach to the issue in this case is consistent with the position of the IRD as stated in its Practice Note No. 21 (DIPN No. 21), namely that listed shares or securities could be traded over-the-counter outside a stock exchange. DIPN No. 21 states that the location of the stock exchange would govern the locality of the source of the trading profits of listed shares or securities only where such shares or securities are traded on the stock exchange. Where the purchase and sale of listed shares or securities takes place over-the-counter, the applicable source rule would be the place where the contracts of purchase and sale are effected.
Changes in fair value of available-for-sale securities
For certain available-for-sale securities held by the taxpayer, the increase in value of the securities between two year-end dates was reflected as an increase in the equity of the taxpayer in accordance with the requirements of the relevant accounting standards, i.e., the increase was not recognized as profit through the profit and loss account of the taxpayer for the relevant years. Nonetheless, the CIR still determined that the increase in value of the securities (not yet sold but still held) as recognized through the equity account of the taxpayer was chargeable to Profits Tax in Hong Kong for the relevant years of assessment.
While dismissing the taxpayer’s argument that the relevant securities were long-term investments such that any appreciation in value was capital in nature and hence non-taxable, the BOR held that the increase in value of the securities was nonetheless unrealized profit, not chargeable to tax in Hong Kong. On this point, the BOR found itself bound by the decision of the Court of First Instance in Nice Cheer that unrealized profits of this nature were not chargeable to tax in Hong Kong under section 14 of the IRO2.
One point to note is that CIR’s stance in D32/12 on this issue appears to be a departure from the IRD’s position as stated in DIPN 42. DIPN 42 states that “… the change in fair value [of available-for-sale securities] is assessed or allowed when the change is taken to the profit and loss account … the change in fair value that is taken to the equity account is not taxable or deductible until the asset are disposed of.”
This BOR decision indicates that in order to determine the taxability of an item of income under dispute, one has to apply the relevant case-law authorities to the interpretation of the relevant provisions of the IRO, and understand the implications of the relevant practice notes issued by the IRD.
Furthermore, when an issue involved is a matter of fact, e.g., whether a taxpayer was trading or making an investment in shares or securities, or whether the trading of listed securities took place on the trading floor of a stock exchange or over-the-counter, taxpayers must gather and present relevant evidence in support of their asserted position.
Tax dispute is by its nature a complicated matter and clients should seek professional tax advice where necessary.
1 Notes of the 2008 and 2009 annual meetings between the IRD and the Hong Kong Institute of Public Accountants refer. The contents can be accessed via http://www.hkicpa.org.hk/en/cpd-and-specialization/specialist-faculties/taxation/technical-support/annual-meeting/. Clients can also refer to our previous Hong Kong Tax alert dated 8 October 2010 for a more detailed discussion on the tax issues related to ELNs.
2 On appeal by the CIR, the Court of Appeal (COA) also upheld the decision of the Court of First Instance in the Nice Cheer case. The CIR has however lodged an appeal against the decision of the COA to the Court of Final Appeal (CFA). The CIR’s appeal to the CFA is scheduled to be heard in October 2013.