Global Tax Alert | 14 October 2013
Hong Kong Tax Authorities comment on deductibility of payments for sub-contracted research and development
This Alert discusses the views recently expressed by Hong Kong's Inland Revenue Department (IRD) regarding the deductibility of expenditures incurred for research and development (R&D) activities undertaken (i) by a subsidiary for a parent; and (ii) in a group cost sharing arrangement.
Given the IRD's interpretation of the relevant legislative provisions explained in this Alert, a tax deduction for expenditures incurred on sub-contracted out R&D activities appears to be very limited.
Legislative provisions regarding R&D expenditures
R&D expenditures, normally incurred with a view to developing new products and improving existing production methods, are generally regarded as being capital in nature. As such, R&D expenditures are 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 expenditures, including payments to an approved research institute for R&D activities related to the company's business and expenditure on R&D related to the company's 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) should be interpreted. In particular, the HKICPA sought the IRD's view on whether a person could claim a deduction with respect to R&D expenditures incurred by contracting a service provider to carry out the relevant R&D activities on behalf of the person. The scenario posed by the HKICPA was that the service provider was not an approved research institute, 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 expenditures 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 expenditures 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.
R&D activities undertaken by a subsidiary under detailed guidance and supervision of a parent
In the 2013 annual meeting between the HKICPA and the IRD held earlier this year, a follow-up question on what amounted to “activities undertaken by the person themselves” was raised by the HKICPA.
The question asked was: whether the activities of the local R&D staff employed by mainland China subsidiary could be regarded as activities undertaken by HK Company, thereby qualifying the amount paid by HK Company to mainland China subsidiary as “in-house” R&D expenditures eligible for a tax deduction under section 16B(1)(b) of the IRO?
In reply, the IRD stated that because HK Company and mainland China subsidiary were two separate legal entities, R&D activities undertaken by mainland China subsidiary could not be regarded as undertaken by HK Company itself. As such, HK Company would not be entitled to claim the amount paid to mainland China subsidiary as “in-house” R&D expenditures deductible under section 16B(1)(b) of the IRO.
R&D activities performed under group cost sharing arrangements
It has become common practice for multinational companies to pool their resources and carry out R&D activities under a cost sharing arrangement (CSA). In general, participants in a CSA agree to share the cost of developing one or more intangibles. Each participant obtains a separate interest in the relevant cost shared intangibles and separately exploits them.
In its 2013 annual meeting with the IRD, the HKICPA also raised a question in relation to R&D expenditures incurred under a CSA arrangement. The scenario posed involved a group CSA arrangement under which a Hong Kong company sent its employees to the group's R&D center to conduct R&D activities where they were joined by employees of other companies in the group. A portion of the cost of the group's R&D center would be allocated to the Hong Kong company. In the scenario proposed, the cost allocated to the Hong Kong company was HK$ 1 million, while the actual staff costs in respect of those employees who were sent by the Hong Kong company to the R&D center was HK$300,000. The question raised was: in such circumstances what amount can the Hong Kong company claim as deductible.
In reply, the IRD stated that the Hong Kong company could only claim a tax deduction of HK$300,000 under section 16B(1)(b) because this was the amount that the Hong Kong company had incurred for its own R&D activities. The IRD added that expenses incurred by other group companies and recharged to the Hong Kong company could not be regarded as “in-house” R&D expenditures incurred by the Hong Kong company itself.
Given the IRD's narrow interpretation of section 16B(1) explained above, the scope for a tax deduction for expenditures incurred on sub-contracted out R&D activities appears to be very limited.
With a view to enhancing the deductibility of relevant expenditure, companies that have incurred or will incur significant costs in respect of sub-contracted out R&D activities should review their tax position and consider amending their R&D arrangements involving group companies.
For additional information with respect to this Alert, please contact the following:
Ernst & Young Tax Services Limited, Hong Kong
- • Tracy Ho
+852 2846 9065
Ernst & Young LLP, Hong Kong Desk, New York
- • Connie Chan
+1 212 773 2661
Ernst & Young LLP, Asia Pacific Business Group, New York
- • Chris Finnerty
+1 212 773 7479
- • Jeff Hongo
+1 212 773 6143
- • Kaz Parsch
+1 212 773 7201
- • Bee-Khun Yap
+1 212 773 1816
EYG no. CM3871