DEPARTMENTAL INTERPRETATION AND PRACTICE NOTES NO. 1 (REVISED) PROFITS TAX PART A: VALUATION OF STOCK-IN-TRADE AND WORK-IN-PROGRESS

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1 Inland Revenue Department Hong Kong DEPARTMENTAL INTERPRETATION AND PRACTICE NOTES NO. 1 (REVISED) PROFITS TAX PART A: VALUATION OF STOCK-IN-TRADE AND WORK-IN-PROGRESS PART B: ASCERTAINMENT OF PROFITS AND THE VALUATION OF WORK-IN-PROGRESS (A) BUILDING AND ENGINEERING CONTRACTS (B) PROPERTY DEVELOPMENT AND PROPERTY INVESTMENT These notes are issued for the information of taxpayers and their tax representatives. They contain the Department s interpretation and practices in relation to the laws as it stood at the date of publication. Taxpayers are reminded that their right of objection against the assessment and their right of appeal to the Commissioner, the Board of Review or the Court are not affected by the application of these notes. These notes replace those issued in October LAU MAK Yee-ming, Alice Commissioner of Inland Revenue July 2006 Our web site :

2 DEPARTMENTAL INTERPRETATION AND PRACTICE NOTES No. 1 (REVISED) CONTENT Paragraph Part A : Valuation of stock-in-trade and work-in-progress 1 The Basic Rule 5 Meaning of Cost or Net Realisable Value 6 Court Decisions 8 Standard Cost and Retail Method 9 Net Realisable Value 10 Replacement Cost 11 Basis of Valuation Used 12 Shares and Securities Held as Trading Stock 14 Work-in-Progress 18 Keeping Stock Records 19 Undervaluations 20 Quantification of Understatements of Profits 21 Part B : Ascertainment of profits and the valuation of 1 work-in-progress (A) Building and engineering contracts (B) Property development and property investment General View of the Inland Revenue Department 3 Building and engineering contracts Ascertainment of Assessable Profits 4 Change in Basis of Valuation 12 Property development 14 Date of Commencement 15 When is Profit Brought in 16 Overhead Expenditure 26 Property investment 28 Conclusion 31

3 PART A VALUATION OF STOCK-IN-TRADE AND WORK-IN-PROGRESS It is essential for the proper computation of taxable profits for a given period that opening and closing stock-in-trade be correctly valued. The argument sometimes encountered that the matter corrects itself if the stock is correctly valued in subsequent years cannot be accepted. 2. These Departmental Interpretation and Practice Notes ( DIPN ), which do not cover professional work-in-progress, are intended to explain the bases of valuation that are acceptable for taxation purposes as such valuations may not always be the same as those used by auditors for the purpose of commercial accounting. 3. As there are no specific provisions relating to stock valuation for taxation purposes in the Inland Revenue Ordinance ( the Ordinance ), other than section 15C which relates to cessation of business, ordinary commercial principles and practice have first to be looked at. In this regard, the recommendations contained in HKAS 2 (Inventories), issued by the Hong Kong Institute of Certified Public Accountants ( HKICPA ) are broadly acceptable to the Department. Reservations the Department has in respect of certain recommendations are referred to in later paragraphs. Further guidance can be found in decided cases. 4. The objective of HKAS 2 is to prescribe the accounting treatment for inventories. It applies to all inventories, except: (a) (b) work in progress arising under construction contracts, including directly related service contracts; financial instruments; (c) biological assets related to agricultural activity and agricultural produce at the point of harvest;

4 (d) (e) inventories of agricultural and forest products, agricultural produce after harvest, and minerals and mineral products, to the extent that they are measured at net realisable value in accordance with well-established practices in those industries; and inventories held by commodity broker-traders who measure their inventories at fair value less costs to sell. For the purposes of these DIPN, the term stock or stock-in-trade generally has the same meaning as the term inventories in HKAS 2. The Basic Rule 5. The basic rule, whether for accounting or taxation purposes, is that stock should be valued at the lower of cost or market value (Whimster v. C.I.R., 12 TC 813). Nowadays, the term net realisable value (see below) is used rather than market value. Meaning of Cost or Net Realisable Value 6. The Departmental view is basically that the cost of stock means the actual or historical cost. As set out in paragraphs 10 to 17 of HKAS 2, this includes all costs incurred directly on the purchase, conversion and bringing the stock to its existing location and condition. Also included is any overhead expenditure which can appropriately be allocated to the cost of stock and carried forward in the circumstances of the business, instead of being recognised as a revenue expense in the period in which it was incurred. In limited circumstances, borrowing costs are included in the cost of stock [see paragraphs 11 and 12 of HKAS 23 (Borrowing Costs)]. 7. For net realisable value, the Department accepts that the term has the meaning stated in paragraph 6 of HKAS 2, i.e. the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. See also paragraph 10 below. 2

5 Court Decisions 8. The Courts have ruled on certain methods of valuation: (a) (b) (c) (d) (e) (f) (g) In the case of Ahmedabad New Cotton Mills Ltd. v. Bombay Commissioners of Income Tax, 8 ATC 575, it was held that where opening and closing stocks have been undervalued, the true profits can only be established by raising both valuations. C.I.R. v. Cock Russell & Co. Ltd., 29 TC 387, established the right to apply cost or lower market value to individual items of stock. In Minister of National Revenue v. Anaconda American Brass Ltd., 34 ATC 330, the L.I.F.O. method of determining cost was rejected by the Privy Council. In Patrick v. Broadstone, 35 TC 44, the base stock method was rejected, even though it was accepted as sound commercial practice in the cotton spinning trade. In Duple Motor Bodies Ltd. v. Ostime, 39 TC 537, consistency in the basis of valuation of stock and work-in-progress was stressed. The Courts, however, in refusing to decide between the rival claims of direct cost and oncost methods of valuation as a broad principle, found that the direct cost method, which had been consistently applied in the past, was one of the methods recognised as sound accountancy practice and saw no reason, in the circumstances of that case, to compel a change to the oncost basis. In Freeman, Hardy & Willis v. Ridgeway, 47 TC 519, it was held that for tax purposes replacement value is not acceptable. In Pearce v. Woodall-Duckham Ltd., 51 TC 271, it was held that the estimated accrued profits resulting from the change in valuation method of work in progress in that case should be treated as a taxable receipt for the year in which the amount was first revealed and brought into account. 3

6 Standard Cost and Retail Method 9. Use of the standard cost method or retail method for measuring the cost of stock in justifiable circumstances, as explained in paragraphs 21 and 22 of HKAS 2, is acceptable for taxation purposes, provided that the method is regularly reviewed, revised and applied on a consistent basis. Net Realisable Value 10. To arrive at a valuation acceptable for taxation purposes based on net realisable value, the expression the estimated costs to be incurred to make the sale mentioned in paragraph 6 of HKAS 2 would not include general selling costs. In practice, specific identifiable items of expenditure directly related to the stock in question, including provision for commission and brokerage which would have been incurred on sale, would be allowed. Replacement Cost 11. The replacement cost (sometimes referred to as replacement value ) of stock is the estimated amount for which, in the ordinary course of business, the stock could be acquired or produced. As was pointed out in paragraph 8(f) above, replacement cost is not acceptable for taxation purposes, as, where the replacement cost is less than the net realisable value, the effect would be to take account of a loss greater than that which is expected to be incurred. Replacement cost is not recommended in HKAS 2, except in the circumstances mentioned in paragraph 32 of the Standard. In the circumstances mentioned in that paragraph, the replacement cost of materials may be the best available measure of their net realisable value, and it will also accordingly be acceptable for taxation purposes. Basis of Valuation Used 12. Since more than one interpretation can be placed on such expressions as net realisable value or cost, the Assessor should be made aware as to exactly what basis of valuation has been used. In addition, where the basis adopted for the valuation of stock and work-in-progress is one that is clearly not acceptable for tax purposes, the adjustment that is considered necessary should be made in the figure of profit returned for assessment. The basis on which the adjustment is made should be brought to the notice of the Assessor. 4

7 13. Once a satisfactory basis of valuation has been agreed, the Department will normally only require information concerning any subsequent change to be given in the taxpayer s annual return. Shares and Securities Held as Trading Stock 14. Shares and securities are financial instruments and thus outside the scope of HKAS 2. The accounting treatment of these financial assets is, however, covered by HKAS 39. According to HKAS 39, financial assets that are acquired or held for the purpose of trading are classified as financial assets at fair value through profit or loss. They are measured at fair value with all resulting gains and losses recognised in the profit and loss account as and when they arise. 15. For taxation purposes, the Department will follow the accounting treatment stipulated in the HKAS 39 in the recognition of profits or losses in respect of these financial assets. Accordingly, the change in fair value is assessed or allowed when the change is taken to the profit and loss account. 16. HKAS 39 defines fair value to be the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm s length transaction. Valuation methods previously permitted for financial instruments prior to the time when HKAS 39 became effective, such as the lower of cost or net realisable value basis, will not be accepted for both accounting and taxation purposes. 17. An exception to this is for small and medium-sized entity ( SME ) which qualifies for reporting under the SME Financial Reporting Standard ( SME FRS ). The SME FRS adopts historical cost method as the principal basis of preparation and requires shares and securities to be valued at the lower of cost and net realisable value. This valuation basis will also, accordingly, be acceptable for taxation purposes. Work-in-Progress 18. HKAS 2 recommends that work-in-progress should include direct costs and a systematic allocation of fixed and variable production overheads incurred in converting materials into finished goods. It is already general 5

8 practice for overheads to be so included, but the Department also accepts as valid a valuation, if consistently adopted, based on direct cost only, i.e. cost of material plus wages. This is in accordance with the decision in Duple Motor Bodies [referred to at paragraph 8(e) above]. Keeping Stock Records 19. Section 51C of the Ordinance requires a person carrying on business in Hong Kong to keep sufficient records, in English or Chinese, of his income and expenditure to enable his assessable profits to be readily ascertained. The required records include statements (including quantities and values) of trading stock held by the person at the end of each accounting period. All records of stocktakings from which any statement of trading stock has been prepared should be retained. Such records should include: (a) (b) (c) (d) (e) a list describing each article of stock on hand (including raw materials and work in progress), together with the value of each; who did the stock-taking; how the stock-taking was done; the date of the stock-taking; and the basis of the valuation. It is an offence not to keep sufficient business records, with conviction carrying a maximum penalty of $100,000. Undervaluations 20. From time to time, a clear undervaluation of stock for taxation purposes is revealed in accounts submitted or discovered in the course of a Field Audit examination by the Department. An undervaluation giving rise to an understatement of profits for a year may result from: 6

9 (a) (b) (c) (d) (e) a change from one valid basis of valuation to another; the use of a non-valid basis of valuation for both opening and closing stock; a change from a non-valid basis of valuation to a valid basis; a change from a valid basis of valuation to a non-valid basis; or an omission of stock or an incorrect estimation of quantity or value. Quantification of Understatements of Profits 21. In quantifying understatements of the kinds referred to in paragraph 20(a) to (e) above, the Department would in general adopt the following approaches: (a) Change from one valid basis to another The opening stock figure in the year of change should remain the same as the closing stock figure for the preceding year. Consequently, the Department will not allow a tax free uplift where the change would result in a higher opening figure, or seek to tax the business where the change would result in a lower opening figure, in response to any contention that the opening and closing figures are normally valued on the same basis. (b) Non-valid basis of valuation for both opening and closing stock (i) Both opening stock and closing stock must be valued on a valid basis which is appropriate for the stock in question; (ii) Depending on the facts of the case, the Department will review liabilities for earlier years; 7

10 (c) Change from a non-valid basis to a valid basis (i) The opening stock must be revalued on the same basis as the closing stock; (ii) The liabilities for earlier years will be reviewed if it is considered appropriate; (iii) In a case where there is no question of fraudulent or negligent conduct, the total tax sought to be recovered for past years would not exceed the tax saving resulting from the uplift of the opening valuation for the year of change. (d) A change from a valid basis to a non-valid basis (i) The closing stock is to be revalued on the same valid basis as the opening stock; (ii) The valid basis must be followed for future years. (e) Omission of stock or incorrect estimation For cases where a valid basis is used, but there has been omission of stock or incorrect estimation, the auditor will ascertain the amount of understatement by a method which is appropriate in the circumstances. Various matters may be taken into account, e.g. the production process and the average stock-holding period. 22. The Department will consider the question of penalty action where an understatement of profits results from an incorrect valuation of stock, such as an omission or incorrect estimation as mentioned in paragraph 20(e) above. 8

11 PART B ASCERTAINMENT OF PROFITS AND THE VALUATION OF WORK-IN-PROGRESS (A) BUILDING AND ENGINEERING CONTRACTS (B) PROPERTY DEVELOPMENT AND PROPERTY INVESTMENT These notes deal with the above subjects as one, because there are aspects which are interrelated, although at the same time there are special features of each. 2. Normally, infrastructure and property development projects take more than one year to complete. As such, the application of proper principles in relation to revenue recognition and valuation of work-in-progress can have an appreciable bearing on the annual tax position. For this reason, it is desirable that the relevant principles on the above subject be stated, together with the Department s policy and practice. General View of the Inland Revenue Department 3. In so far as revenue recognition and valuation of work in progress are concerned, the Department generally accepts the principles promulgated by the HKICPA in relevant accounting standards, including HKAS 11 (Construction Contracts), HKAS 18 (Revenue), HKAS 23 (Borrowing Costs) and HK Interpretation 3 (Revenue Pre-completion Contracts for the Sale of Development Properties)( HK-Int 3 ). BUILDING AND ENGINEERING CONTRACTS Ascertainment of Assessable Profits 4. In the absence of any express or implied statutory rule in the Inland Revenue Ordinance ( the Ordinance ) specifying how profits from long-term contracts should be ascertained, established accounting principles also apply for profits tax purposes. This position is reflected in the judgment of Sir 9

12 Thomas Bingham, M.R., in Gallagher v. Jones [1993] STC 537, where he said at page 555: Subject to any express or implied statutory rule, of which there is none here, the ordinary way to ascertain the profits or losses of a business is to apply accepted principles of commercial accountancy. That is the very purpose which such principles are formulated... so long as such principles remain current and generally accepted they provide the surest answer to the question which the legislation requires to be answered. 5. This view is also supported by the Court of Final Appeal judgment in CIR v. Secan Limited and Ranon Limited, 5 HKTC 266, where Lord Millett said: Both profits and losses therefore must be ascertained in accordance with the ordinary principles of commercial accounting as modified to conform with the Ordinance. Where the taxpayer s financial statements are correctly drawn in accordance with the ordinary principles of commercial accounting and in conformity with the Ordinance, no further modifications are required or permitted. 6. HKAS 11 lays down that when the outcome of a construction contract can be estimated reliably, contract revenue (including any money retained under the contract) and contract costs associated with the construction contract should be recognised as revenue and expenses respectively by reference to the stage of completion of the contract activity at the balance sheet date (paragraph 22 of HKAS 11). This Standard does not adopt the realisation or completion of contract method which recognises profits only when a contract is completed. Profits recognised in the financial statements of an accounting year under the percentage of completion method should also be adopted for tax purposes for that year. If financial statements are prepared using this method, profits must not be excluded from assessment by way of a computational adjustment on the ground that the profits are not assessable until the entire contract is completed. 10

13 7. Paragraphs 22, 32 and 36 of HKAS 11 provide that any expected excess of total contract costs over total contract revenue for a contract should be recognised as an expense immediately. In other words, a loss on the contract as a whole should be recognised in the accounts as soon as it is foreseen. 8. The Department s position in relation to the treatment of such an overall loss has recently been reviewed. The Secan case establishes the principle that the tax treatment should follow the accounting treatment. The Department s view is that the principle should generally apply to all types of income and expense, except as otherwise provided for in the Ordinance. As the making of provisions for foreseen losses is required by generally accepted accounting principles, and is not inconsistent with the provisions of the Ordinance, following Secan, the Department agrees that a full deduction should be allowed in the year the provisions are recognised in the accounts, provided that they are (a) made in accordance with the requirements of HKAS 11; and (b) estimated with sufficient accuracy. 9. An assessment for a year raised in accordance with paragraph 6 above cannot be reopened if a loss on the same contract is subsequently incurred. It is considered that section 70A cannot have application in such circumstances as the earlier estimation of profits would have been an exercise of judgement. The loss incurred would have to be set off against other assessable profits of the same year or carried forward to future years. However, where a contract is the only one undertaken by a taxpayer and the taxpayer has ceased business after the completion of the contract, the Department, as a concession, is prepared to re-open earlier years where profits were assessed, if an overall loss situation has eventuated on completion of the contract. 10. A contract is regarded as having been completed when a final certificate is issued by the supervising architect or consulting engineers. 11. Assessments already finalised on the completion basis in the fiscal year 1997/98 will not be reopened, but the following practice will apply to any assessment which remains open in that fiscal year and all future years: 11

14 (a) (b) the percentage of completion basis of assessment will apply to contracts that commenced in that open year of assessment and all subsequent years until their completion; the realisation or completion basis of assessment previously accepted by assessors for profits tax purposes for unfinished contracts that commenced in a year of assessment prior to that open year of assessment will continue to apply to those contracts in every year from commencement until their completion. Change in Basis of Valuation 12. Where there is a change in the basis of valuation of long-term contracts from one valid basis to another, the opening figure in the year of change must, for taxation purposes, be the same as the closing figure for the preceding year. [This is in line with the decision in Pearce v. Woodall-Duckham Ltd. referred to in paragraph 8(g) of Part A]. 13. The Department will not accept a claim for a tax-free uplift based on the grounds that the opening and closing figures in the year of change must be on the same basis. However, the Department will accept the continuance of the existing basis for long term contracts current at the beginning of the year of change, with the new basis being applied only to contracts entered into during or after the year of change. PROPERTY DEVELOPMENT 14. For the purposes of these DIPN, the term property development refers to development for profit by sale, whereas property investment refers to development for letting or some other long-term use in a trade, profession or business. 12

15 Date of Commencement 15. Where a person first enters into a property development project, he is regarded as having commenced business for the purposes of section 18C of the Ordinance when he takes the first clear step towards that end. This may be the date of acquisition of the site, or if the land has been held for some time, when some definite move is made towards development. When is Profit Brought in 16. It is common practice for agreements for sale of flats or units in a development to be entered into before or during construction. These normally provide for payment of a deposit and instalments to the developer, with a provision that failure to meet any payments due under the agreement will result in the forfeiture of all payments made. 17. Notwithstanding that agreements for sale are entered into and part payments are received prior to the completion of the building, the profit on sale is regarded normally as arising when the contract is capable of completion by performance and the purchaser can be given possession. The sale is therefore regarded as taking place when the Occupation Permit in respect of the relevant unit is issued by the Building Authority. 18. This view is consistent with HK-Int 3 issued by the HKICPA in May 2005 (this Interpretation was first issued in March 2005 as SSAP-Int 24). HK-Int 3 concludes that pre-completion contracts for the sale of development properties do not meet the definition of construction contracts set out in HKAS 11 if the contracts in question are not specifically negotiated for the construction of the properties. As a result, the stage of completion method shall not be used to recognise revenue arising from such contracts. Property developers need to apply HKAS 18 in recognising revenue arising from pre-completion contracts for the sale of development properties. In broad terms, this Standard requires property developers to recognise profits at the time when the risks and rewards of ownership of properties have been transferred. In other words, profits are only recognised upon completion of a building. 13

16 19. In respect of pre-completion contracts entered into prior to the effective date of the HK-Int 3 and with profits already recognised under the stage of completion method, there are two ways to deal with the contracts. The developers could continue to account for these contracts using the percentage of completion method or by restating the prior year profits through equity accounts. 20. The first method will not have any taxation consequence. Regarding the second method, the following assessing practice will apply: (a) (b) (c) (d) Profits derecognised will not be allowed for deduction as expenses in the current year (profits derecognised are not expenses); Profits derecognition does not arise from a change of valuation of trading stock (the valuation remains the lower of cost or net realisable value); Back year assessments will not be reopened under section 70A because back year returns did not contain any error or omission; and Profits assessed under the stage of completion method but derecognised on the adoption of HK-Int 3 will not be assessed again in subsequent years (presumption against double taxation). 21. The most common practice nowadays is for property developers to team up with financial institutions to provide loan facilities to the initial buyers of their newly developed properties. Normally, a buyer has to make a down payment with the balance financed by a mortgage loan. Upon receipt of the entire consideration, the property developer assigns the legal title of the property to the buyer who, in turn, executes a mortgage deed in favour of the financial institution as mortgagee. Under such circumstances, the profit should be brought in according to the practice described in paragraph 17 above. 22. Sales may also take place on instalment terms. HKAS 18 provides that there are two methods of recognising revenue for the sale of properties under instalment terms. The developers may either recognise sales in full at 14

17 the time when the risks and rewards associated with the ownership of the properties have been transferred ( the full accrual method ) or only to the extent of cash received ( the instalment method ). A relevant factor distinguishing the adoption of these two methods is whether there is evidence on the buyer s commitment to complete payment with reference to the buyer s initial and continuing payments. 23. The choice of the appropriate accounting method depends on the taxpayer s circumstances and the management should be in the best position to make judgement on this. In the absence of specific provisions governing the timing of assessment in the Ordinance, the Department s position is that the accounting treatment made in accordance with accepted accounting principles should be followed for tax purposes. Any excess of total payments over the cash price is treated as interest and is assessable when paid or credited. 24. In C.I.R. v. Montana Lands Ltd., 1 HKTC 334, the contracts for sale provided for payment by instalments over a period of 100 months, with assignment of the property deferred until payment of the final instalment. The taxpayer adopted the instalment method to account for the revenue. The Court held that the company s method of bringing in only the portion of the profit that was represented by the instalments received was in accordance with established accountancy principles, and should be followed for taxation purposes. The Department considers that this method can be adopted for taxation purposes in similar circumstances. 25. However, in D103/99, 15 IRBORD 214, the taxpayer adopted the full accrual method in the recognition of profits for the units sold under instalment terms. The taxpayer also declared and paid an interim dividend for that financial year. For tax return purposes, the taxpayer made an adjustment to exclude the profits attributable to the outstanding instalments in respect of the instalment sales. The Board held that the Montana Lands case is not applicable. In Montana Lands case, the directors adopted the cash receipts accounting method, while in the present case, they chose the full accrual method and even paid a dividend. Therefore, the Board held that the profits in respect of future instalments receivable were correctly assessed to profits tax. 15

18 Overhead Expenditure 26. In many cases, the period covered by a development project will extend over two or more years of assessment. The same considerations will apply as to when and if so, to what extent, overhead expenditure should be included for tax purposes in the cost of work-in-progress, as in the case of building contractors. Here again it may not be the general practice to carry forward any of the overhead expenses in the developer s accounts or to treat only some as in the nature of oncost. This may be accepted when there is relatively little effect on the overall tax position, but the Department must reserve the right to examine the position more closely where circumstances so require. 27. Borrowing costs that are directly attributable to the acquisition of land, old buildings or the construction of units in a development project should be included as part of the cost of these assets until substantially all the activities necessary to prepare the development for sale are completed. This is in agreement with HKAS 23. PROPERTY INVESTMENT 28. Where a person incurs expenditure on the acquisition and construction of a property which is to be used for the purposes of his trade or business, or for the production of income by way of letting, it is of primary importance that all capital expenditure is correctly identified for taxation purposes; it is always necessary that there be a strict application of proper principles in distinguishing between revenue and capital expenditure. 29. Where the person is carrying on business and there is already an established organisation, it is necessary to see that all overhead expenditure, including administration expenses, correctly attributable to the acquisition of the site and the construction of the property, are properly capitalised. These will include finance expenses up to the date when the property is capable of being used for the production of profits (HKAS 23 and the Privy Council judgment in Wharf Properties Ltd. v. C.I.R. [1997] STC 351 refer). This will usually be the date of the Occupation Permit or the date from which rent is first receivable. After that date, interest is correctly a revenue charge. 16

19 30. The remuneration of employees and staff directly engaged on the planning, construction and fitting up of the property should also be included in the expenses charged to the cost of the property. CONCLUSION 31. The practice of the Department is not to insist upon a strict application of the full requirements and principles in small cases, or where the tax deferral effect is insignificant. 32. However, where the method of accounting in use results in a distortion of the profits for taxation purposes, it is expected that necessary adjustments will be made in returns and computations. Where detailed costing records are not available and the cost of work-in-progress is based solely on direct costs, a reasonable estimate should be made of the indirect expenses and general overhead properly attributable to the cost of production and work-in-progress. 17