Hong Kong Tax Competitiveness Series: Tax Loss Relief TAX

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1 Hong Kong Tax Competitiveness Series: Tax Loss Relief TAX

2 2 Hong Kong Tax Competitiveness Series: Tax Loss Relief Hong Kong tax competitiveness series 1 Hong Kong Taxation Post Handover - A retrospective of the decade 2 Corporate Tax Rates 3 The Shipping Industry 4 Tax Loss Relief Introduction Continuing our series on the competitiveness of Hong Kong s tax system, this publication looks at the tax loss regime for companies and considers possible refinements to the provisions in light of similar rules in our main competitor jurisdictions. Current tax loss regime The current tax loss regime in Hong Kong is relatively simple. Where a tax loss is incurred by a corporation, it can be carried forward indefinitely and set off against the corporation s future assessable profits until fully utilised. However, in contrast to many other jurisdictions, tax losses cannot be carried back to offset against taxable profits in prior years or transferred between group companies (commonly known as group relief). The Hong Kong loss utilisation rules work well where companies operate separate businesses under the same legal entity. However, these days it is less common for enterprises to organise their businesses under a single entity. Corporations are usually organised along lines of business operated through separate legal entities. This may be in order to limit the liability and risk of their investments or to reflect the structure of their businesses. Even though the business of the parent company may be legally separated from those of its subsidiaries, the group is commonly managed and controlled as a consolidated economic unit. It is generally accepted that a good tax system is one that incorporates neutrality and equity between different forms of commerce. Taxpayers in similar situations conducting similar transactions should be subject to similar levels of taxation. In the absence of any tax loss carry back or group loss relief, the current tax loss regime in Hong Kong could give rise to an inequitable tax result. For example, a loss-making enterprise which derived profits and paid tax in the earlier years can never obtain a tax refund and will remain in a tax paying position overall even though it is in losses during its lifetime. Further, a corporate group consisting of profit-making companies and loss-making companies may suffer a higher overall tax burden and higher effective tax rate than would be the case had the businesses been carried out by a single company.

3 Hong Kong Tax Competitiveness Series: Tax Loss Relief 3 Inequitable tax results will likely become more apparent in Hong Kong as a result of the Inland Revenue Department s (IRD) interpretation of the Court of Final Appeal decision in the Commissioner of Inland Revenue v Secan Limited and Ranon Limited (2005) 85 HKTC 266. Prior to the Secan decision, it was a long established tax principle in Hong Kong that unrealised revenue income or profits should not be taxed until realised. However, following the Secan decision, the IRD is of the view that unrealised profits that are revenue in nature are taxable as they are recognised in the taxpayer s income statement. The recognition of an income or a profit is governed by accounting standards which have been developed mainly to facilitate the provision of financial information rather than for determining the timing of taxation. Accordingly, a company will be liable to tax on unrealised revenue profits recognised in its income statement, even if the gain reverses in a later period. In the absence of a tax loss carry back or group loss relief mechanism, corporate groups in Hong Kong are more likely to: suffer a higher tax burden and higher effective tax rates pay tax even though they are loss making as a group have less favourable cash flow positions have higher costs of running business in Hong Kong suffer higher legal, economic and capital risks in undertaking new business in Hong Kong be discouraged from expanding or investing in Hong Kong, especially for projects which involve higher risks, heavier upfront investments and / or longer pay back periods suffer from more prolonged and accentuated business cycles within their groups and in response to external economic conditions engage in more complex intra-group transactions have relatively lower returns to investments. Hong Kong should therefore look to introduce a tax loss carry back and group loss relief mechanism in line with other developed jurisdictions.

4 4 Hong Kong Tax Competitiveness Series: Tax Loss Relief Tax loss regimes in other jurisdictions Many developed economies now allow tax losses to be carried back and offer some form of group relief mechanism to taxpayers, either by way of group consolidation, group loss transfer, consortium relief or a combination thereof. The following table highlights the features of the tax loss carry back and group loss relief regimes in a number of selected jurisdictions. Jurisdiction Tax loss carry back Group relief Austria Not available Group consolidation Australia Not available Group consolidation Canada 3 years Not available Cyprus Not available Loss transfer Denmark Not available Group consolidation France 3 years Group consolidation Germany 1 year Group consolidation Ireland 1 year Loss transfer Italy Not available Group consolidation Japan 1 year Group consolidation Luxembourg Not available Group consolidation Malaysia Not available Loss transfer Netherlands 1 year Group consolidation New Zealand Not available Dual system 1 Portugal Not available Group consolidation Singapore 1 year Loss transfer Spain Not available Group consolidation United Kingdom 1 year Loss transfer United States 2 years Group consolidation 1 New Zealand offers both group consolidation and loss transfer mechanisms to taxpayers on an elective basis.

5 Hong Kong Tax Competitiveness Series: Tax Loss Relief 5 Group consolidation A group consolidation regime is a comprehensive system for taxing corporate groups. Broadly, corporate group entities are treated as a single economic unit and the taxable income and loss of member entities are considered together in order to determine the group s overall tax position. The mechanism of consolidation is quite diverse between countries and is generally more complex than a loss transfer regime (see next paragraph). Typically, a consolidation regime involves a new discreet body of tax law, more complex consolidation requirements, separate anti-avoidance provisions and higher administration and compliance costs. Countries such as Austria, Australia, Denmark, France, Germany, Italy, Japan, Luxemburg, the Netherlands, New Zealand, Portugal, Spain and the United States currently operate consolidation regimes. Loss transfer A group loss transfer regime is generally speaking simpler than a consolidation regime. It allows unutilised tax losses of one group company to be transferred to and set off against the taxable income of another company within the same corporate group. Transfer rules are relatively straightforward and easier to administer. Typically, a loss transfer regime would require only amendments to existing laws (rather than a new body of law), more flexible joining requirements (by percentage of direct or indirect ownership) and less administration and compliance costs. Accordingly, the loss transfer regime is likely to fit better into Hong Kong's current tax system as compared to the group consolidation regime. Countries such as Cyprus, Ireland, Malaysia, New Zealand, Singapore and the United Kingdom currently operate group loss transfer regimes. Consortium relief Consortium relief is an extension of group loss transfer regime that allows tax losses to be transferred between the consortium entity and its consortium members. For example, in the United Kingdom, consortium relief is available if the corporate members: hold between them at least 75 percent of the ordinary share capital of the consortium; and each holds at least 5 percent of the ordinary share capital of the consortium. Singapore is believed to be considering the introduction of consortium relief. Key issues to consider In considering the introduction of a tax loss carry back or a group relief mechanism, the following key issues should be considered: How many years should Hong Kong allow the tax loss to be carried back? Usually, tax losses are allowed to be carried back for one, two or three years. Which mechanism should Hong Kong use for the group relief regime? It appears that the loss transfer mechanism is simpler and easier to operate and interacts better with the current tax law in Hong Kong than the group consolidation mechanism.

6 6 Hong Kong Tax Competitiveness Series: Tax Loss Relief What should be the ownership requirements in order to qualify for the group relief regime? Should Hong Kong claw back group relief if the claimant company leaves the group? The ownership requirements such as the shareholding requirement (typically ranging from 75 percent to 100 percent), period of ownership (e.g., throughout the relevant year or at the end of the relevant year) and level of ownership (e.g., direct or indirect) vary between different jurisdictions. Should Hong Kong allow group relief by election and let the taxpayers decide how much and to whom losses are surrendered or should Hong Kong adopt an all in all out approach and impose rules for automatic set off? Clearly the group relief regime would offer more flexibility if it operates on an elective basis. Should Hong Kong allow consortium relief? Consortium relief will increase the flexibility of the group relief regime and extend the benefits to joint venture partners. However, it would make the system more complex to administer. Outlook Hong Kong s low corporate tax rate has traditionally been its major attraction for capital and investment. However, as more and more countries offer better tax incentives and concessions to attract and retain capital, Hong Kong should continue to improve the competitiveness of its tax system in order to maintain its status as an international finance centre and a leading business and trading hub in Asia. The Financial Secretary indicated in his 2006/07 Budget that he had no intention of introducing any tax loss carry back or group loss relief regime in Hong Kong. In particular, the Financial Secretary was concerned that the loss carry back arrangement would place enormous pressure on tax revenue during periods of economic downturn and the group loss relief arrangement could easily be abused as a means to evade tax. Singapore has also considered the potential loss of revenue in evaluating the tax loss carry back regime. In the report prepared by the Economic Review Committee: Sub-Committee on Policies related to Taxation, the CPF System, Wages and Land in 2002, it is stated that: We recognise that a loss carry-back feature would lead to greater uncertainty in government revenue. However, there is no long-term impact on government revenue as the current system already allows losses to be carried forward. The loss of revenue only arises if the company does not recover from its current losses and subsequently fails. It would also help to relieve the cash-flow burdens of businesses suffering losses during hard times. We therefore recommend introducing a one-year loss carry-back feature in the corporate tax system. Further, Hong Kong s existing tax law also has anti-avoidance provisions to strike down tax avoidance schemes. We are aware that Singapore implemented the group loss transfer regime successfully without any legal and regulatory difficulties or a fundamental overhaul of their existing anti-avoidance rules. In assessing the competitiveness of Hong Kong s tax loss regime, one may perhaps argue that the tax systems of most developed economies are very different from and hence are not directly comparable to the tax system in Hong Kong. In particular, Hong Kong has a distinctive tax system which adopts:

7 Hong Kong Tax Competitiveness Series: Tax Loss Relief 7 a territorial tax scope (i.e., only local source income is subject to tax) low rates of tax (i.e., Hong Kong has competitive tax rates) no time limit to carry forward tax loss (i.e., tax loss can be carried forward indefinitely) one-tier taxation of dividend (i.e., dividends are exempt from tax in the hands of shareholders) no capital gains tax (i.e., profits from sale of capital assets are exempt from tax) simple compliance requirements (i.e., tax law is relatively simple and easy to comply with and administer both for taxpayers and tax authorities). However, Singapore which shares all of the abovementioned characteristics has also adopted a tax loss transfer regime from the year of assessment 2003 and a tax loss carry back regime 2 from the year of assessment 2006 onwards. Hong Kong s neighbouring competitors including Singapore, Japan and Australia have already adopted a more flexible and equitable tax loss regime. We consider it is time for Hong Kong to re-assess its tax loss regime. With an effective tax loss carry back and group loss relief regime, Hong Kong could achieve a more neutral and equitable tax system and promote better growth and investments in new business. Ultimately, that could allow Hong Kong to attract more foreign investments and maintain a more competitive tax system internationally. 2 Singapore allows all businesses to carry back an aggregate amount of SGD100,000 of current year unutilized capital allowances and trading losses for one year. Contact us Lloyd Deverall Charles Kinsley Chris Abbiss Peter Kung Vaughn Barber Ayesha Macpherson Darren Bowdern Curtis Ng Barbara Forrest Jennifer Wong Chris Garboden Michael Wong John Gu Karmen Yeung This Tax Loss Relief Report is printed on "Polymax", made of 20-25% pre-consumer waste, using fibre from a sustainable forest. 100% acid and chlorine free.

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