Departmental Interpretation and Practice Notes No. 42
Imputed Interest on Interest-free Loans and Non-arm's Length Loans
Under Hong Kong Accounting Standard 39 ["HKAS 39"], the amortised cost of a financial asset or financial liability should be measured using the "effective interest method". Imputed interest will then be measured in respect of the interest-free loans or loans bearing above or below market interest rate and recognized accordingly. As such, should the interest income and expenses calculated under the "effective interest method" or the actual interest income and expenses be taxable and deductible for tax purpose?
As stated in Departmental Interpretation and Practice Notes No. 42, the Department takes the view that in analysing a financial instrument, the starting point is to decide its nature according to its legal form rather than the accounting treatment or the underlying economic characteristics. For interest-free loan, the lender does not have any right (legal or contractual) to receive interest while the borrower has no legal obligation or accrued liability to pay the interest. The interest income and expenses so recorded in the profit and loss account are merely book entries for which there is no actual receipt or payment. Notwithstanding the accounting treatment, only the actual interest income/expenses based on the contractual rate (zero rate for interest-free loans) will be assessed/allowed for tax purpose. Similar taxation treatment will also be applied to the imputed interest involved in those loans bearing off-market interest rate.
Assuming that a Hong Kong company advances an interest-free loan to a third party (a natural person) for 3 years in Hong Kong. There will be an imputed interest expense in year 0 and imputed interest income in subsequent years using the "effective interest method". Will the imputed interest expense in year 0 be deductible under section 16 of the Inland Revenue Ordinance ("IRO")? Will the imputed interest income in subsequent years be taxable as the "provision of credit" is made in Hong Kong?
As analysed in A1 above, the imputed interest expense in year 0 is not tax deductible and the subsequent imputed interest income (reversal) from the same interest-free loan transaction recognized over the life of the interest-free loan is not taxable.
Rental deposit is a kind of financial instruments. If a company calculates the imputed interest on the rental deposit paid or received on its Hong Kong properties using the "effective interest method" under HKAS 39, will the interest be deductible or taxable?
A rental deposit paid by the tenant to the landlord is usually non-interest bearing and repayable upon termination of lease. When the rental deposit is recognized at amortised cost using the "effective interest method", the accounting treatment is similar to that for interest-free loan. As stated in A1 above, the imputed interest expense or discount so recognized under HKAS 39 is not deductible while the interest income or reversal of discount is not taxable.
The Application of Sections 61 and 61A of the IRO to Imputed Interest
The adoption of HKAS 39 on interest-free loans will result in imputed interest recognized in the accounts. Will the interest income and expenses so calculated under "effective interest method" fall within the scope of sections 61 or 61A of the IRO?
HKAS 39 establishes the principles and sets out the basis for the measurement and recognition of financial instruments including loans and receivables. When considering if a transaction is "artificial or fictitious" or is designed to avoid liability for tax under sections 61 or 61A, the primary concern is the loan transaction itself together with its underlying motive/purpose, rather than its basis of recognition under HKAS 39.
If a company is not allowed to deduct the imputed interest expenses in year 0 by reason of sections 61 or 61A of the IRO, will the imputed interest income in subsequent years be charged under section 14 of the IRO?
If a loan transaction falls within the ambit of sections 61 or 61A, the transaction may be disregarded as if it has not been carried out. Where a loan transaction has been so disregarded, the interest expenses in year 0 will be denied for tax deduction whereas the interest income arising from the same transaction recognized in subsequent years will not be taxed.
Under the amendments to HKAS 39 issued in October 2008, non-derivative financial assets (other than those designated at fair value through profit or loss ["FVTPL"] upon initial recognition) can be reclassified, only in rare circumstances, out of the trading category (i.e. out of the FVTPL category). These assets shall be reclassified at their fair value on the date of reclassification, which will become their new cost or amortized cost, as applicable. The difference between the carrying amount in the previous financial statements and the fair value of the assets on the date of reclassification shall be taken to the income statement. As such, should the recognised fair value change be taxable and deductible for tax purpose?
Yes. The assets reclassified out of FVTPL category are formerly classified as held for trading purposes. By definition, the assets are trading assets. As stated in Departmental Interpretation and Practice Notes No. 42, the Department follows the accounting treatment stipulated in HKAS 39 in the recognition of profits or losses in respect of financial assets of revenue nature. The fair value change taken to the income statement is assessable or allowable, as the case may be.
Assuming that an entity reclassifies an asset out of FVTPL into the available-for-sale ["AFS"] financial asset. All the change in fair value of the asset subsequent to reclassification will be taken to the equity account. The cumulative change in fair value of the reclassified asset will be recognised in the income statement in the year of disposal. Should such change in fair value taken to the equity account be taxable or deductible?
As analysed in A6 above, for the asset reclassified into AFS category, any change in fair value that is taken to the equity account is not taxable or deductible in the year of assessment in which the change is taken to the equity account. Where the asset remains a trading asset after reclassification, the cumulative change in fair value is assessed or deducted, as the case may be, when it is recognized in the income statement in the year of disposal.
Assuming the asset in Q7 above is sold with a cumulative gain recognised in the income statement. Should such gain be accepted as a capital profit since the asset is no longer classified under trading category at the time of disposal?
As analysed in A6 above, the reclassified asset is originally a trading asset. Unless the taxpayer could establish there is a change of intention towards the asset upon reclassification, the asset remains a trading stock and the gain on disposal would be taxed. Whether there is a change of intention upon reclassification is a question of fact to be decided after considering all the relevant facts and circumstances. The reclassification under the amendments to HKAS 39 alone cannot operate to change the character of a financial asset from trading to long-term investment.