The Hong Kong Government has published a response to questions posed in the Legislative Council on whether it will consider relaxing restrictions to enable manufacturers to claim tax allowances in respect of the machinery, equipment and intellectual property rights used in their production procedures located outside Hong Kong. The response is as follows:
Section 39E of the Inland Revenue Ordinance (IRO) is an anti-avoidance provision, which aims at limiting tax avoidance opportunities arising from machinery or plant leasing arrangements. According to that provision, depreciation allowance will not be granted if the machinery or plant owned by a taxpayer is used outside Hong Kong by other parties. However, Hong Kong enterprises which use their own machinery or plant in or outside Hong Kong may claim depreciation allowance with respect to such machinery or plant in Hong Kong. Regarding the tax deduction for capital expenditure incurred for the purchase of intellectual property rights (IPRs), a limitation similar to that under section 39E is also found in section 16EC of the IRO if the IPRs are used outside Hong Kong by other parties.
There are views suggesting that the Government of the Hong Kong Special Administrative Region (HKSAR) should relax the relevant provision such that Hong Kong enterprises would be allowed to claim depreciation allowance in Hong Kong for their machinery and plant provided for use by Mainland enterprises on a rent-free basis under the "import processing" arrangement. It has also been suggested that tax deduction should be granted for capital expenditure incurred by Hong Kong enterprises for the purchase of IPRs provided to Mainland enterprises for the manufacture of products for sale by the former.
The Government conducted an in-depth review on the matter in 2010 and concluded that there are no justifiable grounds to relax the restriction in section 39E of the IRO. The main reason is that under the "import processing" mode, Hong Kong enterprises engaging in "import processing" merely involve in trading activities concerning buying/selling of goods, and therefore are only liable to profits tax in Hong Kong for taxable profits derived from their trading activities. The machinery or plant concerned is solely used by the Mainland enterprises (being separate legal entities) in their manufacturing activities and the profits thus generated are wholly derived from the Mainland and liable to the Mainland taxes. In other words, the profits generated from the Mainland manufacturing activities as stated above are not derived from Hong Kong. Based on the established "territorial source" principle of Hong Kong's tax regime, the Inland Revenue Department (IRD) would not charge profits tax on such profits which are not derived from Hong Kong. Under the "tax symmetry" principle, neither would the IRD grant depreciation allowance for the machinery and plant solely used in the Mainland manufacturing activities. If we were to relax section 39E of the IRO such that depreciation allowance in Hong Kong would be provided to such machinery and plant, we would not only violate the above taxation principles but may also be perceived as encouraging transfer pricing, which would affect the taxing rights of Hong Kong and other tax jurisdictions (including the Mainland). This would be against the international principles and guidelines for handling transfer pricing and Hong Kong might be regarded as a harmful tax competitor. Along the same considerations, according to section 16EC of the IRO, capital expenditure incurred for the purchase of IPRs for use outside Hong Kong by other parties would not be eligible for tax deduction in Hong Kong either.
On the issue of transfer pricing, the State Administration of Taxation has confirmed with the IRD before that if a Hong Kong enterprise provides machinery and plant (including moulds) to its associated enterprise in the Mainland rent-free for production of finished products which would be sold to the Hong Kong enterprise at a price below the normal price, such arrangement may constitute an "offsetting transaction" under the "Implementation Measures of Special Tax Adjustments (Provisional)" (Guoshuifa 009] No. 2) of the Mainland. In conducting transfer pricing investigations, the Mainland tax authorities will make transfer pricing adjustments to restore the offsetting transactions.
As it can be seen from the above, the subject matter is not only concerned with Hong Kong's tax policy, but also the tax arrangements in the Mainland. In the light of possible economic integration that may be brought about by the Bay Area development, the HKSAR Government has communicated with the industry and is re-examining the issue, and will study and explore feasible options that comply with the principles of "tax symmetry" and transfer pricing, etc.
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