Taxation can be an effective tool for influencing corporate behaviour. Cheng & Cheng Taxation Services Limited ("Cheng & Cheng's Taxation") regards it is the reason why many jurisdictions are devoting huge amounts of resources in an effort to attract research and development (R&D) centres. In this, Hong Kong is no exception.
A 'super tax deduction' on certain R&D activities was introduced in Hong Kong with effect from the year of assessment 2018/19. This was a breakthrough in Hong Kong's taxation system as it was the first time that the Inland Revenue Department (IRD) had allowed deductions of 300%/200% on certain operating expenditure. The first HK$2 million spent on qualifying R&D expenses is eligible for a 300% tax deduction. For amounts over HK$2 million, a 200% tax deduction will be granted.
There are two important tax considerations relating to R&D expenses in Hong Kong:
- Requirements for Hong Kong's super tax deduction on R&D activities
- Tax risk on R&D expenses paid by a Hong Kong corporation to overseas entities
A three-minute video relating to each consideration to facilitate your understanding of the issues. Please refer to this link (Link) to access to the videos.
Cantonese Version : Link
Mandarin Version : Link
Requirements for Hong Kong's super tax deduction on R&D activities
Carrying out the R&D activities in Hong Kong is compulsory for qualification for the super tax deduction.
Hong Kong Science Park and Cyberport are popular incubators for start-ups in Hong Kong, particularly for those with significant R&D functions, as they offer appealing incentives and funding for start-ups. The super tax deduction is a further incentive introduced by the Hong Kong government for corporations carrying out R&D activities in Hong Kong.
Below is a summary of some of the basic requirements for the super tax deduction:
The R&D activities must be carried out either by the taxpayers themselves, or must be outsourced to designated local research institutions. Outsourcing of R&D activities to group companies or external parties that are not designated local research institutions are generally not eligible for the super tax deduction, except under proper cost-recharge arrangements. A list of designated local research institutions can be found on the Hong Kong government website. (Link)
For R&D activities carried out by the taxpayers themselves, only consumables and staff costs directly related to the R&D activities qualify for the super tax deduction. These expenses have to be exclusively and directly related to the R&D activities in order to qualify for the super tax deduction. (Link for illustration of Qualifying R&D Expenses)
Tax risk on R&D expenses paid by a Hong Kong corporation to overseas entities
At first, R&D payments made to overseas group companies were not tax deductible in Hong Kong under the IRO's original Section 16B. The recent amendments under Departmental Interpretation and Practice Notes (DIPN) 55 have now slightly relaxed the situation, but it is still difficult.
R&D expenses are subject to specific tax deduction rules in Hong Kong. The underlying reason is that R&D is treated as a capital expenditure by the IRD, since R&D activities tend to bring fundamental change and significant advancements to the products or services of a company. Capital expenditure is generally not tax deductible in Hong Kong.
Section 16B of the IRO is the legal provision that governs tax deductions for R&D expenses. It is too complex to go through all details of Section 16B here, but Cheng & Cheng's Taxation will highlight the current situation of cross-border R&D cost recharge arrangements, which are common for multinational corporations.
Regardless of the super tax deduction, R&D payments made in the past to overseas group companies were not tax deductible in most circumstances under Section 16B. Now, under DIPN 55, R&D fees paid to overseas group companies could qualify for the 100% normal tax deduction if both the following conditions are met:
Not more than 20% of the total R&D costs of the Hong Kong company are subcontracted to overseas group companies; and
The R&D costs paid to overseas companies should not be more than HK$2 million.
Despite the relaxation in DIPN 55, it is still difficult for multinational corporations with significant R&D functions outside Hong Kong to pursue tax deductions for R&D costs. Multinational corporations should plan their R&D cost contribution and subcontracting arrangements carefully.
Tax advisory consulting
Multinational corporations should consult their tax advisors to ensure thorough cross-border tax planning is in place to maximise the tax benefits.
There are pros and cons to incurring R&D costs in Hong Kong from a tax perspective. Multinational corporations should consult their tax advisors to ensure their current R&D arrangements are eligible for the maximum tax deduction, with a view to improving their group's overall tax efficiency.