Radical Change in the IRD’s Attitude on Offshore Claim of Interest Income: One-off Loan does not equal to “Simple Loan Arrangement”

IRD: Operation test would be the default test in determining the source of profits (interest income)

“Provision of credit test” has always been under the impression to be the dominant source rule for interest income, except for financial institutions and money lenders. Many taxpayers and tax representatives consider that, once the borrower is located outside Hong Kong or the loan funds are made to a non-Hong Kong bank account, the interest income will be offshore sourced and not subject to Hong Kong Profits Tax. However, this is certainly not the case now, at least from the view point of the IRD.

In the 2023 annual meeting between the IRD and the HKICPA, the IRD clarified that "provision of credit test" is applicable only when it is a "simple loan arrangement". More surprisingly, the definition of “simple loan arrangement” is quite narrow from the IRD’s view.

The IRD has pointed out that one-off loan does not infer simple loan arrangement. Operation test may also apply, and thus if the Hong Kong company maintained economic substance in Hong Kong, even though the borrowers may be from outside Hong Kong, the interest income will be onshore sourced and taxable.  

The below 3 scenarios are raised by the HKICPA and discussed during the meeting:

Source of fund of lender	Diagram	Operation test / Provision of credit test
Own surplus cash		Provision of credit test
Share capital from parent company		Provision of credit test
Shareholder loan from parent company		Operation test

Particular attention should be made to Scenario 3 in which “on-lending” activities appear. From the IRD’s view, the Hong Kong company does not use its own funds for lending to the subsidiary. Instead, it has borrowed money from others (e.g., the parent company) to support the lending activities. As such, operation test should apply.

Overall speaking, in the past, the frequency of lending tends to be the major criterion to determine whether it is a simple loan arrangement or not. However, the IRD now considers that whether on-lending activities exist seems to be very important as well (i.e., whether the lender borrows money from others, no matter third-party companies or related companies, for on-lending purposes).

Reference:
https://www.hkicpa.org.hk/-/media/Document/APD/TF/Tax-bulletin/034_April-2024.pdf

Points to note

•    Every taxpayer who is pursuing offshore claim on interest income should now revisit its existing intra-group financing arrangements to ensure that provision of credit test still applies. Successful offshore claim in the past does not infer current success due to radical changes in the IRD’s attitude.

•    Based on our experience, on-lending activities among group companies are very common, no matter it is interest-free or interest-bearing arrangement.

•    Many taxpayers still misunderstand that one-off loan will always adopt provision of credit test, while in practice the IRD keeps pushing for operation test, especially for SPV which is set up for carrying out loan transaction(s) only.  

•    As discussed in previous seminar, under the FSIE Regime, offshore claim on interest income requires economic substance in Hong Kong, while under operation test, you should avoid setting up economic substance in Hong Kong. This dilemma would require taxpayers to have the only solution for offshore claim: convince the IRD that it is a simple loan arrangement as much as possible.