Taxation of financial instruments - Interaction between source and fair value taxation
Regarding the non-taxability of investment income, tools like unified fund exemption, offshore claim and capital gain claim should come first, while Nice-Cheer case should be the last resort
In the annual meeting, HKICPA enquired the practical difficulty to apply offshore claim if the taxpayer applies fair value basis (i.e., unrealised gain are taxable) instead of realisation basis (i.e., unrealised gain are non-taxable as per Nice-Cheer case).
Very often the source of investment income could be finalised after both sales and purchase transactions are completed as the place of effectiveness of sales transactions is also an important factor in determining the source of investment income. However, if the relevant unrealised gains have been treated as taxable already, it would be difficult for the taxpayers to re-open the assessment of prior years even when the taxpayers can prove that the source of investment income is offshore sourced.
In this regard, the IRD has replied that, under the prevailing practice, if one of the sales or purchase contracts is effected in Hong Kong, the source of investment income would become Hong Kong sourced already. As such, if the purchase contracts are already effected in Hong Kong, the profits would be Hong Kong sourced regardless of how the sales contracts are effected. However, the IRD also realised that the determination of the source of investment income could be complex as well.
In our opinion, the same dilemma also applies to capital gain claim. The validity of capital gain claim highly depends on the length of ownership and circumstances leading to disposal, which could only be determined when the sales are made. As such, the taxpayers should think thoroughly how the unrealised gains should be treated under Hong Kong Profits Tax on their investment income.
Points to note:
Imagine your accounting year-end is 31 March. You have been investing in Tencent Holdings Limited (0700.HK) over the past few years and accumulated a substantial amount of unrealised gain until 31 March 2021. Unfortunately, the stock price dropped significantly since then.
Assuming that you adopt fair value model, the unrealised gain accumulated up to 31 March 2021 has been treated as taxable and subject to Hong Kong Profits Tax. Following the same basis, the subsequent unrealised loss would be deductible and the loss can be used to set off against future assessable profits.
From cash flow perspective, the taxpayer suffers a lot because it has to pay substantial amount of tax on unrealised gains first, while the losses can only be used to offset against future profits and cannot relieve immediate cash burden.
However, if the principle of Nice Cheer case is adopted, the unrealised gain would become non-taxable. In such case, the taxpayer does not have to pay any tax before the sales of the investment. If the taxpayer eventually does not derive any realised gains (due to significant drop in price in the later stage of holding period), the taxpayer does not have to pay any tax throughout the whole holding period.
The principle of Nice Cheer Case is particularly useful for investment entities. However, this should only be the last resort. Taxpayers should first consider flexible use of various tools to pursue non-taxable claim, including capital gain claim, offshore claim, unified fund exemption.
