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  • Inland Revenue Ordinance Section 15F – Double Taxation Risk on MNC with Research & Development (R&D) functions in Hong Kong

Pre-Revenue Cross-Border Tax Planning (R&D Cost Recharge Arrangement) needed

Hong Kong has been promoting itself as the Asian R&D hub in recent years. Lots of subsidies have been provided by the HKSAR government, HKSTP (Science Park), Cyberport and other organisations to encourage MNCs to set up their R&D center in Hong Kong. Meanwhile, as Hong Kong is just a small city with small population size, very often these MNCs would carry out R&D activities in other tax jurisdictions as well (e.g., the PRC, the US, Taiwan).

Effective from the year of assessment 2020/21, Section 15F of the Inland Revenue Ordinance (IRO) has been proven to be a catalyst for taxpayers with R&D functions in multiple locations (including Hong Kong) to implement tax planning. In particular, it applies to the following situations:-

  • A Hong Kong company has been set up to carry on R&D functions in Hong Kong. Most of them are located in Science Park, Cyberport and other incubation centres;
  • The legal title of the Intellectual Property (IP) generated from the R&D activities does not belong to the Hong Kong company despite the fact that the Hong Kong company contributes all or part of the value creation processes (i.e., DEMPE [1] );
  • Particular attention would be paid by the Inland Revenue Department (IRD) if the IP legal owner is located in low-tax jurisdictions (e.g., the BVI, Cayman Islands); and
  • The IP is expected to generate income in the future either via licensing (royalty) income or sales of IP.

Section 15F of the IRO allows the IRD to impose Hong Kong Profits Tax on the income generated from the IP even though the legal owner of the IP is a non-Hong Kong tax resident as long as part or all of the R&D activities are performed in Hong Kong. In most cases, the overseas legal owner is a related company of the Hong Kong company.

The underlying principle is that taxpayers should pay tax in their value creation jurisdiction / operating jurisdiction (i.e., Hong Kong in this case) over the place of incorporation of the legal owner. 

Double Taxation risk arises as the legal owners of the IP may also have to pay tax in their own jurisdictions. If that jurisdiction is not a Double Taxation Agreement (DTA) partner of Hong Kong (e.g., the US and Taiwan), tax credit may not be available to resolve the double taxation risk.

[1] Development, Enhancement, Maintenance, Protection or Exploitation

Points to note

Section 15F of the IRO aims to tackle situations when a Hong Kong company performs R&D functions for the group but with low or no remuneration. Unfortunately, without inter-company arrangements, it is impossible for the Hong Kong R&D company to earn an income from its R&D activities in an early stage and thus would fall within the target of the IRD.

As such, setting up R&D proper inter-company arrangements such that the Hong Kong company is fairly compensated for its functions and risks is the solution to the double taxation risk. 

Based on the above logic, Start-Up companies have to commence considering cross-border tax planning even during pre-revenue period. All these arrangements have to be first reflected in the accounting records and financial statements of the Hong Kong company. As such, taxpayers cannot wait until the challenges from the IRD to remedy the situation. 

Two important considerations should be in place in setting up R&D inter-company arrangements:-

  • Common arrangements include Cost Recharge Arrangements and Cost Contribution Arrangement (CCA). Taxpayers should select the best suitable methods based on its own situations. Under a typical CCA, the IRD expects that the Hong Kong company would share a portion of the benefits (profits) arising from the relevant IPs; and
  • Transfer pricing policy and documentation should be in place to demonstrate that arm’s length (fair) amount of income have been allocated to the Hong Kong company to reflect the value created by its R&D activities.

Last but not least, always keep the enhanced R&D tax incentives in mind. With double or even treble amount (200% / 300%) of tax deduction on qualified R&D expenses, it could help you save significant amount of Hong Kong tax or even turn the Hong Kong company into tax loss position even when the Hong Kong company is compensated by overseas group companies with reasonable amount of income for its R&D activities. 

All in all, proper early pre-revenue tax planning will not only reduce your double taxation risk, but may not necessarily increase your immediate tax burden at the same time. You can always find your tax consultants for a tailor-made advice. 

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