Trading Securities and Commodities and Corporate Income
The question whether or not the profits including commissions arising out of securities and commodities trading are subject to Hong Kong corporate income tax have been subject to several Hong Court cases. In Nice Cheer Investment Limited v CIR (HCIA 8/2007), dated 28th of June 2011, were however the unrealised gains arising out of the revaluation of trading securities to their respective market value subject of discussion.
Trading Securities Corporate Tax Court Case
Within HCIA 8/2007, Taxpayer is a limited company and has as principal activity investment trading. The Taxpayer adopted Hong Kong Accounting Standard (‘HKAS) 39, under which either unrealised gains or losses arising out of the revaluation of trading securities are also treated as profits or losses in the profit and loss account for accounting purposes.
For tax purposes however, Taxpayer excluded these unrealised gains from the corporate income tax assessment and claimed a tax deduction of the unrealised losses at the same time. The CIR disagreed with this approach as it actually gave “precedence to ordinary commercial accounting principles in ascertaining profits without construing the word ‘profits’ in section 14(1)” of the Hong Kong corporate income tax act.
Ruling of the Court
In short, the Court of First Instance in HCIA 8/2007 came to the following conclusions:
1.”Lord Millett said in Secan Ltd that “both profits and losses therefore must be ascertained in accordance with the ordinary principles of commercial accounting as modified to conform with the Ordinance. Where the taxpayer’s financial statements are correctly drawn in accordance with the ordinary principles of commercial accounting and in conformity with the Ordinance, no further modifications are required or permitted.””;
2.”Put in another way, within the realm of ascertainment of profits, ordinary commercial accounting principles prevails; but which of those profits are chargeable to tax is prescribed by the statute”;
3.”In my opinion, despite Sharkey and Wernher, the principle that a man cannot trade with himself as a principle of statutory construction remains unshaken in Hong Kong”;
4.”Thus, adopting a literal approach to the construction of section 14(1) […], I reach the conclusion that the word “profits” […] means real profits arising in or derived from actual buying and selling of commodities in commercial transactions between the taxpayer and his trading partners […] and do not include notional or unrealised profits arising out of revaluation of the taxpayer’s stock of trade”; and
5.”A dichotomy in treatment between profits and losses has to be accepted, if the accounting principles applicable to the treatment of profits require modification with the Ordinance, while those applicable to treatment of losses do not”.
Please note that it was further determined in HCIA 8/2007 that the Courts decision should not apply to foreign exchange transactions.
Court’s Ruling Tax & Trading Consequences
The above actually shows that the tax accounts do not always follow the commercial accounts as is often the case in many high (civil) tax law jurisdictions. Somehow, it would therefore be better for accountants to stick to the preparation of the commercial accounts and leave the tax accounts up to tax law specialists.
Please also note in this case the 2002 USA Sarbanes-Oxley Act which refers to the independency of auditors in order to avoid conflict of interest. The Court of First Instance in HCIA 8/2007 said further: “While accountants are authorised to ascertain what are profits, which of those profits are chargeable to tax is a matter for the legislature and a matter for the court to interpret the intendment of the legislature”. As a result of the above, Departmental Interpretation and Practice Note No 42 as far it relates to HKAS 39 might have no longer effect and correction prior-assessments should be considered.
Following this ruling, the Hong Kong Government on 17 July 2015 published in the Gazette, the Inland Revenue (Amendment) (No. 2) Ordinance 2015 (‘Amendment Ordinance’), under which the profits tax exemption for offshore funds are extended to private equity funds.