IRD issues revised practice note explaining the tax treatment of financial instruments under HKFRS 9 - A Plus (2024)

Equating the tax treatment for negative fair value changes of all financial assets held for trading purpose regardless of how they are measured under HKFRS 9

Revised DIPN 42 indicates that in certain circ*mstances the IRD is prepared to equate the tax treatment of financial assets that are measured at amortized cost or FVTOCI, and are acquired for trading purposes, with the tax treatment of financial assets that are FVTPL and are acquired for trading purposes.

As a result, if an assessor is satisfied that financial assets measured at amortized cost or FVTOCI are acquired for trading purposes, ECL for such assets need not be claimed under sections 18K(3).

Instead, for tax purposes, taxpayers can presumably make an adjustment in the tax computation as if the financial assets concerned were measured at FVTPL. In the event that such an “as-if” remeasurement would result in a negative fair value change of the asset, the hypothetical resulting debit to the profit and loss account could be claimed for a tax deduction.

Revised DIPN 42 does not however address the issue of where a tax deduction is claimed on such an “as-if” basis, what would be the tax treatment if the ECL or other impairment losses for such a financial asset are subsequently fully written back and there are subsequent fair value gains of the instrument which are not reflected in the profit and loss account under HKFRS 9.

Taxation of unrealized foreign exchange gains or losses

In Nice Cheer, Judge To took the view that year-end translation gains or losses for transactions denominated in foreign currencies, before the underlying items are settled, are nonetheless realized profits or losses.

However, since the profits or losses at issue in the case were year-end revaluation gains or losses in respect of securities held for trading purposes, but not year-end translation differences in foreign currencies, Judge To’s view on the matter is not binding, only an obiter.

In this regard, revised DIPN 42 indicates that the IRD adheres to the view that year-end translation differences in foreign currencies are unrealized profits or losses, thus falling within the realization principles established in the Nice Cheer decision.

As such, as a matter of law, where such translation differences are not in respect of a financial instrument, the IRD cannot include any such translation gains for tax assessment. Conversely, taxpayers cannot claim any such translation losses for tax deduction.

Where such translation differences are in respect of a financial instrument, the IRD can still treat these as non-taxable or non-deductible if the taxpayer has not made an election under the new law.

However, a tax treatment following the realization basis will require taxpayers to undertake the burdensome task of tracking when the items denominated in foreign currencies are subsequently settled. Tax adjustments will then have to be made in the tax computation to account for the realized profits or losses for the relevant year of assessment.

In order to relieve taxpayers of such a burdensome task, and as a matter of tax administrative practice, revised DIPN 42 indicates that taxpayers who have not made an election under the new law, can nonetheless consistently treat any unrealized year-end translation gains or losses for tax assessment or deduction purposes.

Revocation of an election

The election to be assessed on the fair value basis will cease to have effect under the following circ*mstances:

i) When the taxpayer ceases to prepare their financial statements under HKFRS 9; or

(ii)The Commissioner of Inland Revenue (CIR) approves an application in writing by the taxpayer to revoke the election. The CIR may approve such an application where he is satisfied that there are good commercial reasons for the revocation and that avoidance of tax is not the main purpose, or one of the main purposes, of the revocation. Such a revocation will apply from the year of assessment as specified by the CIR.

Whether there are good commercial reasons for revocation of an election is considered based on the facts and merits of a case. Nonetheless, revised DIPN 42 indicates that if a company’s reason for the revocation of its election is to conform with the tax reporting policy of a new parent company pursuant to a business merger or restructuring, the CIR would generally accept this as being a good commercial reason for the revocation.

Under both (i) and (ii) above, section 18H(7) provides that all financial instruments held at the end of the year preceding the cessation year are deemed as being disposed of and reacquired on the first day of the cessation year on a fair value basis.

The application of the deeming provision in section 18H(7) will have a tax impact where the financial instruments held on revenue account at the end of the year preceding the cessation year are not measured at FVTPL.

For example, take the case of a debt instrument acquired at HK$10 million which is measured at FVTOCI at HK$12 million at the end of the year preceding the cessation year. As a result of the application of section 18H(7), HK$2 million (HK$12 million – HK$10 million) will be assessed in the year of cessation. This will be the case even though the instrument has not been sold, and under HKFRS 9 the HK$2 million fair value gain has been reflected in the other comprehensive income and not yet recycled through the profit and loss account.

Nevertheless, the application of section 18H(7) will also mean that the cost basis of the instrument for tax purposes will be uplifted to HK$12 million for the purposes of calculating the subsequent profits or losses on disposal of the instrument.