Hong Kong: Updated guidance on taxation of financial instruments, foreign exchange differences

Hong Kong: Taxation of financial instruments

The Inland Revenue Department (IRD) released an updated version of Departmental Interpretation and Practice Note (DIPN) 42—guidance that concerns the taxation of financial instruments and the taxation of foreign exchange differences.


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Updates in DIPN 42 generally reflect:

  • A judgement of the Court of Final Appeal in Nice Cheer Investment Ltd. v. CIR (2013) 16 HKCFAR 813 (accounting practice held not to form an appropriate basis for the measurement of taxable profits where they contained unrealized profits)
  • The resulting legislative amendments (Inland Revenue (Amendment) (No. 2) Ordinance 2019) effective 1 March 2019, allowing taxpayers to elect to be taxed in respect of financial instruments on the basis of their accounting profits notwithstanding the judgment in Nice Cheer
  • The introduction of HKFRS 9 that makes significant changes to the accounting rules for measuring financial instruments.

Guidance provided by DIPN 42

DIPN 42 sets out in some detail the effect of making an election to be taxed on an accounting basis, and goes through various examples in the form of different financial instruments. It largely reflects established practice and marks a stepping back from the practice of assessing all taxpayers on unrealized profits as advocated in the previous version. The broad principles of taxation still take precedence over accounting presentation such that (among other things):

  • The distinction between capital and revenue for accounting purposes remains as best indicative for tax purposes, but other relevant factor must also be considered.
  • The source of profits still needs to be determined separately.
  • The legal nature of a contract still needs to take priority over accounting classification—preference share dividends, for example, remain dividends for tax purposes even if accounted for as interest.

KPMG observation

DIPN 42 mainly focuses situations when a taxpayer has elected to be taxed on the accounting basis, although there are some more general comments on assessing practice and the impact of accounts in the appendix. Thus, the position of the IRD continues that legal form must determine the taxability or deductibility of an item and that accounting entries must only be relevant once the source and nature of the amount has been ascertained. It is not clear how fully these are supposed to apply to companies with regard to taxing the realized basis and given that many companies will not elect to tax on the accounting basis.

The rules on bad and doubtful debts may be of particular interest. While DIPN 42 makes clear that the normal restrictions on bad debts do not apply, it paraphrases the legislation in limiting deductions to losses on credit impaired assets. In effect, Stage 1 and Stage 2 expected credit losses are not allowed while Stage 3 would be allowed. This has the advantage of reducing the need for additional analysis beyond what is required for the preparation of the accounts, and tax professionals have expressed hopes that following the logic laid out in DIPN 42, the IRD might extend the logic of allowing a deduction for all credit impaired debts to companies also applying the realization basis. 

The IRD also provides some comments on the deductibility of impaired assets, noting that most trading securities are measured at fair value with changes taken to profit and loss, and that any movement would therefore be reflected in the tax computation. However, the IRD also noted that when an asset is held for trading purposes but with fair value differences taken to other income or even recorded at amortized cost, an adjustment can be made in the tax computation as though it were recorded at fair value (it is not clear what sort of evidence the IRD would require to accept the trading intent when a deduction for impairment is being claimed).

For more information, contact a KPMG tax professional:

David Ling | +1 (609) 874-4381 | davidxling@kpmg.com

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