The Inland Revenue (Amendment) (No. 7) Ordinance 2018, which introduces an enhanced tax deduction regime for qualifying research and development (R&D) expenditure was passed by Hong Kong’s Legislative Council on 25 October 2018 and became effective on 2 November 2018.
Overview of the regime
The regime classifies R&D expenditure as one of two types:
1. Type A expenditure, which qualifies for the existing standard deduction of 100% of the expenditure; and
2. Type B expenditure, which qualifies for an enhanced deduction of 300% for the first HKD 2 million of R&D expenditure and 200% on the remainder (without any cap on the amount of the enhanced deduction).
The enhanced deduction applies retroactively to expenditure incurred on or after 1 April 2018.
To ensure symmetry of the tax rules, royalties derived from the intellectual property generated from the R&D activities will be considered trading receipts chargeable to tax. This provision applies to amounts received or accrued on or after 2 November 2018.
Changes made to bill
A number of issues were discussed and clarified in the Bills Committee before the bill was passed, including the following:
Qualifying R&D activity: The definition of R&D activity that qualifies for the enhanced deduction is not straightforward. As a general rule, if an R&D project seeks to directly contribute to achieving an advance in science or technology by resolving scientific or technological uncertainty, it will be considered a qualifying R&D activity. However, an item does not become an advance in science or technology simply because science or technology is used in its creation. Taxpayers are expected to provide comprehensive and accurate information in their tax returns to support a deduction claim and provide sufficient supporting documents at the request of the Inland Revenue Department (IRD). To reduce any potential uncertainty, a taxpayer may request an advance ruling from the IRD to clarify whether a planned R&D project meets the requirements and would be eligible for the enhanced tax deduction.
Overseas R&D activities: Considering that the objective of the enhanced tax deduction regime is to encourage Hong Kong R&D activities, the government concluded that the enhanced deduction would not be available for R&D activities conducted outside Hong Kong. Nevertheless, such expenditure still may qualify for the 100% standard deduction as Type A expenditure if the relevant conditions are fulfilled.
Cost-sharing arrangements: In some cases, taxpayers may make payments for R&D activities outsourced to group companies under a cost-sharing arrangement (CSA). The government clarified that if a taxpayer has undertaken part or all of the underlying R&D activities under a CSA, the portion of R&D expenditure borne by the taxpayer under the arrangement may be treated as its in-house R&D expenditure and may be eligible for the standard or the enhanced deduction. Based on this, we may interpret that if the payment is made to an overseas group company under a CSA where the R&D activities are undertaken outside Hong Kong, the expenditure borne by the taxpayer may be regarded as Type A expenditure and hence eligible for the standard deduction. If the payment is made to another Hong Kong group company under a CSA, assuming that it is not a designated institution and the R&D activities are carried out in Hong Kong, can the portion of expenditure attributable to direct R&D staff cost and consumables (i.e. Type B expenditure) be eligible for enhanced deduction? The IRD will provide more guidelines in the Departmental Interpretation and Practice Notes (DIPN).
Designated local research institution: In general, a payment made to a designated local research institution would qualify for the enhanced tax deduction. Currently there are a limited number of approved institutions. Local research entities may now apply for designated status from the Innovation and Technology Commission (ITC) if they meet certain requirements. Given the time needed for the ITC to
process applications, the bill was amended to allow a taxpayer to take the standard or an enhanced deduction for a payment made to a local institution if that institution becomes a designated local research institution within six months after the date the payment is made. The government will set up an expert panel to advise on the process for assessing whether an institution should receive designated status.