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Subsequent to the judgment of Hong Kong's Court of Final Appeal in Nice Cheer Investment Limited v Commissioner of Inland Revenue (CIR), FACV 23/2012, the Inland Revenue Department has been requested, and has agreed, to accept financial statements prepared on a fair value basis for tax reporting.
The Appeal Court allowed an appeal by the taxpayer against a determination by the CIR. The IRD had confirmed an assessment that the investment trading company was liable for profits tax in respect of unrealized gains for the three years between 2003/04 and 2005/06.
In its annual profit and loss accounts, the taxpayer had recorded an item of net realized and unrealized gains or losses on trading investments and securities. The realized gain/loss was based on the disposal of those financial assets, while the unrealized gain/loss was based on the changes in the fair value (i.e. quoted market price) of those unsold and held by the taxpayer during the relevant period.
In computing its adjusted losses or assessable profits, the taxpayer excluded from assessment the unrealized gains, but claimed deduction of the unrealized losses, whereas the IRD was of the view that both the unrealized gains and losses arising from revaluing the unsold trading investment and securities held at the year-end should be included in the profits tax assessment.
The difference between the profits tax assessed over the years, and the tax calculated by the taxpayer without taking into account the unrealized gains was substantial, being in the region of HKD250m (32.25m).
There was no effective dispute between the parties that, in accordance with prevailing accounting standards, unrealized gains and losses should be shown in the taxpayer's profit and loss account at fair value.
However, the taxpayer relied (and the CFA agreed) on the provision of the Hong Kong Inland Revenue Ordinance (IRO) that taxable profits mean "real profits arising in or derived from actual buying and selling of commodities in commercial transactions between the taxpayer and his trading partners or supply of professional or other services by the taxpayer to another person and do not include notional or unrealized profits arising out of revaluation of the taxpayer's stock of trade." Anticipated or imputed profits must therefore first be realized before they are subject to tax.
Subsequently, following the final resolution of the case, it was confirmed that the Financial Services and Treasury Bureau and the IRD are studying the issues arising from the judgment, and, in particular, whether there should be a change in law to allow continuation of the mark-to-market practice.
In the meantime, however, with regard to 2013/14 profits tax returns, the IRD has understood that substantial costs will be incurred by firms if profits computed on a fair value basis now have to be immediately recomputed on a realization basis. The IRD has agreed to accept returns in which the assessable profits are computed on a fair value basis, but stressed that taxpayers and their representatives should take note that this is an interim administrative measure.
The IRD has also agreed to re-compute the 2013/14 assessable profits computed on a fair value basis if the taxpayer subsequently adopts the realization basis. However, any request for re-computation should be made within the time limits laid down in the IRO.
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