Revised Departmental Interpretation and Practice Note No. 28 on the deductibility of foreign tax

07 November 2019, Tax, Legal Alert, by Stefano Mariani,

In August of this year, the Commissioner of Inland Revenue (Commissioner) has unilaterally and without forewarning amended the Departmental Interpretation and Practice Notes No. 28 (DIPN 28), a practice note that until that point had been current since 1997.

Historically, it was understood (correctly) that overseas withholding taxes levied by a foreign revenue authority on certain gross income (as distinct from profits taxes) charged on royalties, service fee payments, etc. would be deductible sums for the purposes of section 16(1) of the Inland Revenue Ordinance (IRO), without being excluded under any express prohibition in section 17, in ascertaining the profits of a person taxable in Hong Kong. The reasoning behind that policy was that a withholding tax was an expense that had to be borne regardless of whether or not a profit had been derived: it was a necessary incident of earning the amount subject to the overseas withholding tax, and the tax itself was to be charged on the gross amount, and not some measure of profit, howsoever computed. 

Effect of the new DIPN 28

The proper starting point of the inquiry into the general deductibility of withholding taxes should be whether the withholding tax in question was incurred in the production of profits assessable to tax in Hong Kong. The Inland Revenue Department (IRD), in its new guidance, answers that question in the negative. The new DIPN 28 states that:

“Since a tax on profits or income is an application of the profits and not an outgoing or expense incurred in producing chargeable profits, the tax is not deductible. The assessable profits of a trade, profession or business are the profits before, and not after, deduction of profits tax.”

To be clear, the IRD now understands such tax on profits and income to include most foreign withholding taxes on gross income, since such taxes are in effect income taxes. The upshot of this is that it is now IRD’s policy that overseas taxes on gross income are not deductible. That leaves, in the IRD’s view, as deductible under section 16 a limited number of incidental imposts that are not levied by reference to profits or income, such as rates levied on properties, vehicle licence fees, excise duties, and foreign taxes such as value added tax and goods and services tax not charged by reference to profits or income. 

By implication, the IRD will therefore likely disallow or otherwise challenge any future claims by a taxpayer for a deduction for foreign taxes borne on gross income.

Nothing in the new DIPN 28 purports to affect the application of any double taxation agreement to which Hong Kong is a party. It is abundantly clear from section 49 of the IRO that the provisions of such arrangements in general prevail over domestic tax legislation.

Comments

In the only published decision in Hong Kong relating to the deductibility of foreign taxes D43/91 (1991) 1 HKRC 80-154, the Inland Revenue Board of Review (Board) allowed the appeal to the extent that the overseas taxes were charged on gross receipts and not on net income or profits on the basis that these are outgoings or expenditure incurred in the production of taxable profits, and not excluded by virtue of section 17(1)(b). In so doing, the Board recognised and approved the general principle as stated by Buckley LJ in the English Court of Appeal in AG v Ashton [1904] 2 Ch 621 at 624 that: “a sum which is an expense which must be borne whether profits are earned or not, may no doubt be deducted before arriving at profit”. Withholding tax is evidently an outgoing: it is a fixed amount that must be paid as a necessary incident of receiving a given income stream. Economically speaking, it is no different from a fixed cost.

The chief distinguishing factor in establishing the deductibility of foreign tax was the nature of the fund on which that tax was assessed: if it is a profits tax, then it is not deductible, following the reasoning in Inland Revenue Commissioners v Dowdall O’Mahoney & Co, Ltd [1952] AC 401; if, however, it is charged on gross receipts, it is deductible, following the reasoning of the Chancery Division in Attorney General v Ashton Gas Company [1906] AC 10. Paradoxically, these two authorities were cited by the IRD in the new DIPN 28 as though they supported the Commissioner’s views on the non-deductibility of foreign taxes on gross income, despite their combined effect leading to the opposite conclusion.

It is apparent that DIPN 28 is wholly unfounded in law. It is not clear to us why the Commissioner would have resolved to resile from the long-established understanding between the IRD and practitioners. Though plainly wrong, the new guidance has the net effect of potentially placing taxpayers in Hong Kong with substantial overseas investments and/or operations at a relative disadvantage by purporting, unlawfully, to deny them the historically allowable tax deductions. Clients are advised to take note of this change in policy and if necessary seek follow-up advice to address any future tax risk.