The interaction of the accounting standards with the tax laws – HKFRS 15 and HKFRS 16 A look at tax principles for determining whether and when accounting profits or losses are taxable or deductible The Inland Revenue Department (IRD) has recently updated Departmental Interpretation and Practice Note No. 1 (revised DIPN 1) which deals with the valuation of stock-in-trade and the taxation of long-term construction contracts, property development and property investment. At the outset, revised DIPN 1 indicates that where the accounts of a person are drawn up in accordance with the ordinary principles of commercial accounting and are in conformity with the Inland Revenue Ordinance (IRO), no further tax adjustments are required or permitted. Revised DIPN 1 cites CIR v. Secan Ltd & Another (2000) 3 Hong Kong Court of Final Appeal Reports (HKCFAR) 411 in support of this position. However, the accounting profits or losses would nonetheless need to be disregarded for tax purposes under the two cardinal tax principles established in Nice Cheer Investment v. CIR (2013) 16 HKCFAR 813: (i) “profits” connotes realized but not unrealized profits; and (ii) neither profits nor losses can be anticipated.
HKFRS 15 Recognition of revenue Before Hong Kong Financial Reporting Standard (HKFRS) 15 Revenue from Contracts with Customers became effective on 1 January 2018, revenue recognition of long-term construction contracts, including contracts for the pre-sale of units of property development projects, was governed by several accounting standards and interpretations. Some taxpayers have expressed the view that the variable consideration of a customer contract, recognized as revenue October 2020
in the accounts under HKFRS 15, may represent unrealized profits. As a result, such consideration should not, based on the principles established in the Nice Cheer case, be taxable until the amount is contractually due. Under HKFRS 15, a person has to recognize variable consideration as revenue when performance obligations are satisfied, and it is highly probable that a significant reversal in the amount of cumulative revenue recognized will not occur as a result of a change in the estimate of the variable consideration. Revised DIPN 1 notes that while an element of estimation may be involved when an amount of variable consideration under a customer contract is recognized as revenue, the amount so recognized would nonetheless be taxable, realized profits or losses. The IRD has also previously indicated that unlike notional year-end revaluation gains in respect of listed securities held for trading purposes, such as in the Nice Cheer case, variable consideration recognized as revenue under HKFRS 15 stems from the performance of a customer contract which is an actual business transaction. As such, any amount so recognized cannot generally be regarded as being unrealized profits. Imputed interest Under HKFRS 15, a contract is considered to contain a significant financing component if the timing of payments agreed to by an entity and its customer under a contract (either explicitly or implicitly) provides a significant benefit as regards the financing of the transfer of the goods or services to the entity or the customer. Where a significant financing
component is involved, an entity is required to present the effect of financing (either interest income or expense) separately from the customer contract revenue, and thereby account for the effects of the time value of money. Revised DIPN 1 states that such imputed interest would be disregarded for tax purposes. This is because the legal form of a transaction generally takes precedence over its economic substance for tax purposes, i.e. an entity receiving advance or deferred payments from a customer has no legal obligations or rights to pay or receive interest to or from the customer. As such, tax adjustments will need to be made in tax computations to exclude such notional interest income or expense recognized under HKFRS 15. Taxpayers who wish to better understand how such tax adjustments are to be made can refer to examples 3 and 4 of revised DIPN 1. Transitional adjustments In the year a new accounting standard such as HKFRS 15 is first adopted, entities are generally required to account for the transitional adjustments under either of the following two methods: (a) Full retrospective method: retrospectively to each prior reporting period presented in accordance with Hong Kong Accounting Standard (HKAS) 8 Accounting Policies, Changes in Accounting Estimates and Errors; or (b) Modified retrospective method: retrospectively with the cumulative effect of initially applying the relevant accounting standard at the date of initial application. Regardless of the method adopted, 59
