Introduction

Tax incentive can be an effective tool for influencing corporate behaviour. For instance, substantial tax benefits are often provided by jurisdictions that wish to encourage corporations to set up research and development (“R&D”) centres. In this respect, Hong Kong is no exception.

R&D expenses are subject to specific tax deduction rules in Hong Kong. Since R&D activities tend to bring fundamental changes and significant advancements to the products or services of a company, R&D expenses are regarded by the IRD as a capital expenditure, which is generally not tax deductible in Hong Kong.

Nevertheless, an enhanced tax deduction, commonly known as “super tax deduction”, was introduced for certain R&D activities in Hong Kong with effect from the year of assessment 2018/19. This was a breakthrough in Hong Kong’s taxation system as it was the first time that the Inland Revenue Department (“IRD”) had allowed deductions of 300%/200% on certain operating expenditure. The first HK$2 million spent on qualifying R&D expenses is eligible for a 300% tax deduction. For any portion exceeding HK$2 million, a 200% tax deduction will be granted.

Companies that wish to qualify for tax deduction of R&D expenses in Hong Kong should take note of the following requirements:

·           requirements of super tax deduction for R&D expenses; and

·           requirements of tax deduction for R&D expenses paid to overseas entities.

Requirements of super tax deduction for R&D expenses

R&D activities must be carried out in Hong Kong in order to qualify for the super tax deduction.

Hong Kong Science Park and Cyberport are popular incubators for start-ups in Hong Kong, particularly for those with significant R&D functions, as they offer appealing incentives and funding for start-ups. The super tax deduction is a further incentive introduced by the Hong Kong government for corporations carrying out R&D activities in Hong Kong.

Some of the basic requirements for the super tax deduction are as follows.

Requirement 1

The R&D activities must be carried out either by the taxpayers themselves, or must be outsourced to designated local research institutions. R&D activities outsourced to group companies or external parties that are not designated local research institutions are generally not eligible for the super tax deduction, except under proper cost-recharge arrangements. The list of designated local research institutions can be found on the Hong Kong Innovation and Technology Commission website.

Requirement 2

For R&D activities carried out by the taxpayers themselves, only consumables and staff costs directly related to the R&D activities qualify for the super tax deduction. These expenses have to be exclusively and directly related to the R&D activities in order to qualify for the super tax deduction.

Requirements of tax deduction for
R&D expenses paid to overseas entities

Cross-border reimbursements of R&D costs to overseas group companies, which is a common practice for multinational corporations, were formerly not tax deductible in Hong Kong under the original Section 16B of the Inland Revenue Ordinance whether before or after the introduction of super tax deduction. Subsequent amendments under Departmental Interpretation and Practice Notes 55 (“DIPN 55”) have slightly relaxed the restriction. Under the current DIPN 55, R&D expenses paid by a Hong Kong company to overseas group companies could qualify for the 100% normal tax deduction if both of the following conditions are satisfied:

1.      the R&D expenses paid by the Hong Kong company to subcontracted overseas group companies do not exceed 20% of the total R&D costs; and

2.      the R&D expenses paid to overseas companies is not more than HK$2 million.

Despite the relaxation under DIPN 55, it is still difficult for multinational corporations with significant R&D functions outside Hong Kong to qualify for tax deductions for their R&D costs. As such, multinational corporations should plan their R&D cost contribution and subcontracting arrangements carefully.

The table below summarises the types of expenses qualified for tax deduction and their deduction rates: 

*The expenditure could qualify for a 100% normal tax deduction if it does not exceed 20% of the total costs of the R&D project and the subcontracting fee is not more than HK$2 million.

Takeaway

There are pros and cons of incurring R&D costs in Hong Kong from a tax perspective. Multinational corporations should consult their tax advisors to ensure that thorough cross-border tax planning is in place to maximise the tax benefits and that their current R&D arrangements are eligible for the maximum tax deduction in order to enhance their group’s overall tax efficiency.