Hong Kong Tax News Flash 

Originally, trading financial assets classified as FVTPL were not allowed to be reclassified to other categories according to HKAS 39.  As such, any further declines in the value of the trading financial assets in the recent financial turmoil would have further impact on the profitability of companies holding these assets.
      
In response to the concerns raised by the business community, on 13 October 2008, the International Accounting Standards Board (IASB) issued amendments to IAS 39 "Financial instruments: Recognition and measurement" and IFRS 7 "Financial instruments: Disclosures", that permit reclassification of certain non-derivative financial assets if conditions specified in the amendments are met.  On the following day, the Hong Kong Institute of Certified Accountants announced that it would adopt the IASB amendments for the equivalent Hong Kong Financial Reporting Standards (i.e. HKAS 39 and HKFRS 7).  For more details about the HKAS 39 amendments from a financial reporting perspective, please refer to our HKFRS Newsletter - November 2008 Supplement entitled "Reclassification of financial assets: Amendments to HKAS 39 Financial Instruments: Recognition and Measurement and HKFRS 7 Financial Instruments: Disclosures".
      
Accounting-wise, permitting companies to reclassify certain financial assets will allow companies not to report the further decline in the value of these assets in their income statements.  However, what are the Hong Kong profits tax implications of the reclassification and the subsequent accounting treatments?  This news flash looks at the key profits tax issues arising from the reclassification of financial assets under HKAS 39 amendments.

Details are as follows:

1. Non-derivative financial assets classified as FVTPL (other than those designated as FVTPL upon initiation recognition) may be reclassified as L&R if they meet the definition of a loan or receivable at the date of reclassification and the company now has the intent and ability to hold them for the foreseeable future or to maturity.
        
   Other non-derivative financial assets (i.e. those that do not meet the definition of a loan or receivable at the date of reclassification) may be reclassified out of the FVTPL only in rare circumstances.  According to the press release issued by the IASB announcing the publication of these amendments, the deterioration of the world's financial markets in the third quarter of 2008 is a possible example of these "rare circumstances".
    
   Since HKAS 39 amendments do not allow reclassification of derivatives, financial assets that can be reclassified out of FVTPL are likely to be either equity instruments or debt instruments.
    
2. Non-derivative financial assets classified as AFS (other than those designated as AFS upon initial recognition) may be reclassified as L&R if they meet the definition of a loan or receivable and the company has the intent and ability to hold them for the foreseeable future or to maturity.

The reclassified assets will be carried at their fair value on the date of reclassification, which will become their new cost (for equity instruments) or amortized cost (for debt instruments).
 
For assets reclassified out of FVTPL, the difference between the fair value at the date of reclassification and the fair value at the last reporting date will be reflected in the income statement of the current reporting period.  Any gain or loss recognised in the income statement prior to the reclassification is not reversed upon reclassification.
 
For assets reclassified out of AFS to L&R, the difference between the fair value at the date of reclassification and the fair value at the last reporting date will be taken to equity.  The loss recognised upon reclassification, together with any previous gain or loss taken to equity, will be transferred to the income statement either through (1) amortisation over the remaining life, using the effective interest rate method (if the asset has a fixed maturity), or (2) upon disposal (if the asset does not have a fixed maturity).
 
Reclassification under HKAS 39 amendments cannot be reversed once elected.

According to the HKAS 39 amendments, equity instruments under FVTPL can only be reclassified as AFS and the reclassification is only possible if the instruments are no longer held for the purpose of selling or repurchasing in the near term and in "rare circumstances".
 
According to DIPN 42, the tax treatment of financial assets classified as FVTPL adopted by the Inland Revenue Department (IRD) is different from those in AFS.
 
A financial asset that is classified as FVTPL is a trading asset by definition, hence any gain or loss from a change in fair value recognised in the income statement is prima facie revenue in nature and taxable (gain) or deductible (loss) if such gain/loss is with a Hong Kong source (for the sake of simplicity, all the gain or loss is assumed to be of Hong Kong source in the remaining discussion in this news flash).
 
DIPN 42 is, however, silent on the nature of the financial instruments classified as AFS.  That means that an AFS financial asset can either be held for trading or for long-term investment purposes, depending on the facts of each situation.  If the AFS financial asset is considered to be a trading asset, the timing of taxing the whole gain/loss arising from a change in fair value will be the time at which the gain/loss is reported in the income statement following the accounting treatment under HKAS 39.

• Tax consequence at the time of the reclassification:
   
  An unrealised loss will be recognised in the income statement at the time FVTPL equity instruments are reclassified as AFS.  Since equity instruments under FVTPL are likely to be trading assets, such loss will usually be deductible for profits tax purposes.
     
• Tax consequence subsequent to the reclassification:
   
  The tax treatment after reclassification depends on whether the equity instrument reclassified as AFS is still considered to be a trading asset by the IRD.  HKAS 39 amendments only allow reclassification in "rare circumstances" provided that the asset is no longer held for trading purpose in the near term without clear indication of a change of the intention of holding the asset for the long term.  As such the taxpayer may not have sufficient evidence to prove the nature of the asset has changed from trading to capital for tax purposes.  Subsequent to reclassification, any revaluation gain recorded in the equity will be recycled to the income statement upon disposal.  The IRD will likely seek to argue that the asset remains revenue in nature after reclassification and therefore the gain is taxable.
   
  Hence if the reclassified asset remains a trading asset after the reclassification, the reclassification to AFS does not alter the taxability or deductibility of the revaluation gain or loss but just likely defers the timing of taxing or deducting such gain or loss until the asset is sold.
   
  If there is sufficient evidence to show that the intention of holding an equity instrument has changed from trading to long-term investment, the portion of revaluation gain or loss arising after the change of intention is arguably capital in nature and not taxable or deductible.

Debts held for trading purpose can be reclassified from FVTPL to L&R only if the entity can demonstrate for accounting purpose the intent and ability to hold the assets for long term and the assets meet the definition of L&R.  In the current market situation, a loss likely arises at the time of reclassification, and hence the subsequent amortisation is to reverse portion of such loss into the income statement as income.
 
DIPN 42 states that for L&R with a revenue nature, the gain or loss is taxable or deductible when the financial asset is derecognised or impaired or when the financial asset is amortized to the income statement.  Presumably such treatment can be applied to both L&R acquired and L&R reclassified from other categories.

• Tax consequence at the time of the reclassification:
   
  Similar to equity instruments reclassified out of FVTPL, the unrealised loss recognised in the income statement upon reclassification should be deductible based on the same argument discussed above.
     
• Tax consequence subsequent to the reclassification:
   
  Following the approach adopted in DIPN 42 for L&R, the portion of gain amortised to the income statement using the effective interest rate method subsequent to the reclassification could arguably be taxable if this represents the reversal of the loss previously allowed.
   
  Any impairment of the carrying amount of loans and receivables, according to DIPN 42, will be considered as bad debts written off and tests in section 16(1)(d), that is (a) the debt has to be trade debt and (b) it is proved to the satisfaction of Assessor that the amount is not recoverable, will be applicable.
   
  Please note that the tax treatment discussed in this section applies to loans and receivables that can be reclassified from FVTPL to L&R.

Loans can be reclassified from AFS to L&R if the entity can demonstrate for accounting purpose the intent and ability to hold the assets for a long term, and the assets meet the definition of L&R.

• Tax consequence at the time of the reclassification:
   
  As the loss upon reclassification will not be recognised in the income statement, but in the equity, there is no immediate tax implication at the time of reclassification.
   
• Tax consequence subsequent to the reclassification:
   
  Similar to the situation where loans are reclassified from FVTPL to L&R, upon reclassification, IRD will likely follow the profits tax treatments for the loans and receivables as explained in DIPN 42, that is (a) impairment will be subject to the tests in section 16(1)(d) and (b) the amount amortised to the income statement (after the loan is reclassified to L&R) will be taxable/deductible.