Hong Kong has a vision of becoming a hub for innovation and technology (I&T) which builds on the city’s high level of literacy and education. This also aligns with the national development strategies, and enables Hong Kong to contribute its strengths to the Greater Bay Area.
The I&T sector involves research and development of various intellectual property (IP) that is new and unique. The legal owner of the IP may commercialize the inventions in various ways such as by building production lines for manufacturing the products. Entrepreneurs may leverage the IP of others by way of acquisition or licensing to enhance the inventions or speed up the commercialization. The IP required may be owned by innovators or entities in other jurisdictions and thus cross-border acquisition or licensing of IP between related and unrelated parties is now very common. The costs associated with the development, acquisition and licensing of IP may not always be deductible for Hong Kong profits tax purposes, which would result in a very high tax cost.
Let’s assume a Hong Kong company develops certain IP by its employees in Hong Kong. The research and development costs may be deductible for profits tax purposes under the specific provisions under section 16B of the Inland Revenue Ordinance (IRO). Enhanced deduction of more than 200 percent of the relevant costs incurred may be available if the research and development activities are performed in Hong Kong if the qualifying conditions (which are quite complicated and restrictive) are met. In reality, not a lot of taxpayers could enjoy the enhanced deduction as the research and development activities are often not performed in Hong Kong given the high costs of maintaining a research and development team in Hong Kong, and the lack of suitable talent in Hong Kong (these factors explain why a lot of corporations are setting up their research and development centre(s) outside the city). Research and development service fees paid to research and development centres outside Hong Kong would not be entitled to the enhanced deductions.
If a Hong Kong company acquires IP from others, the acquisition costs may be deductible under the specific deduction provisions in the IRO, such as section 16E (for purchase of patent rights), and section 16EA (for purchase of specified IP rights, e.g. copyright, registered design, registered trade mark, etc.). The deduction may be available in the year of acquisition (one-off) or over five years starting from the year of acquisition (20 percent per annum). If the IP rights acquired are developed by a group company (e.g. headquarters or the group’s research and development hub), no deduction would, however, be allowed if the purchase is between associated persons even if the transaction is at arm’s length and commercially genuine. This restricts the applicability of the specific deduction although transfer of IP between group companies is common.
The original IP owner may wish to retain the legal ownership, a Hong Kong company may enter into a licensing agreement to obtain the right to use the IP. Commercially, the original IP owner (licensor) may want to receive an upfront licence fee to monetarize the costs invested, plus a recurring royalty which is dependent on the future sales or profits to share the economic success. This fee charging basis is a common market practice in the life science sector. Given the upfront licence fee is one-off for acquiring an asset, producing enduring benefits which enables and upgrades the Hong Kong company’s (licensee) income producing capacity, the upfront fee is regarded as capital in nature for profits tax purposes, and specifically disallowed under section 17(1)(c) of the IRO. The licence acquired is an intangible asset where no capital allowances would be available. As the Hong Kong company does not acquire the legal ownership of the relevant IP, the above-mentioned deduction for purchase of IP rights is also not available. The accounting amortization of such licence (if the upfront licence fee is capitalized as an intangible asset) is also not deductible for profits tax purposes.
If the Hong Kong company structures its business properly where it generates offshore sales or offshore royalty income, the non-deductibility of the IP costs may not be a big issue given that the company would be tax neutral due to its income being non-taxable for profits tax purposes. However, things have changed. To respond to the European Union’s concerns over potential double non-taxation arising from tax exemption for offshore passive income in Hong Kong, the city enacted its Foreign-sourced Income Exemption (FSIE) regime on 1 January 2023, which covers passive income like interest, dividend, equity disposal gains and IP income (e.g. royalty). Under the current FSIE regime, offshore-sourced patent-related IP income is subject to a nexus ratio in determining the non-taxable (offshore) portion. This would be favourable if the Hong Kong company carries on many research and development activities itself (however, significant onshore research and development activities may suggest that the royalty income should be onshore-sourced in the first place based on the Hong Kong Inland Revenue Department’s prevailing assessing practice). In reality, the underlying research and development is often outsourced to related parties outside Hong Kong, where the resultant nexus ratio could be very low, and thus only a small portion of the patent-related income is offshore-sourced. For corporate taxpayers receiving other types of IP income (non-patent-related, such as franchise fees), the royalty would be deemed as taxable unless other exemption conditions are met. It could result in a significant tax cost if the Hong Kong developer’s royalty income is taxable but without appropriate deductions on the costs incurred.
It is encouraging to see in the recent 2023-24 Budget Speech that the Hong Kong government is attempting to address the difficulties mentioned.
In the most recent China Mobile case, the Court of Appeal ruled that the spectrum utilization fees (such as the so-called “5G licence fees”) paid by the taxpayer to the Telecommunications Authority are capital in nature. The logic behind this is similar to what is discussed previously in connection with upfront licence fees. The government has listened to the voices of the telecommunications industry and professional bodies to enact specific legislations to circumvent the traditional case law principles, such as the badges of trade, where this kind of technology advancement had not been foreseen. The government is proposing to allow tax deduction for spectrum utilization fees paid by future successful bidders of radio spectrum.
On the other hand, legislative amendments in the first half of 2024 devising a patent box preferential regime is expected. A patent box regime typically aims to provide lower tax rates on the income derived from specified IP (usually patents). The industry hopes that the regime could be wide enough to cover income generated from IP other than patents. The patent box regime could be designed to include specific deductions on expenditure which is capital in nature, such as the above-mentioned development costs, acquisition costs and/or license fees. The government could also consider expanding the scope of deduction for spectrum utilization fees to cover this kind of IP costs (or the so-called “black hole expenditure”). The government could also take the chance to revisit and expand the current scope of research and development enhanced deduction to cover the service fees paid for research and development activities performed in the Greater Bay Area.
However, when global minimum tax rules are implemented, the patent box concession may be neutralized if the relevant Hong Kong company is part of a corporate group that is subjecting to the Pillar 2 initaives under Base Erosion and Profit Shifting 2.0 (i.e. those groups with global consolidated revenue of €750 million and above). A large part of the tax savings may be paid as “top-up tax” which will be introduced in Hong Kong not earlier than 2025.
In combination of a concessionary tax rate, and enhanced deduction of research and development costs, the relevant business’ “tax breakeven point” could be postponed. This would be particularly helpful to start-ups in the I&T sector to maintain a strong cash position which is critical for business growth.
In line with Hong Kong’s other tax concession regimes and to uphold tax integrity and transparency, it would be reasonable to expect that a certain level of business substance is required to be maintained in Hong Kong in order to be eligible for the patent box regime. These not only justify the commercial reasons for using Hong Kong as an IP ownership location but also bring in real economic activities, further energizing the Hong Kong economy. Other tax and non-tax measures for attracting and enabling I&T talent mobility should also be introduced to fuel the business substance requirement under the patent box regime, such as providing subsidy or education assistance to qualified expatriates with targeted skillsets, etc.
By providing a fair and favourable tax regime for the IP-related industries, the I&T sector could grow in Hong Kong and bring Hong Kong’s economy to the next level.
The article is contributed by Eugene Yeung, KPMG China’s Tax Partner and Co-head of Technology and New Economy in Hong Kong, and Deputy Chairman of the Institute’s Taxation Faculty Executive Committee.