Tax implications of IFRS 9 - PDF

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					Taxation                                                                                                                                       A PLUS




Tax implications of IFRS 9
With IFRS 9 Financial Instruments coming into effect soon,
John Timpany and Conrad Turley explain its main tax ramifications




C
          hanges to how financial assets and      •	 	 n increase in the number of fair value
                                                     A                                                    credits are posted to the credit allowance
          liabilities are classified and measured    movements through the income state-                  account. For loans in an identified book of
          will become mandatory from 2015            ment. The abolition of the available-for-sale        bad debts, expected losses are determined
under the published phases of IFRS 9 Financial       asset category, under which many fair value          on an individual basis and credited to the
Instruments. Further changes to impairment           movements went through reserves, means               credit allowance account up front. For
and hedge accounting are impending under ex-         that most fair value movements should now            good loans, expected losses are estimated
posure drafts ED/2009/12 and ED/2010/13. The         go through the income statement. Under               at a portfolio level and credited over the
main changes to accounting for financial instru-     the new election option, where fair value            life of those loans. In addition, in each peri-
ments have been outlined in earlier issues of        movements on a particular non-trading                od the losses expected to occur in the next
A Plus, particularly in the April 2010 article       equity instrument are accounted for through          12 months need to be credited in full. Loans
“Deconstructing IAS 39.” The major changes of        reserves, the gain on the asset no longer            may be transferred between the books.
potential tax relevance are as follows:              needs to be recycled to the income state-            But the exact mechanics of this accounting
                                                     ment on realization. In addition, fair value         treatment, set out in the exposure draft on
•	 	 bolition of the existing classification
   A                                                 movements on financial liabilities, which            impairment, are yet to be finalized.
   of financial assets. The four categories          arise from changes to own credit risk, will
   under IAS 39 are abolished, with assets           be put through reserves and not be recycled          The starting point for the calculation of
   simply being classified as measured at            to the income statement on the extinction         Hong Kong profits tax, as confirmed by the
   amortized cost or fair value.                     of the liability. A hybrid financial instrument   Court of Final Appeal in 2000 in Commissioner
•	 	 lassification based on business
   C                                                 will no longer be bifurcated into a host          of Inland Revenue v Secan Limited & Ranon
   models and contractual cash flow                  contract and embedded derivative and              Limited (5 HKTC 266) is the profits per the
   characteristics. Assets will be measured          measured separately on different bases. It        financial statements, subject to any adjust-
   at amortized cost if they are held within         will be assessed as a whole for classification    ments required by the provisions of the Inland
   a business model, the objective of which          and therefore be fair valued through the          Revenue Ordinance. Until recently the Inland
   is to hold assets and collect contractual         income statement in its entirety.                 Revenue Department’s stance, and the com-
   cash flows consisting solely of payments •	 	 he mandatory use of a credit allow-
                                                     T                                                 monly accepted position among practitioners,
   of principal and interest. All other assets       ance account for loan impairments.                was that fair value gains or losses recorded in
   are measured at fair value. The tainting          The impairment event is no longer                 the accounts on the basis of the IFRS standards
   rules – whereby a portfolio of assets             required for impairment losses to be recog-       would be given tax effect as long as they were
   measured at amortized cost would be               nized in the income statement. Projected          Hong Kong-sourced and not capital in nature.
   reclassified as available for sale if one ele-    credit losses over an instrument’s life must      But the recent decision by the Court of First
   ment of the portfolio were to be sold – no        be estimated in the first year and updated        Instance in Nice Cheer Investment Ltd. v CIR
   longer apply, providing that the business         in each subsequent period to reflect the          (2011; HCIA 8/2007), if upheld in the higher
   model does not change.                            latest projections. The resulting debits or       courts, makes it possible that gains will not be

                                                                                                                                    September 2011    51
Taxation




recognized for tax purposes until they are actu-     in arriving at the revenue figure, not an         calculated after a consideration of individual
ally realized. Until the case goes higher, the IRD   expense for tax purposes. If this position can    loans, is a matter for further consideration.
is likely to continue with its existing assessment   be supported, the profit calculated per the          The implementation of the new IFRS 9 may
practice. Regardless of the case’s outcome,          accounts would be the profit for tax purposes     be a good opportunity to clarify the legislation
with the changes in accounting for financial         and the ordinance’s provision governing           and the administrative practice concerning
instruments set out in IFRS 9, the amount and        deductions for bad debts – section 16(1)(d) –     the deductibility of bad debts. In the absence
timing of profits tax liabilities are expected to    would not apply to restrict the tax deduction     of changes to the IRD practice, taxpayers
change and certain technical tax issues may          allowed.                                          should consider the implications of having to
arise over obtaining tax deductions.                    On the other hand, if the movement on          calculate substantial deferred tax assets for
                                                     the credit allowance account is treated as        inclusion in the financial statements.
Accelerated tax deductions                           an expense for tax purposes, the manner in
for bad debts?                                       which section 16(1)(d) operates will almost       Capital versus revenue
Under IAS 39, if the relevant impairment             certainly hinder the taking of deductions         The accounting treatment of a transaction does
event or bad debt recognition occurs after           in practice. The provision allows bad or          not determine its tax treatment for the purposes
a business has already been in the red for a         doubtful debts incurred to the extent they        of the distinction between capital and revenue,
while, then losses recognized might not be           are estimated to the assessor’s satisfaction      but it can be influential. Under IAS 39, entire
used until profits have recovered sufficiently       to have become bad. This section is enforced      portfolios of loans can be re-characterized
to absorb the accumulated tax losses carried         strictly in practice and the IRD requires         as available-for-sale assets under tainting,
forward. This may not be for many years.             evidence that the potential debt has become       but this is unlikely to occur under the new
Use of the credit allowance account does not         partly or wholly irrecoverable. The manner        business model approach in IFRS 9. A taxpayer
require an impairment event to occur before          in which the new credit allowance account         selling an asset classified as available for
doubtful debt losses may be recognized. If it        debits are calculated may come under close        sale might find it hard to argue that the asset
is followed for tax purposes, this may mean          scrutiny by the IRD, because the absence          is held for the long term and that the gain is
that bad debt deductions can be taken earlier        of an identifiable impairment event may           on capital account and not subject to tax.
and used against other profits. But the exact        lead it to dispute the loss incurred. Certain     With the abolition of the tainting rules, it can
tax impact of the new approach is uncertain          international cases, such as the Privy Council    be argued that the asset has remained part
because it is not yet final how credit losses        decision in CIR v Mitsubishi Motors New           of a business model whose objective is to
will be presented in the income statement.           Zealand Limited (1995; 17 NZTC 12,351),           hold the assets for the long term and simply
    One proposal is that the income statement        indicate that a statistically estimated expense   collect the contractual cash flows. This may
should show two figures for interest revenue:        can be considered as incurred. But given          aid the argument that the gains are on capital
a gross interest revenue figure before taking        the requirements of section 16(1)(d) and the      account, at least for taxpayers that aren’t in the
account of debits to the credit allowance            IRD’s history of denying general provisions       money-lending business.
account and a net interest revenue figure            for doubtful debts, it’s unlikely that the IRD
after an adjustment for movements on the             will allow such provisions. Whether the IRD       Greater profits tax liability
credit allowance account. Arguably, under            could be persuaded to allow credit allowance      volatility
this approach, the movement on the credit            account adjustments in respect of the bad         The abolition of available for sale assets
allowance account is simply an adjustment            loans book on the basis that allowances are       and bifurcation, and the establishment of

52   September 2011
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tighter criteria for assets to fall within the      influenced by the notion that taxpayers may transition to the new accounting standards.
amortized cost business model, may lead             keep gains outside the income statement     The case of Pearce v Woodall-Duckham (1978;
to an increase in the number of fair value          of their own volition. This treatment would 51 TC 271) gives the IRD a basis for adopting the
movements passing through the income                be considerably worse than the current      position, as the IRD has noted in the section on
statement. This will result in volatility in the    treatment for assets for sale instruments,  transitional adjustments in DIPN 42. Whether
accounting profit figure, forming the basis for                                                 the IRD will allow taxpayers to spread their
                                                    whereby fair value gains are taxed at the time
assessable profits. But, in light of the decision                                               tax liabilities arising on transition is open to
                                                    of realization. But the law is unclear and it
in Nice Cheer Investment Ltd., it might be                                                      question – jurisdictions such as the U.K. and
                                                    would be helpful if the IRD could clarify its
asked whether fair value gains on financial         technical basis for such treatment.         Singapore allowed for the deferred recognition
assets now need to be derecognized for tax                                                      of adjustments on the transition to IAS 39, but
purposes until realization.                      Hedge accounting accessibility Hong Kong didn’t. Taxpayers should expect
                                                 Changes to hedge accounting are intended       a repeat of this policy on the transition to
Equity instruments accounted to make this more widely applicable. While                         IFRS 9. The IRD should reconsider DIPN 42 to
for through reserves                             hedging for tax purposes may occur even        deal with the problems likely to arise on IFRS 9’s
Gains on the disposal of certain non-trading     without the use of hedge accounting, using     implementation, and revisions to the guidance
equity instruments, where an election has        hedge accounting more may help taxpayers       should consider the IRD’s practice when it dealt
been made to account for the fair value          argue that specific hedges are acceptable for with the implementation of IAS 39.
movements through reserves, are not              tax purposes – i.e., that the gains and losses    The new IFRS 9 is part of a wider
recycled to the income statement. Equally, the on the hedging and hedged instruments have programme of accounting reforms for the
fair value movements on financial liabilities,   the same source and nature – and thereby       financial services industry and is likely to
which arise from changes to an entity’s own      limit tax exposure. Current IRD practice,      have a big effect on taxation. Changes to the
credit risk, will be put through reserves and    as set out in Departmental Interpretation      accounting for financial instruments have yet
won’t be recycled to the income statement        and Practice Note No. 42, defines hedge        to be finalized and further tax issues may be
on the extinction of the liability. The IRD      accounting as matching the offsetting effects identified once the final standard is published.
could take the view that annual fair value       of the fair value changes in individual hedged Nonetheless, it’s already clear that IFRS 9’s
movements through reserves should be taxed items and hedging instruments. Concepts              implementation will change the amount
in the year in which they arise to ensure that   of macro, portfolio and other forms of         and timing of profits tax liabilities, resulting
no amounts fall outside the tax charge.          net exposure hedging are proposed for          in a greater volatility of annual tax liabilities
   The IRD has indicated, in notes from its      introduction in the new standards. The IRD’s (although the final outcome of Nice Cheer
2005 meeting with the Hong Kong Institute of     guidance and approach should be revised to Investment Ltd. will be highly relevant in this
CPAs, that it had obtained legal advice from     deal with such new approaches.                 regard). Technical issues may also arise with
the Department of Justice indicating that an                                                    the IRD in terms of tax deduction availability.
item reflected in an equity account, rather than Increased tax liabilities in the
the profit and loss account, was not decisive    transition year
for determining its taxability or deductibility. Substantial tax liabilities (or additional
The IRD’s attitude towards gains put through     losses) may crop up if the IRD chooses to tax  John Timpany is a tax partner at KPMG China and
reserves as a result of an election may be       the entire prior-year adjustment during the    Conrad Turley is a tax manager at the firm.


                                                                                                                              September 2011   53

				
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