In April this year, the Inland Revenue Department (IRD) issued the Departmental Interpretation and Practice Notes No. 55 – known as DIPN 55 – to explain its views and practices on the amended Section 16B and Schedule 45 in the Inland Revenue Ordinance (IRO) on deduction of research and development (R&D) expenditure.
For expenditure incurred from 1 April 2018, qualifying R&D activities are eligible for either Type A expenditure (100% tax deduction) or Type B expenditure (300% tax deduction for the first HK$2 million and 200% of amounts exceeding HK$2 million). The expenditure on R&D activities which cannot be regarded as qualifying R&D activities can be 100% deductible if other conditions under Section 16B are met.
Type B expenditure (entitled to enhanced deduction) refers to:
- a payment to a “designated local research institution” for outsourced qualifying R&D activities;
- an expenditure in relation to an employee (excluding a director) who is engaged directly and actively in a qualifying R&D activity; and
- an expenditure on a consumable item that is used directly in a qualifying R&D activity.
Type A expenditure (100% deduction) means R&D expenditure other than Type B expenditure, such as machinery and equipment.
Qualifying R&D activities means:
(a) an activity in the fields of natural or applied science to extend knowledge;
(b) an original and planned investigation carried on with the prospect of gaining new scientific or technical knowledge and understanding; or
(c) the application of research findings or other knowledge to a plan or design for producing or introducing new or substantially improved materials, devices, products, processes, systems or services before they are commercially produced or used. (Schedule 45)
These activities are in line with those that are regarded as “research” and “development” in the Hong Kong Accounting Standard 38. The IRD states that a R&D activity needs to exceed minor or incremental upgrades. It is an activity working for tomorrow to develop new products, new lines and improvements to present production.
It does not, however, cover “quality control” which is more working for today’s production. If a particular advance in science or technology has already been made or attempted by others but details are not readily available (eg a trade secret), work to achieve such an advance can still be an advance in science or technology, and be regarded as qualified R&D activity.
DIPN 55 clarifies that the R&D activity is not required to be wholly carried out in Hong Kong, but only local Hong Kong expenditure may qualify for the enhanced deductions. R&D activity carried on outside Hong Kong may still qualify for 100% deduction under Section 16B if the relevant conditions are met.
Qualifying R&D expenditure
Only expenditure relating to in-house direct staff, direct consumables and payments to designated local research institutions are eligible for the enhanced deduction. The staff must be engaged directly and actively in qualifying R&D activities. Whether an employee is directly and actively engaged in qualifying R&D activity is based on the duties performed and not on the job title.
For example, the head of an R&D department spent a certain amount of time managing the research team as well as carrying out scientific studies. Strictly speaking, the time involved in the management work may not be regarded as “engaged directly and actively” in qualifying R&D activity. Nevertheless, if such time is not significant, the IRD would be prepared to accept the full payroll cost of this employee as qualifying expenditure for enhanced deduction.
An employer-employee relationship should exist between the enterprise and the employee in order to qualify for enhanced deduction. Secondees from other related entities sponsored by the enterprise, expert consultants under a temporary employment contract with the enterprise, and part-time R&D staff would be regarded as employees of the enterprise if these individuals are subject to the supervision, direction or control by the enterprise. Their costs could qualify for enhanced deduction provided that other conditions are met.
On the contrary, fees paid to freelancers or organizations who supply R&D personnel would not qualify for enhanced deductions, as they are not employees of the enterprise. But the costs paid to them may still be eligible for 100% deduction as Type A expenditure.
Strictly speaking, compensation paid to directors is not qualified for enhanced deduction. However, the IRD may allow apportionment of the relevant expenditure for enhanced deduction where a person occupies a dual role (ie a director and an employee directly and actively engaged in a qualifying R&D activity). The remaining amount may still be eligible for 100% deduction as Type A expenditure.
Expenditures incurred under Cost Contribution Arrangements (CCA) may be eligible for enhanced deduction provided they meet the specified conditions, including:
- Enterprises derive proportionate benefits from the R&D activities under the CCA
- Each participant actively participates in the R&D project
- There is co-ownership of rights amongst CCA participants
However, payments to external contractors (other than designated local research institutions) are not eligible for the enhanced R&D deduction.
Section 16B specifies that no deduction is allowed if the rights generated from the R&D activity (eg intellectual property) are not fully vested in the enterprise. The IRD clarifies in DIPN 55 that co-ownership of rights is covered. For example, some enterprises may jointly carry on an R&D activity, and the rights generated from that R&D activity are fully and jointly vested in them. Each of the enterprises involved may claim deduction for the R&D expenditure incurred under Section 16B, provided that other conditions are satisfied.
Unlike the old R&D deduction regime, in DIPN 55, the IRD provides a concession where the core part of the R&D project is undertaken in Hong Kong by the enterprise and only an insignificant part of an R&D project is subcontracted to its affiliates outside Hong Kong, the subcontracting fee paid to the overseas associate could be deductible under Section 16B, provided that other conditions are met.
Specifically, it may allow deduction (at 100% for Type A expenditures) of a subcontracting fee paid to an overseas affiliate for the R&D services if such fee is not more than 20% of the total costs of the R&D project and does not exceed HK$2 million.
The DIPN 55 clarifies and provides detailed explanation on some silent areas by illustrative examples. It seems the IRD is prepared to adopt a practical and less stringent approach in applying Section16B, such as allowing deduction of subcontracting fees for certain R&D work outsourced to overseas associates, accepting co-ownership of rights, nominee arrangement, CCA etc.
In view of this new tax incentive, multinational groups with R&D activities in Hong Kong and overseas, particularly involving CCA and/or subcontracting arrangements, should review their existing arrangements on how to maximise their deduction claim on R&D expenditure. In any case, taxpayers should keep relevant documentation regarding R&D projects to support their deduction claims under Section 16B for profits tax return filing purpose.