Implications of IFRS9 on financial instruments for tax in Hong Kong

International financial reporting standards (IFRS) 9 is the replacement for international accounting standards (IAS) 39 (Financial instruments: recognition and measurement). It is fully adopted in Hong Kong through Hong Kong financial reporting standards (HKFRS) 9, and becomes mandatory for annual periods from January 1 2018 onward for all companies in Hong Kong.

IFRS 9 substantially changes the approach taken to the classification and measurement for financial assets, and this can have a knock-on effect on the taxation of the financial assets. Specifically, there are implications in how the accounting classification, measurement and impairment would be treated for tax purposes, with some potential tax divergences from the accounting treatment, and there may be legislative amendments to narrow the gap, going forward.

The development of IFRS 9 was a response to the April 2009 call by the G20, and followed a recommendation of the G20 Financial Stability Board (FSB). The push to introduce IFRS 9 was accelerated by the global financial crisis of 2008 and its aftermath, for which IAS 39 was unable to provide timely information on the credit impairment position of affected banks. Banks have long criticised IAS 39 for its complexity and the potential consequences of its approach to the mark-to-market measurement of financial instruments. IFRS 9 introduces a less complex, principles-based approach, which contrasts with the rules-based approach of IAS 39.

IFRS 9 rolls out a new, standardised classification and measurement model for financial assets, moving from an in incurred loss to an expected loss model, and applies an improved hedge accounting model. IFRS 9 also has certain features that converge with the US GAAP equivalent: US Accounting Standard Updates, ASU 2016-1 Financial Instruments – Overall (Subtopic 825-10), and ASU 2016-13 Financial Instruments – Credit Losses (Topic 326). The introduction of IFRS 9 will have the biggest impact on banks, though small and medium enterprises may also be affected.

IFRS 9 contains three main topics, which are dealt with below:

• Classification and measurement of financial assets;

• Impairment; and

• Hedge accounting.

Under IAS 39, financial assets were categorised as held to maturity, loans and receivables, fair value through profit and loss (FVPL), and available for sale.

Under IFRS9, most financial assets should be classified and measured at fair value, with any fair value change recognised in the profit and loss account as they arise (FVPL). Only when specific criteria are met, are financial assets classified and measured at either amortised cost, or fair value through other comprehensive income (FVOCI). A high level comparison is shown in Table 1.

The classification is based on the expected cash flow of the financial instrument and the objectives of the entity's business model. In summary, only assets that meet the following criteria can be classified and measured at amortised cost or FVOCI, respectively.

IAS 39	IFRS 9
Classification	Classifications and measurement models	Measurement model
FVPL	FVPL	FVPL Financial assets should be measured at fair value with all changes recorded through profit or loss.
Held to maturity	Amortised cost	Amortised cost. Financial assets are initially recognised at fair value and subsequently measured at amortised cost.
Loans and receivables	Amortised cost	Amortised cost
Available for sale	FVOCI	FVOCI Financial assets are initially recognised and subsequently measured at fair value. Carrying amount movements are recorded through other comprehensive income (OCI), except for the recognition of impairment gains or losses, interest revenue and foreign exchange gains and losses, which are recognised in profit and loss.  Where the financial asset is de-recognised, the cumulative gain or loss previously recognised in OCI is re-classified from equity to profit or loss.

• The asset is held to collect its contractual cash flows; and

• The assets contractual cash flow represent solely payments of principal and interest (SPPI).

• The asset is held to collect its contractual cash flows and to be sold; and

• The assets contractual cash flow represent SPPI.

Under IFRS 9, a single impairment model will be applied to all financial instruments subject to impairment testing.

One of the key impacts for banks is the timing for recognising losses on loans. The new standard requires banks to be more forward thinking and to be better at estimating potential losses. Under IFRS 9, loan impairment recognition uses an expected loss model that focuses on the risk that a loan will default. This is in contrast to IAS 39 where credit losses were only recognised where there was objective evidence of impairment.

The adoption of IFRS 9 involves a degree of judgment by management, and more accurate financial modelling based on available data, past events and prevailing conditions. Impairment losses are recognised on the first initial recognition of the financial asset, and the impairment is reviewed and adjusted at subsequent reporting periods. The objective is to recognise the full lifetime expected losses on a more timely basis.

IFRS 9 revamped the hedge accounting requirements and introduced new criteria for hedge accounting. The new model more closely aligns with the risk management activities, and is less complex than IAS 39.

The adoption of IFRS 9 will have an important impact on bank financial reporting, affecting investors, regulators, analysts and accountants. IFRS 9 implementation requires changes to IT systems, processes and risk controls, and this presents an opportunity for banks to develop an efficient and timely reporting process.

The change in loss provision accounting, from an incurred loss model to an expected loss model, potentially creates problems for banks. Banks will have to take a position on the likelihood of recovery of a loan and adjust the loss provisioning on a regular basis.

The overall effect of IFRS 9 is that banks will report their losses sooner, though these may not necessarily be new losses. Such losses have been priced-in during the initial lending, and only the timing of their recognition is impacted.

Nevertheless, IFRS 9 presents some real challenges. Measurement of losses is very subjective because it relies on estimates, which could potentially lead to volatile results. Similarly, as banks may adopt different forecasting models, financial analysts will face difficulties comparing the performance of banks, as the banks may have a completely different outlook of the future. It will take some time for the rules to be fully integrated and for financial reports for banks to be fully understood.

In Hong Kong, the tax treatment of financial assets and financial liabilities generally follows their accounting treatment. The starting point for the calculation of Hong Kong profits tax, as confirmed by the Court of Final Appeal in 2000 in Commissioner of Inland Revenue v Secan Limited and Ranon Limited (5 HKTC 266) (Secan), is the profits per the financial statements, subject to any adjustments required by the provisions of the Inland Revenue Ordinance (IRO), which sets out the Hong Kong tax statute.

In the past, the generally accepted position was that fair value gains or losses recorded in the audited accounts prepared in accordance with IFRS would be taxable/deductible, as long as they were Hong Kong-sourced and not capital in nature. However, this position is no longer as clear.

In November 2013, the Court of Final Appeal (CFA) held in the Nice Cheer Investment Limited (FACV 23/2012) (Nice Cheer) case that unrealised gains arising from year-end mark-to-market in respect of listed securities held for trading purposes were not chargeable to tax in Hong Kong. In giving his judgment on the case, Lord Millet NPJ emphasised the two basic tax principles that: "the word 'profits' connotes actual or realised and not potential or anticipated profits" and "neither profits nor losses may be anticipated".

Although the non-taxability of such unrealised gains is clear, the deductibility of unrealised losses was not as straightforward because the issue of unrealised losses was not under dispute in Nice Cheer. Section 16 of the IRO states that in ascertaining the assessable profits there will be deducted outgoings and expenses to the extent to which they are incurred in the production of the profits chargeable to tax. Lord Millet NPJ commented that a provision for diminution in value of trading stock would be tax deductible if the provision represented a "material and permanent fall in value" of the trading stock at the balance sheet date. If not, such a provision would only be anticipated losses and, as such, would not be tax deductible as the loss has not been "incurred".

Subsequent to the judgment of the Court of Final Appeal in Nice Cheer, the Inland Revenue Department (IRD) has agreed, as an interim administrative measure, to accept profits tax returns in which the assessable profits are computed on a fair value basis since the year of assessment 2013/14. That is, fair value gains and losses were taxable and deductible, provided these were Hong Kong sourced and not capital in nature. We would expect this concession to be accepted until such time there is a legislative amendment.

The adoption of IFRS 9 (HKFRS 9 in Hong Kong) could result in timing differences between the accounting and taxation treatment of financial assets and liabilities for Hong Kong profits tax purposes. More importantly, tax deductibility issues for expected credit losses could lead to increased tax compliance and operational costs. While the adoption of IFRS 9 is not limited to financial institutions, its impact will be most substantial for banks given the volume and types of financial instruments that they transact.

For expected credit losses, IFRS 9 also prescribes new rules for calculating impairment losses. It employs a three-staged approach to determine the quantum of impairment losses.

At stage 1, the loan is performing and there is no sign of credit deterioration, thus a 12-month expected loss impairment allowance is applied. At stage 2, the loan is under-performing and there are signs of credit deterioration, thus a lifetime expected losses impairment model is applied. At stage 3, the loan is not performing, a lifetime expected losses impairment model is applied, and the effective interest rate is computed based on the amortised cost (the gross carrying amount less the loss allowance).

Based on prevailing law and practice, financial instruments should only be regarded as credit-impaired at stage 3, at which stage the impairment should qualify for a bad debt deduction under section 16(1)(d) of the IRO. There are a number of considerations that would need to be taken into consideration in determining whether a loan was impaired and that the impairment loss was tax deductible.

A deduction for bad or doubtful debts is allowed to the extent they are estimated to the IRD assessor's satisfaction to have become bad. In practice, this provision is strictly enforced by the IRD. In many cases, the IRD only allowed a deduction in respect of debts that had actually gone bad (that is, where a loss had been incurred and a loan was irrecoverable – for example, debtor bankruptcy or a loss on disposal of the financial asset), and denied a deduction for specific provisions made merely in anticipation of a loss. While this is not entirely in accordance with the IRO, taxpayers have followed the IRD's practice (especially where it is only a timing difference).

The way in which the impairment allowance under IFRS 9 is calculated may come under close inspection by the IRD. In the absence of an identifiable impairment event mentioned above, a deduction claim may lead to queries being raised by the IRD on whether a loss was incurred, or whether the conditions under section 16(1)(d) were satisfied. Certain international cases, such as the Privy Council decision in CIR v Mitsubishi Motors New Zealand Limited (1995; 17 NZTC 12,351), suggests that a statistically estimated loan loss provision can be considered as incurred.

However, given the requirements of section 16(1)(d) and the IRD's position of denying general provisions for doubtful debts, it is unlikely that the IRD will allow a deduction for the impairment allowances for stage 1 and stage 2 impairment allowances. This was reiterated in Departmental Interpretation and Practice Notes No 42 Profits tax – taxation of financial instruments and taxation of foreign exchange differences (DIPN 42), in which paragraph 30 states:

"HKAS 39 contains rules governing the determination of impairment losses. In short, all financial assets must be evaluated for impairment except for those measured at fair value through profit or loss. As a result, the carrying amount of loans and receivables should have reflected the bad debts and estimated doubtful debts. However, since section 16(1)(d) lays down specific provisions for the deduction of bad debts and estimated doubtful debts, the statutory tests for deduction of bad debts and estimated doubtful debts will apply. Impairment losses on other financial assets (e.g. bonds acquired by a trader) will be considered for deduction in the normal way."

Although DIPN 42 has no binding force in law, in practice, the IRD will generally follow the principles set out in their practice notes in determining the deductibility of impairment losses on financial instruments. Given that DIPN 42 was issued in November 2005, it is expected that the IRD will update the DIPN to reflect the substantial changes brought about by IFRS 9.

Whether the IRD could be convinced to allow a deduction on impairment losses (particularly at stage 1 and stage 2), is a matter for further consideration. The IRD has verbally stated that it will not change its assessing practice, notwithstanding the IFRS 9 changes. In the absence of changes to the IRD practice, taxpayers should consider the implications of having to calculate substantial deferred tax assets for disclosure in the financial statements.

The accounting treatment of a transaction is not determinative of its tax treatment for the purposes of the distinction between capital and revenue, but it could be influential. In Hong Kong, capital gains are non-taxable and excluded from the calculation of profits tax. Whether gains are revenue or capital in nature is a question of fact. In this regard, consideration should be given as to whether the receipt relates to the disposal of an asset forming part of the permanent structure of a business or is a trading receipt, the former being capital in nature. Under IFRS 9, financial assets could be classified as amortised cost or FVOCI based on their contractual cash flow and business model. For these assets, it could be argued that the asset has remained part of a business model where the objective is to hold the assets for the long term and collect the contractual cash flows. This may support the argument that the gains are on capital account and therefore not taxable.

However, whether financial instruments are capital or revenue in nature (and thus whether gains or losses arising from the financial instruments are assessable or deductible for tax purposes) will still depend on the facts and circumstances of each case. This is particularly relevant as the IRD's starting position is that all assets of a bank are revenue in nature, unless proven otherwise.

Under IFRS 9, an irrevocable election can be made to treat certain equity instruments as FVOCI, instead of FVPL. Upon election, only dividends are recognised in the profit and loss. All fair value movements are recognised in the equity account and never enter the profit and loss statement, even if the equity instrument is subsequently sold.

The IRD explained in the 2005 meeting with the Hong Kong Institute of CPAs, legal advice was sought from the Department of Justice, which advised that the fact that an item was not reflected in the profit and loss account (i.e. reflected in the equity account) was not determinative of the item's taxability or deductibility.

The IRD went on to say that an increase or a decrease in retained profits would be assessable or deductible in the year of assessment in which the prior period adjustment was recognised, if such profits or losses were revenue in nature and Hong Kong sourced. The IRD could, therefore, take the view that annual fair value movements through reserves should be taxed in the year in which they arise.

On adoption of IFRS 9, there is no requirement to restate the prior period financials, unless the restatement can be done without the use of hindsight. If an entity does not restate comparative figures, any difference in carrying amounts should be adjusted against the opening retained earnings.

From a tax perspective, the IRD has stated in DIPN 42 that a prior period adjustment on trading assets to increase or decrease in retained profits should be treated as a taxable or deductible in the year of assessment in which the prior period adjustment is recognised in the retained earnings. The IRD also cited the case of Pearse v Woodall-Duckhall Ltd, [1978] 51 TC 271 that allows for the IRD to adopt this position.

During the adoption of IAS 39, the IRD did not allow taxpayers to defer the recognition of adjustments and to defer tax liabilities arising on the transition. To date, the IRD has not indicated how the IFRS 9 transition adjustments will be treated for tax purposes, but one would expect the same position that was taken in the transition to IAS 39.

The implementation of IFRS 9 will be one of the most important accounting changes for banks in Hong Kong since the introduction of IAS 39. IFRS 9 will result in increased reported credit losses and more volatile movements, year-on-year, directly impacting a bank's regulatory capital requirements. The initial tax impact on the adoption of IFRS 9 will be apparent once the tax returns covering financial year ended December 31 2018 are filed in August 2019.

While the IRD continues to accept tax returns prepared on a fair value basis, this is an interim measure without legal backing. The Financial Services and the Treasury Bureau (FSTB) has submitted a proposed amendment to the Legislative Council (LegCo) for the adoption of fair value accounting for financial instruments for tax purposes. The FSTB is proposing to introduce an amendment bill to the LegCo in late 2018. One of the proposals is to allow taxpayers to make a one-time, irrevocable election for fair value reporting for tax reporting. The election would have effect in the year the assessment is made and for all subsequent years of assessment. However, there has been no mention of amending section 16(1)(d) to allow a deduction on impairment losses based on estimated losses prescribed under IFRS 9. The Hong Kong government is consulting the relevant stakeholders to provide their views on the proposed amendment to the IRO.

The proposed amendment by the Hong Kong government is a welcome move, and would provide clarity and certainty for practitioners and the general public. The IRD should also consider updating DIPN 42 to deal with the potential issues that would arise on IFRS 9's implementation, and to consider allowing a staggered recognition of transition adjustments.

Darren Bowdern

Partner, Tax KPMG China 8th Floor, Prince's Building 10 Chater Road Central, Hong Kong Tel: +852 2826 7166 darren.bowdern@kpmg.com Darren Bowdern is the head of alternative investments and head of financial services in KPMG's Hong Kong tax practice. For more than 20 years, Darren has been involved in developing appropriate structures for investing into Hong Kong, mainland China and the Asia Pacific region. Darren's extensive experience includes cross-border buy- and sell-side M&A tax services (e.g. tax due diligence and tax vendor due diligence), tax structuring, tax planning and optimisation and international corporate tax issues, restructuring and optimisation. Many of these projects comprise tax effective regional planning including consideration of direct and indirect taxes, capital and stamp duties, withholding taxes and the effective use of double taxation agreements. Darren is also a regular speaker and writer on private equity related tax issues, and advises on establishing direct investment, private equity and other investment funds in Hong Kong and in the Asia Pacific region. He also advises on structuring tax efficient performance and co-investment arrangements for private equity funds, as well as effective remuneration and employment arrangements. Darren is a member of the technical committee of the Hong Kong Venture Capital Association (HKVCA), a member of the tax committee of the Alternative Investment Management Association (AIMA), the chair of the finance, legal and tax committee of the Australian Chamber of Commerce and deputy chair of the Australian Chamber of Commerce in Hong Kong (AustCham).

Johnson Tee

Senior manager, Tax KPMG China 8th Floor, Prince's Building 10 Chater Road Central, Hong Kong Tel: +852 2143 8827 johnson.tee@kpmg.com Johnson Tee is a senior manager in the Hong Kong corporate tax practice. Johnson has 16 years of Hong Kong and Malaysian corporate tax experience, performing tax advisory and compliance services for financial institutions and multinational corporations with a particular focus on asset management clients. Johnson has a wide range of experience in the establishment and structuring of offshore funds, advising on operating protocols for funds, assistance with applying for treaty benefits and advising on the structuring of management fees and carried interest. Johnson graduated with a bachelor's degree in business from Monash University (Australia) and is a member of the CPA Australia.

Matthew Fenwick

Partner, Tax KPMG China 8th Floor, Prince's Building 10 Chater Road Central, Hong Kong Tel: +852 2143 8761 matthew.fenwick@kpmg.com Matthew Fenwick has provided tax services to many multinational clients over a number of years, having worked for the KPMG tax advisory groups in New Zealand, the UK and Hong Kong. During this time, he has worked on numerous tax engagements for a wide variety of clients. He has a focus on both Hong Kong specific and regional tax issues, meaning that he regularly liaises with colleagues in other jurisdictions on the myriad of tax-related issues clients face. As well as 'business as usual' matters, Matthew has been involved in various significant engagements involving market entry, mergers and acquisitions, and divestment or restructuring of substantial businesses across various industries. This has included consideration of all aspects of the fund, investment and transaction lifecycle, as well as diligence on new markets and/or businesses. Matthew graduated from the University of Otago with bachelor degrees in Commerce and a law. He is a member of the Hong Kong Institute of Certified Public Accounts and Chartered Accounts Australia and New Zealand. He was also admitted as a barrister and solicitor of the High Court of New Zealand.

Malcolm Prebble

Partner, Tax KPMG China 8th Floor, Prince's Building 10 Chater Road, Central, Hong Kong Tel: +852 2685 7472 malcolm.j.prebble@kpmg.com Malcolm Prebble has extensive experience in advising on regional merger and acquisitions projects including a number of tax due diligence and structuring projects for acquisitions by fund organisations and other professional investors. Through this work he has developed significant expertise in issues associated with cross border structures and is familiar with specific structuring issues associated with investments into a number of countries within the Asia Pacific. Malcolm has also assisted a number of organisations with the establishment of new funds focused on investments in the Asia Pacific region, or reviewing existing fund structures to recommend improvements to mitigate tax risks for the fund, sponsors and/or carried interest participants. Malcolm has advised clients in a wide range of industries, including manufacturing, infrastructure, real estate and private equity.