The Inland Revenue Department (IRD) issued an updated guidance Departmental Interpretation and Practice Notes No. 1 (DIPN 1) on: (a) computing assessable profits; (b) revenue recognition under HKFRS 15: Revenue from Contracts with Customers; and (c) measurement of inventories or stock.
The updated guidance primarily sets out the IRD’s views and assessing practice under HKFRS 15, and contains examples illustrating the accounting and tax treatments; and the stock valuation methods for tax purposes.
Part A: Computation of assessable profits
The updated DIPN 1 outlines the core principles for computing assessable profits on revenue derived from customer contracts under HKFRS 15. In particular:
Accounting profits that have been determined in accordance with HKFRS 15 would form the starting point for computing assessable profits (or adjusted loss as the case may be). In most cases, the accounting treatment should align with the tax treatment unless a specific tax treatment has been established through case law or legislation, or where the accounting treatment deviates significantly from the tax principles;
Profits recognised on an accruals basis in accordance with generally accepted accounting principles are normally taken as profits ‘arisen’ or ‘derived’ for the purposes of Section 14 provided that the profit is not anticipated; and
The DIPN refers to the decision established in Nice Cheer, where it was ruled that chargeable profits are actual or realised; and neither profits or losses may be anticipated.
Part B: Revenue recognition
HKFRS 15 introduces a five-step recognition model for an entity to recognise revenue from contracts with customers and is effective for periods beginning on or after January 1 2018, with early adoption permitted.
Under HKFRS 15, an entity recognises revenue when performance obligations of the contract are satisfied either at a point in time or over time. A performance obligation is satisfied when the control of goods or services is transferred to a customer. Revenue recognised under step 5 of the revenue recognition model would be regarded as having been realised and such revenue would be included as assessable profits of the taxpayer.
The potential impact on taxpayers
Businesses with long term contracts will be mostly affected by HKFRS 15. Particularly, revenue from long-term contracts would often be recognised at a later point than under the previous standard. This is because the threshold in recognising revenue is stricter under HKFRS 15.
In the previous DIPN 1, real estate developers would recognise revenue when a contract is regarded as completed when a final certificate is issued by the supervising architect or consulting engineers. However, under HKFRS 15, the revenue recognition for developers from the sale of units in a multi-storey residential building could be deferred even later, until when the developer fully satisfies the performance obligation (i.e. when the customer obtains control of the purchased unit which could be when keys are obtained to purchased units).
Another notable area of concern is when a contract contains variable consideration (such as claims, rebates, etc). Where a consideration is ‘variable’, HKFRS 15 allows an amount to be recognised when it is highly probable that a significant reversal will not occur when the uncertainties relating to that variable are resolved.
This means that when estimating variable consideration, HKFRS 15 sets a higher barrier than the previous standard to recognise revenue, resulting in the deferral of the recognition of revenue. From a tax perspective, this is particularly welcomed given the absence of loss-carry back provisions under Hong Kong SAR tax law.
Significant financing component
Long-term construction contracts typically includes a significant financing component where payments by a customer and performance by a person may occur at different times. Where the timing of payments to a contract provides a significant benefit of financing the transfer of goods or services to the customer, it may indicate that the contract contains a significant financing component and that promised amount of consideration should be adjusted for time value of money.
Under HKFRS 15, notional interest revenue or notional interest expense is recognised as accounting profit or loss to reflect the time value of money associated with the financing. For tax purposes, notional interest expense or revenue will be disallowed or excluded from tax since no actual expense or income has been incurred or derived for Hong Kong SAR tax purposes.
These adjustments are ultimately a timing difference. Taxpayers with a high volume of transactions containing a significant financing component may find it administratively burdensome, as they would be required to maintain separate records and account for the effects of the significant financing component for each contract.
Part C: Measurement of stock or inventories
The key update is the inclusion of Section 15BA to codify the market value principle as established in Sharkey v Wernher. Section 15BA is effective from the year of assessment commencing on or after April 1 2018 and requires that tax adjustments are brought into account to reflect the market value of a stock, when a stock is appropriated for non-trade purposes or disposed of other than in the course of trade.
The adoption of HKFRS 15 is likely to lead to significant changes in the timing pattern of revenue recognition for some taxpayers. HKFRS 15 essentially replaces the concept of transfer of ‘risks and rewards’ with ‘control’ and the introduction of performance obligations and the overall the impact of HKFRS 15 on most taxpayers is generally a deferral of revenue recognition until performance obligations are met.
Given HKFRS 15 has tightened up the revenue recognition policy, the IRD considers that they can tax profits as realised when performance obligations are satisfied. This represents a change from the position under the old accounting standards and previous DIPN, when they considered the profits would be unrealised. Although this in general will push the timing of revenue recognition back, it may result in some cases in the timing of tax payments being brought forward.
Taxpayers should discuss with their accounting and tax advisors, at an early stage, of any complex arrangements with customers to assess whether changes to the terms of contracts should be made as this may impact the timing of revenue recognition and when profits are taxed. Taxpayers should also assess whether their accounting systems and internal control procedures adequately support the tax and accounting requirements under the necessary accounting standards.
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