On March 27, 2020, Hong Kong’s Inland Revenue Department (IRD) issued its revised Departmental Interpretation and Practice Notes (DIPN) No. 39, laying out how the department was to treat various actors in Hong Kong’s tech and financial sectors.
In particular, it offered new information and clarification of previous guidance on Hong Kong’s digital assets sector, clarifying how digital assets businesses and transactions would be taxed.
In this post, we’ll go over what the DIPN says, as well as touching on some areas where further clarification is still needed.
Hong Kong has been a preferred place to do business for decades, thanks to a regulatory environment that provides both security and freedom, and a tax regime that’s unambiguous and light. In particular, the lack of taxes on added value and transactions make it a popular location for the financial services industries, which can also expect to draw staff and expertise from a pool of talent on the island.
But digital assets are something so new that it hasn’t been clear how they will be treated by Hong Kong’s tax authorities. Now, that’s changed, with the release of new guidance by the Inland Revenue Department on March 27.
Here’s what we know:
Categorization of digital assets under Hong Kong tax law
Hong Kong will treat tokens differently based on how they act rather than what they’re called, dividing digital assets into three types: those intended for payments only, those that represent securities contracts, and those that represent utilities.
Payment tokens are used solely for payments — think of tokens designed to replace currencies, like Bitcoin. They don’t provide their users with any additional rights, such as rights to network resource access or the profits of a company. Rather than viewing them as money, Hong Kong will view these tokens as virtual commodities.
Security tokens provide the holder with rights and interests in a business. The definition of security tokens used by the IRD includes tokens that provide a share of ownership in a business, those that tokenize a debt form the business to the holder, and those that entitle the holder to a share of the business’ profits. Where digital tokens meet these definitions, they will be taxed as securities under the relevant sections of the Inland Revenue Ordinance.
These tokens provide the user with access to goods and services, typically through the issuer’s own blockchain platform. Their issuers usually commit to accepting these tokens as payment for the specific goods and services offered on their platform.
It’s important to note that any type of token may be traded on an exchange and the token itself may gain or lose value.
How ICOs are taxed in Hong Kong
The peak of the ICO market was in 2018, and far fewer coin offerings are now carried out. However, in Hong Kong, taxes are normally not filed until 18 months after the commencement of a business, though if they receive taxable profits in their first accounting period they may find they are liable earlier. Thus, the IRD is now receiving and reviewing the tax submissions from the bulk of ICOs carried out in Hong Kong.
The guidance offered states that the IRD will review the white papers and other documentation ICOs provide, with the aim of discovering what exactly their customers are buying when they buy a token. This, rather than the name or form of the sale, will determine how the ICO is treated for tax purposes, and some will be taxed as securities sales while others will be viewed as utilities.
Taxing ICOs selling securities tokens
If an ICO sells tokens that grant purchasers rights as shareholders, gains will be viewed as capital and in Hong Kong this means they will not be subject to taxation.
Taxing ICOs selling utilities tokens
Where an ICO has sold tokens that grant purchasers future benefits from the issuer — access to network-based services, for instance — these will be viewed as prepayment for those services, and these transactions will be taxed as if they were purchases, if sourced in Hong Kong.
Taxing Digital asset investments
If digital assets are bought as a long-term investment, revenue that results will be viewed as capital and will not be subject to profits tax in Hong Kong.
How will the IRD determine whether assets are capital assets or trading stock? The usual approach to assets will be used, including consideration of facts and circumstances and the use of ‘badges of trade.’
How digital assets used for business payments will be taxed in Hong Kong
Transactions using digital assets will be accrued based on the prevailing market value of the relevant digital asset on the date of transaction.
Taxing digital asset businesses in Hong Kong
The DIPN lays out the common business practices associated with a digital assets business: trading, exchange and mining. The extent to which performing these activities amounts to carrying on a trade or business is determined on examination of the circumstances, rather than by imposition of a fixed threshold of income derived from them or some other measure. For instance, factors under consideration include the degree and frequency of the activity, the level of systemization and organization which speaks to the extent to which the activities are carried out in a businesslike manner, and expectation of profit.
Where it can be established that a business is a digital asset business, there are tax implications.
Hong Kong-sourced profits from digital asset businesses located in Hong Kong are subject to profits tax. The source of the profits will be determined by the broad guiding principle: what were the person’s operations that produced the profits, and where did those operations take place?
This has been known for some time; the DIPN echoes comments made at the Annual Meeting between the IRD and the Hong Kong Institute of Certified Public Accountants as far back as 2018, and while it reiterates their sense it contains no new or more specific guidance.
New digital assets, received in the course of carrying on a digital assets business through events like airdrops or blockchain forks, will be considered business receipts of the company and assessed accordingly.
How will you be taxed on digital assets received as employment income?
Salaries received in digital assets should be reported as usual. Their amount should be reported as the market value of the digital assets in question at the time of accrual, and it’s worth remembering that both employees and employers have reporting obligations under Hong Kong law.
While this broad guidance is clear, there remain areas of uncertainty, and there are also areas of Hong Kong tax law where special concessions or specific tax treatments are available to certain kinds of business when those businesses enter into securities transactions. In many cases, the purpose of these special measures has been to improve the competitiveness of Hong Kong’s tax regime.
However, while digital assets can be traded on exchanges, they are not all securities. While access to favorable tax structures is available only to businesses transacting in digital assets which are considered securities, while another business conducting fundamentally similar activities using a different type of digital asset will not have access, there is a risk of seeing the financial sector fragment and some businesses may seek more favorable tax regimes elsewhere. There is also likely to be pressure to move toward digital assets that do meet the legal definition of a security, which may come with its own unforeseen consequences.
Unfortunately, there are many areas of the new guidance that are unclear or incomplete, or that require further clarification.
Where we need more guidance and clarity
There are areas of business where we still don’t know how the tax authorities plan to proceed. These include:
Unrealized gains and losses
The DIPN has not mentioned how it proposes to treat fair value gains and losses that may arise from year-end revaluations of digital assets being used to carry on a digital asset business.
One view is that the treatment should depend on the nature of the digital assets in question — are they capital, or revenue? To the extent they’re viewed as revenue, there’s case law showing that they’re not chargeable to tax. In Nice Cheer Investment Limited v CIR, it was established that unrealised gains from the increase in value of trading stock are not chargeable to tax when they’re accounted for but when they’re realized. There’s nothing in the judgement to specify that the principle has wider application, but also no explicit limits to it, so we can reasonably expect it to be applied to digital assets too.
However, there is a provision in the Inland Revenue (Amendment) (No. 2) Ordinance 2019, which allows taxpayers to elect to be taxed on a fair value basis in respect of financial instruments accounted for in accordance with the Hong Kong Financial Reporting Standard/International Financial Recording Standard 9. Since this standard applies only to some digital assets and not to all, it’s possible that the IRD will offer concessions or make legislative changes to make this elective approach cover the whole sector equally.
Profits tax exemption for qualifying investment funds
The Unified Fund Exemption regime enacted in 2019 provides a profits tax exemption for all privately-offered onshore and offshore investment funds operating in Hong Kong. The exemption is offered regardless of structure, size or purpose and requires only that the fund meet certain conditions.
Qualifying assets include securities as well as other types of financial products, and digital assets that are not securities would not be qualifying assets — which means that funds using them would not have access to the tax exemption. It’s possible that this tax regime can be extended to allow digital asset investment funds to benefit from it regardless of the nature of the digital assets involved, particularly in the wake of the recent introduction by the SFC of a new regulatory regime covering crypto fund managers.
Digital asset borrowing and lending: the tax implications
Traditional financial institutions may engage in regular securities borrowing and lending transactions. Similarly, players in the digital assets space may engage in borrowing and lending digital assets, commonly referred to as ‘crypto borrowing and lending.’ In a separate DIPN, the IRD has indicated that it will base its decision as to the nature of a given financial instrument on the legal form, rather than on the underlying economic substance or accounting treatment. Given that a digital asset lending transaction could constitute a change in legal title, it could be seen by the tax authorities as a disposal by the lender and an acquisition by the borrower — in which case, the realized gain could be regarded as part of the lender’s taxable profits.
The Inland Revenue Ordinance does contain specific provisions to provide relief for securities borrowing and lending transactions. However, this relief may not be applicable to digital asset borrowing and lending transactions that do not fall under the provisions. It’s possible that the IRD may remedy this by extending the relief to cover all such transactions.
The blockchain is a relatively new technology, and the businesses it has made possible are even newer — especially when viewed from the lens of the traditional financial world. As the space matures and diversifies, it is certain to generate more tax questions — how should the source of profits in digital asset mining be determined? Is there a difference between proof of work and other consensus algorithms when considering this, and how should non-mining algorithms like BTS, or hybrid algorithms, be treated? What should the tax authorities do about the changing value of digital assets that change hands over time as part of the operation of self-executing contracts? Will digital assets ever be subject to stamp duty, and will reporting standards need to be adjusted to take account of the new realities of businesses with digital assets at their core?
As the industry evolves, companies operating within it will need answers to these questions, and we expect that both business and regulators will move towards a more clearly and comprehensively regulated digital asset landscape.