It’s universally true that any means to save tax burden are tempting to business owners.
In Hong Kong, one of the most manageable ways to cut the Profits Tax of your company is to book the tax-deductible expense on your corporate accounting books against your profits.
Hong Kong tax laws do not provide a one-size-fits-all framework of Tax-deductible Expense.
Having a grasp of section 16 of the Hong Kong Inland Revenue Ordinance (the tax law of Hong Kong), you can include the expense which is solely for the production of business income as tax-deductible.
There is a catch: whether an expense has the sole purpose of profit production is always debatable among the taxpayers and the IRD. For small companies, the vast grey area is often leaving enormous frustration among their owners.
Here is an example to explain the purpose of an item:
The director of a small company is always the most hardworking employee. One day at a time, the director has purchased a set of tailor-made suit for meetings of business partners but happens to wear the same outfit after working hour to attend his best friend’s wedding banquet where there are possibly potential customers. It’s practically difficult to tell that the cost of this suit is solely business or personal usage.
To address the dispute, the IRD has released the ever-updating Departmental Interpretation and Practice Notes (DIPN).
The DIPNs give further guidance and explanation on specific tax items to the public. The IRD updates the information in the DIPNs according to the latest development of the IRD.
However, why does the DIPN matter?
Although you can book every expense on your books and claim that the costs as the sole business expense on the tax return, your auditor will access these items before you submit your Profits Tax return.
Same as the IRD officers, your auditor will use the IRO and the DIPN to evaluate your books. Summing these two pieces of documents, the two fundamental factors that affect your auditor’s and tax assessor’s benchmark are as follows:
- the ratio of expense to profits
- the nature of business
In short, their judgements are to tell if an item of expenditure in a way that makes sense.
For example, it is challenging for a company to claim that the expense of buying grocery goods if the company’s primary business is a retailer of consumer electronics; it is also hardly acceptable for a company to claim many expenditures as customers entertainment when the company has made a few sales only.
Remember that, no matter what the reasons behind your claim of expense are, your auditor and tax assessor will ask for “reasonable explanations” and supporting documents.
What is the harm of claiming too much expense against the taxable profits?
To your auditor:
If the company cannot give the required information, your auditor will leave an opinion in the Auditor’s Report stating that the company could not provide such information.
Having such an opinion, the company flags the IRD to pay attention to this company and lead to the IRD’s query.
To the IRD’s tax assessor:
Even if your auditor can finish the statutory audit work of your company, the tax assessor will query your company’s tax information and require further explanation and supporting documents.
If the company fails to comply with the IRD query, the manager(s) of the company may be prosecuted by the IRD under section 80(2) of the IRO, the person may subject to a fine of HK$10,000 and treble (three times) the amount of the tax undercharged.
For owners of small businesses in Hong Kong, the tax-deductible expenses are not complex to claim, here are the must-do list for you:
- Be honestly connected:
Before the expenditure happens, you should consult your tax representative and your auditor, tell them the purpose and usage of the acquired products or services to your business operations. So that you can have a preview of the tax deductibility of this item.
- Be well prepared:
After expenditure appeared, you should keep all the direct and indirect document proofs to show that what / when / how the product or service brings work in your business process.
- Be reasonable (in a layman’s viewpoint):
For your own sake, you should give up the claim of an item if your common sense tells you to stop. It’s not worth the risk of the IRD’s prosecution.
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