Hong Kong Updates Guidance on Computing Assessable Profits, Revenue Recognition and Measurement of Inventories
The Inland Revenue Department (IRD) has substantially revised its guidance on the determination of assessable profits for profits tax purposes. Notably, the guidance sets out the generally accepted accounting principles (in other words, the Hong Kong Financial Reporting Standards [HKFRS]) that provide the starting point for computing assessable profits, revenue recognition and inventory valuation for tax purposes. The salient features of the latest guidelines as provided in the Departmental Interpretation and Practice Note (DIPN) No. 1 (revised) are set out below.
Computing assessable profits
Financial statements prepared in accordance with the HKFRS form the basis for computing assessable profits, including the recognition of profits on an accrual basis, and outgoings and expenses. The guidance also discusses the interaction between accountancy and tax laws and the need for adjustments under tax law to arrive at the correct amount of taxable profits.
Companies incorporated in Hong Kong are required to prepare annual financial statements in compliance with the HKFRS. Companies incorporated outside Hong Kong are allowed to follow other financial reporting standards, as long as they reflect true profits and losses.
Revenue recognition (revenue from contracts)
HKFRS 15 replaces a number of Standards and Interpretations, in particular HKAS 11 (Construction Contracts) and HKAS 18 (Revenue). HKFRS 15 took effect on 1 January 2018 and provides comprehensive guidance on the recognition of revenue from contracts with customers.
Under HKFRS 15, revenue is recognized when performance obligations of the contract are satisfied. In contrast, profits tax is charged when the profit is derived and the expense is incurred. Nevertheless, there should be no significant practical difference since the accounting treatment follows a substance-based approach which is based on the transfer of control of the goods or services, using the following five-step revenue recognition model:
- identifying the contract(s) with a customer;
- identifying the performance obligations in the contract;
- determining the transaction price;
- allocating the transaction price to the performance obligations in the contract; and
- recognizing revenue when (or as) the entity satisfies a performance obligation.
Measurement of inventories
HKAS 2 is still recognized as the accounting treatment for inventories as it was in the earlier DIPN, and the basic rule remains that inventories should be valued at the lower of cost or net realizable value.
The revised DIPN provides additional guidance on the basis of valuation, including the deduction of inventory expenses, the use of alternative valuation bases, implications of changes to the basis of valuation, the applicable tax provisions in the case of a cessation of business and appropriation of inventory for non-business use, and relevant case laws. For profits tax purposes, the guidelines note that the IRD generally does not have the right to substitute one valid basis for another valid basis, or to adopt a different basis in computing profits.
DIPN No. 1 (revised) replaces the previous DIPN issued in July 2006 and the full details are available here.