The Board of Review held that return from Equity Linked Notes is not interest income

The Board of Review in the case D32/12 held that investment in Equity Linked Note was not loan arrangement to financial institutions for interest income. Therefore, the return on such financial products was not interest income and that the place where the contract was made should be used to determine the locality of profit of such return instead of using the "provision of credit" test.

In the case, the taxpayer is a company incorporated in Hong Kong and its principal activities are investment holding and provision of management services. The company held investments in equity securities listed in Hong Kong and overseas, held-to-maturity debt securities and overseas investments in equity linked notes and accrual notes in the relevant years of assessment concerned. The taxpayer lodged an appeal to the Board of Review objecting the profits tax assessments raised by the Inland Revenue Department on the following issues.

1. Unrealized gain on overseas investment or changes in fair value of investment securities should not be subject to profits tax.
2. Gain on trading of offshore securities in overseas stock exchange or offshore derivatives/held-to-maturity debt securities was sourced outside Hong Kong.
3. Gain on disposal of long-term available-for-sale securities or capital asset was not assessable to profits tax.
4. Overseas investment in the equity linked notes and accrual notes were in substance loan arrangements with overseas financial institutions. The interest income from such financial products was sourced outside Hong Kong.

The Board only allowed the taxpayer's appeal in issue 1 that the unrealized gains are not assessable to profits tax under the Inland Revenue Ordinance. In this issue, the Board agreed that the facts in this case are not distinguishable from those in Nice Cheer case. Therefore, the Board is bound by the Nice Cheer case to allow the appeal.

Regarding the issues 2 and 3, the Board dismissed the appeal because the taxpayers failed to discharge its onus of proof that the gain on trading of overseas investments are sourced outside Hong Kong and the gain on disposal of investment securities in Hong Kong is capital in nature.

As for issue 4, the Board held that the overseas investments in the equity linked notes were different from the arrangement of advancing a sum of money to a financial institution for interest income. The Board found that the determinant for the taxpayer to receive either the whole nominal sum or certain amount of the shares at the maturity date of the equity linked notes is whether the market price of the underlying shares reaches the strike price or not at the time of maturity. Therefore, the return obtained from the equity link notes (i.e. the difference between the discounted purchase price and the nominal sum received at the maturity date) is not in nature an interest income. To determine whether the return is sourced in Hong Kong or not, the Board held that the place to conclude the contract that generated profit to the taxpayer is the question of source. Since the transactions were done by the taxpayer with the bank in Hong Kong, the return from the equity linked notes were sourced in Hong Kong and should be subject to tax. Accordingly, the Board dismissed the appeal in this issue.

Following the judgment of the Court of Final Appeal in the Nice Cheer case, the unrealized gains based on "mark to market" valuations are by law, not taxable. It is still uncertain whether an appeal to the court against the decision of the Board will be lodged by the appellant at this moment. However, as a matter of protection of your own interest, taxpayers who have invested or will invest in such complexly structured financial products should evaluate the nature of the income generated by these financial products case by case to ascertain the potential tax implication on that income. Furthermore, they also need to keep sufficient documentation if they wish to lodge offshore or capital claims for the income derived from the financial instruments.

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