Draft legislation on (1) deduction for lease reinstatement costs and (2) allowances for commercial / industrial buildings

The 2024/25 Budget¹ announced that the HKSAR Government will (1) grant a tax deduction for reinstatement costs incurred for leased premises and (2) remove the time limit for claiming the commercial building allowance (CBA) and industrial building allowance (IBA). Subsequently, the government issued a Legislative Council briefing paper² in June 2024 discussing the proposals on the two tax enhancement measures.

On 18 October 2024, the Inland Revenue (Amendment) (Tax Deductions for Leased Premises Reinstatement and Allowances for Buildings and Structures) Bill 2024³ (the Bill) was gazetted to set out the legislative amendments necessary to implement the above two measures. The Bill will be introduced into the Legislative Council on 30 October 2024. On the same day, the Inland Revenue Department (IRD) released its guidance on the two proposed profits tax relief measures⁴, with FAQs on (1) and an illustrative example on (2) above.

Currently, taxpayers are not allowed to claim a tax deduction for reinstatement costs actually incurred for leased premises at the end or early termination of the lease as they are regarded as capital expenditures.

Effective from the year of assessment (YOA) 2024/25, taxpayers would be allowed to do so if all of the following conditions are met:

• the taxpayer is a lessee of the lease;
• the taxpayer has a reinstatement obligation for the premises;
• the reinstatement costs do not relate to any provisions made under the HKFRS 16 on Leases or other similar accounting standards (e.g., the amortisation and interest expenses of the capitalised reinstatement costs recognised in the financial statements); and
• the amount of the reinstatement cost is reasonable in the circumstances.

In this regard, the term “reinstatement costs” is defined to mean the costs of restating the premises to their original condition at the end or on an early termination of the lease and includes any amount paid or payable by the lessee to the lessor to discharge a reinstatement obligation. The term “reinstatement obligation” is defined to mean an obligation (whether expressed or implied and whether arising from the lease or from another arrangement between the lessor and the lessee) to reinstate, or pay in full or in part for the reinstatement of, the leased premises to their original condition at the end or early termination of the lease. 

Under the current CBA regime, taxpayers are entitled to annual allowances for the capital expenditure incurred on commercial buildings but the claim period is limited to 25 years starting from the year of first use of the building (i.e. the usage period).

This means that if a commercial building is sold after the usage period, the seller may be subject to a balancing charge whereas the buyer will be unable to claim any annual allowances⁵. There is a similar issue for aged industrial buildings under the current IBA regime.

To address the above issue, the Bill seeks to refine the existing CBA and IBA regimes with the following effects: 

* Including any balancing charge imposed on the seller 

We set out an example in the Appendix to illustrate the new rule under the refined CBA regime.

The government's proposals to introduce a tax deduction for lease reinstatement costs and refine the existing IBA and CBA regimes are particularly encouraging. They demonstrate the government’s commitment to responding to concerns raised by stakeholders (including KPMG) and enhancing the competitiveness of the Hong Kong tax system. 

In particular, the proposed tax deduction for lease reinstatement costs is more business-friendly than the one in Singapore⁶ in the following two aspects: (1) the lease reinstatement costs are not required to be contractually provided for in a tenancy agreement and (2) taxpayers are not prohibited from claiming the deduction in cases where the premises are vacated due to cessation of business.

However, under the current proposal, taxpayers can only claim a deduction based on the amounts of lease reinstatement costs actually paid or payable (normally at the end of the lease) and cannot claim a deduction based on the amounts of accounting provisions recognized in the financial statements⁷ during the lease period. This means that taxpayers would need to make tax adjustments for profits tax filing purposes and provide for deferred taxes during the lease period. In addition, taxpayers would not be able to benefit from the deduction in cases where insufficient assessable profits are derived or losses are incurred in the year the lease is ended and the business is ceased upon the end of the lease.

Taxpayers who have acquired or are planning to acquire a second-hand commercial or industrial building in or after the YOA 2024/25 should take note of the annual allowances available under the modified CBA/IBA regimes. For second-hand industrial buildings acquired before the YOA 2024/25 of which the usage period has expired at the time of purchase but there is unclaimed residual expenditure, the buyers should take note of the new 4% IBA available for such industrial buildings starting from the YOA 2024/25 and consider whether the back-year information necessary for ascertaining the IBA amount can be retrieved.

Appendix