The Inland Revenue (Amendment) (Tax Deductions for Leased Premises Reinstatement and Allowance for Buildings and Structures) Bill 2024 enables tenants of leased premises to deduct lease reinstatement costs in computing profits tax with effect from the tax year beginning on April 1, 2024. In this article, we provide an outline of the new legislation. If you’d like more information about the deductibility of lease reinstatement costs or Hong Kong tax generally, please contact one of our Tax lawyers.
Passed on December 18, 2024, the Inland Revenue (Amendment) (Tax Deductions for Leased Premises Reinstatement and Allowance for Buildings and Structures) Bill 2024 (“Lease Reinstatement Costs Bill”) amends the Inland Revenue Ordinance (“IRO”) to permit tenants of leased premises who are subject to reinstatement obligations under their lease to deduct lease reinstatement costs in computing profits tax for the tax years beginning April 1, 2024.
Leases typically permit tenants at their own cost to fit-out the premises to which the lease relates with the approval of the landlord. A retail tenant may, for example, renovate a space let as a shop to suit the tenant’s brand and operations. The renovations are known as tenant improvements. However, where a tenant fits-out the premises, the lease typically provides that the tenant has an obligation at its own cost to reinstate (i.e. restore) the premises to their original condition when the term of the lease expires.
Historically, the tenant could deduct neither the cost of the renovation nor the cost of reinstating the premises. This is because as a general principle, under the IRO, a taxpayer may only deduct outgoings and expenses to the extent to which they are incurred during the tax year in the production of profits. The IRO specifically prohibits a taxpayer from deducting capital expenditures and the cost of any improvements. As a lease confers exclusive possession of the premises to which it relates over a period of time, it is typically regarded as a capital asset. Any cost incurred in connection with the acquisition of a capital asset is a capital expenditure. For accounting purposes, the costs of reinstatement are regarded as part of the costs of acquisition.
The Lease Reinstatement Costs Bill changes the historical position by allowing a tenant to deduct the lease reinstatement cost. It has no effect on the initial cost of renovation, which remains generally non-deductible.
The new legislation establishes a number of conditions to be satisfied to qualify for deductibility of lease re-instatement costs.
Original Condition
The reinstatement costs must be incurred to restore the premises to their “original condition”. The legislation defines the term “original condition” to mean “the condition the premises are in at the beginning of the term of the lease”.
There is some uncertainty in practical application of this definition. Under the language, in principle, costs should not qualify for deduction if the taxpayer incurs them to put the premises into a condition “better” than the original condition. However, for example, if on reinstatement, ceiling tiles, lights or fire sprinklers and related pipes in the premises are newer or better models than the originals, possibly because the older models are no longer available at a reasonable cost, would the reinstatement be regarded as a restoration of the “original condition”? If not, would the entire reinstatement cost be non-deductible or would the reinstatement cost be deductible only to the extent it could be regarded as equivalent to the “original condition”?
Equally, under the language, it may be the case that the entire premises must be re-instated. This may create issues where a tenant surrenders a portion of the premises originally leased as may happen in a downsizing of space. In this case, can the tenant claim a deduction for the cost of re-instating that portion of the premises surrendered even though the entire premises have not been re-instated?
Mandatory Reinstatement Obligation
To qualify for tax relief, the re-instatement costs must be incurred under a mandatory obligation. The obligation can be express or implied and can arise under the lease or a separate agreement.
Reasonableness of Reinstatement Costs
The amount of the reinstatement costs must be “reasonable in the circumstances”. The legislation does not define what constitutes “reasonable”, resulting in some uncertainty as to what amount may qualify for relief and what processes may need to be followed to support a characterization of reasonableness.
Reinstatement costs must be actually incurred and cannot relate to any provisions made under HKFRS 16 (Leases) or similar accounting standards for expected future reinstatement.
Payments in Lieu of Reinstatement
The legislation provides that an obligation “to pay (whether in full or part) for the reinstatement” of the premises will qualify as a mandatory re-instatement obligation. Equally, the legislation provides that “any amount paid or payable” by the tenant to the landlord to discharge the tenant’s reinstatement obligation will qualify as a reinstatement cost.
No Effect on Landlords
The new legislation has no tax effect on landlords.