Inland Revenue Department

The Government of the Hong Kong Special Administrative Region

of the People's Republic of China

DEPARTMENTAL INTERPRETATION AND PRACTICE NOTES

NO. 27 (REVISED)

PROFITS TAX

STOCK BORROWING AND LENDING

These notes are issued for the information of taxpayers and their tax
representatives. They contain the Department’s interpretation and practices in
relation to the law as it stood at the date of publication. Taxpayers are
reminded that their right of objection against the assessment and their right of
appeal to the Commissioner, the Board of Review or the Court are not affected
by the application of these notes.

These notes replace those issued in November 1996.

CHU Yam-yuen
Commissioner of Inland Revenue

June 2010

Our web site : www.ird.gov.hk

 DEPARTMENTAL INTERPRETATION AND PRACTICE NOTES

No. 27 (REVISED)

CONTENT

Paragraph

INTRODUCTION 1

TRANSACTIONS TO WHICH SECTION 15E APPLIES 4

SBLTs 5

Repos 10

Conditions for relief 14

Types of securities 15

Specified purposes 18

COLLATERAL SECURITIES 20

TAXATION TREATMENT 21

Borrowed stock 22

Borrowing fees 25

Actual distributions in respect of borrowed stock 26

Compensatory payments 28

Loan rebate fees and price differentials 31

ASSESSMENTS 33

ACCOUNTING TREATMENT 34

INTRODUCTION

This Practice Note was first issued in November 1996, and serves to
outline the Profits Tax treatment of stock borrowing and lending transactions
which come within the scope of section 15E of the Inland Revenue Ordinance
(the Ordinance). The current revision reflects changes in the definition of
certain terms, but the Department’s approach in applying section 15E remains
the same.

2. Section 15E was added to the Ordinance by the Inland Revenue

(Amendment) (No. 2) Ordinance 1994 and came into effect on 8 July 1994.
On the same date, the Stamp Duty (Amendment) (No. 2) Ordinance 1994 also
came into effect and extended the scope of the relief from Stamp Duty
provided under the Stamp Duty Ordinance (the SDO) in respect of stock
borrowing and lending transactions. Stamp Office Interpretation and Practice
Notes No. 2 (Revised) explains how the Collector of Stamp Revenue interprets
the relevant SDO provisions. As several of the terms used in section 15E of
the Ordinance are defined by reference to the corresponding terms in the SDO,
this Practice Note should be read and construed in conjunction with the Stamp
Office Practice Notes.

3. It should be noted that the ambit of section 15E has been extended
since it was introduced. Originally the section only provided Profits Tax
relief in respect of transactions which also qualified for Stamp Duty relief,
namely those concerning Hong Kong stock the sale and purchase of which in
Hong Kong are subject to the rules and practices of the Stock Exchange of
Hong Kong. With the enactment of the Inland Revenue (Amendment) (No. 4)
Ordinance 1996, section 15E was amended to also provide relief, with
application to the year of assessment commencing on 1 April 1996 and
subsequent years of assessment, for transactions involving “specified
securities”, i.e. securities specified by the Commissioner in accordance with the
definition of the term in section 15E(8) of the Ordinance.

TRANSACTIONS TO WHICH SECTION 15E APPLIES

4. In broad terms, section 15E is concerned with what are in substance

stock loans, even though transactions are involved which have the effect of
transferring the legal title to stock between the relevant parties. In this regard,
the Department accepts that there are two main categories of transactions
which come within the scope of section 15E, namely, stock borrowing and
lending transactions (SBLTs) and repurchase transactions (Repos). Each
category is discussed in further detail below.

SBLTs

5. An SBLT is typically initiated by a person who seeks to borrow

stock (the borrower) from a person who has such stock (the lender). The
borrower is generally either (i) a short seller (see note1) who has to deliver
stock sold short to a purchaser (or a securities dealer acting on behalf of its
customer who has sold short); (ii) a securities dealer covering “fails” to deliver
stock by customers; or (iii) an intermediary, typically a securities dealer, who
would on-lend the stock borrowed (e.g. the borrower locates stock and on-lends
it to a person who could not locate it directly; in other words, the initial
borrower “intermediates” between the initial lender and the subsequent
borrower).

6. Under an SBLT, the lender transfers the legal and beneficial

ownership of the borrowed stock to the borrower. The lender loses legal
ownership rights (including the right to vote) in exchange for collateral from
the borrower (usually cash, but can be debt or equity securities). Title to the
collateral passes from the borrower to the lender. The borrower agrees to
return stock equivalent to the borrowed stock to the lender upon the lender’s
demand or within a certain period of time, at which time the lender returns the
collateral to the borrower. The lender remains entitled to the economic
benefits (and risk of loss) of the stock during the period the stock is lent (i.e.
the “borrowing period”). If either party becomes insolvent, the other party
may retain the borrowed stock or collateral as the case may be.

7. Various payments and distributions of property can be made under

an SBLT. The lender generally receives a fee (“borrowing fee”) from the
borrower in respect of the borrowed stock. In addition, if any interest,
dividend or other distribution is made in respect of the borrowed stock during

1
By virtue of s.170 of the Securities and Futures Ordinance (Cap. 571) which requires a seller of
securities to have a presently exercisable and unconditional right to vest the securities in the
purchaser of them, a short seller must first obtain a stock borrowing facility by entering into a stock
borrowing and lending agreement with a stock lender.

the borrowing period, the lender receives from the borrower the distribution (or
identical property) or a compensatory payment, sometimes called a
“manufactured dividend” if paid in place of a dividend, equal to the value of
the distribution.

8. In the other direction, if the borrower provides cash to the lender as

collateral, the lender will pay the borrower a so-called “loan rebate fee” which
is generally calculated with reference to published inter-bank interest rates. If
the borrower instead furnishes non-cash collateral to the lender, then,
depending upon the agreement between the parties, the lender will pay the
borrower compensatory payments in respect of distributions made in relation to
the non-cash collateral (or pass on the actual distributions) or the borrower may
substitute cash for the non-cash collateral prior to each distribution date so that
the borrower receives the distributions directly.

9. Finally, payments of cash or transfers of non-cash collateral can be

made between the borrower and the lender (in either direction) to reflect
variations during the borrowing period in the value of the borrowed stock.
Such payments/transfers are to ensure that the value of the collateral held by
the lender continues to represent the same proportion of the value of the
borrowed stock when the collateral was originally provided to the lender.

Repos

10. In economic terms Repos are very similar to SBLTs. A Repo is

typically initiated by a person (the seller) who has stock in the form of equity
or debt securities but needs cash agreeing to sell the stock to a person (the
buyer) who has the cash. At the same time the buyer agrees to sell equivalent
stock to the seller at a later date, or on demand, at a price which is specified or
is to be determined using a specified basis of calculation. A “Reverse Repo”
is essentially the same, but is initiated by a person (the buyer) who has cash and
is willing to exchange it for securities. The seller in a Reverse Repo also
agrees to repurchase equivalent stock from the buyer. Repos and Reverse
Repos are entered into for purposes of (i) liquidity management (i.e. the
exchange of cash for stock for a temporary period); (ii) intermediation; and (iii)
at times, to cover short sales or “fails” to deliver by customers.

11. As with an SBLT, the seller transfers the legal and beneficial
ownership of the debt or equity securities to the buyer. If either party
becomes insolvent, the other party may retain the purchased stock or cash, as
the case may be.

12. Reflecting the practice with SBLTs, the seller receives from the
buyer the economic benefit of any distribution made in respect of the stock
prior to repurchase, i.e. during the borrowing period. Upon repurchase, the
initial seller pays the initial buyer the repurchase price in cash in exchange for
the stock. The repurchase price includes a pre-determined premium, usually
referred to as a “price differential”, which is generally based on the purchase
price paid by the initial buyer and calculated with reference to published
inter-bank interest rates. Other factors which may affect the amount of the
price differential include the desirability or need for the securities involved, and
whether the securities are scripless or physical (an “inconvenience payment”
may be charged in the case of physical securities).

13. The cash paid by the buyer to the seller in exchange for stock under a
Repo can be likened to the payment of collateral in the context of an SBLT.
The cash paid may subsequently be increased or decreased to maintain the ratio
of the purchase price paid to the market value of the stock. For the same
purpose, “margin securities” may be transferred between the seller and the
buyer (in either direction) during the term of the Repo. Such payments of
cash and transfers of securities are analogous to the increase or decrease of
collateral in the case of an SBLT.

Conditions for relief

14. Section 15E only has application where conditions to the following
effect laid down in section 15E(1) are satisfied:

(a) the “borrowed stock” obtained under a stock borrowing and

lending agreement (which may be in the form of a Repo
agreement) was used by the borrower (buyer in the case of a
Repo) for one or more than one specified purpose (see
paragraph 18 below), and has effected a “stock return” as
defined in section 19(16) of the SDO;

 (b) the borrower either passed on any distribution made in respect

of the borrowed stock to the lender or provided the lender
with a compensatory payment of equal value (e.g. the
so-called “manufactured dividend”);

(c) the lender did not dispose of the right to receive any part of
the total consideration payable by the borrower under the
stock borrowing and lending agreement;

(d) both the borrower and lender were dealing with each other at
arm’s length; and

(e) the lender did not enter into the stock borrowing with the
purpose, or main purpose, of avoiding or deferring the
inclusion of any amount in profits in respect of which the
lender is chargeable to Profits Tax.

Types of securities

15. As was mentioned in paragraph 3 above, relief under section 15E

was originally only available in respect of transactions which also qualified for
relief under the SDO, i.e. those involving “Hong Kong stock the sale and
purchase of which in Hong Kong are subject to the rules and practices of the
recognized exchange company that operates the relevant stock market”.
However, with effect from the year of assessment commencing on 1 April 1996,
relief under section 15E was extended to also apply in respect of transactions
involving “specified securities”. The expression is defined in the section in
the following terms-

““specified securities” means any of the following, not being Hong

Kong stock the sale and purchase of which in Hong Kong are subject
to the rules and practices of a recognized stock market-

(a) any shares, stocks, debentures, loan stocks, funds, bonds or

notes of or issued by any body, whether corporate or
unincorporate, or any government or local government
authority, or any other similar investment of any description;

 (b) any units under a unit trust scheme;

(c) any right, option or interest in or in respect of any security

referred to in paragraph (a) or (b),

which the Commissioner may specify in writing, either generally or

in any particular case, for the purposes of this section.”

16. Pursuant to the terms of the definition, on 30 August 1996 the

Commissioner specified, by means of Departmental Interpretation and Practice
Notes No. 26, that where associated parties are not involved securities falling
into the following categories are specified securities for the purposes of section
15E-

(i) any debt or equity security listed on a stock exchange in Hong

Kong or any other stock exchange or over-the-counter market
recognized for the purposes of this paragraph by the
Commissioner;

(ii) any unlisted debt issued to third parties or guaranteed to third

parties by listed companies (including affiliates owned 50%
or more by listed companies);

(iii) a ny unlisted sovereign debt (including, for this purpose,

government agency debt, multilateral agency debt and debt
guaranteed by multilateral agencies or sovereign
governments); and

(iv) any unlisted debt or equity securities issued pursuant to a

private placement authorized by the Hong Kong Securities
and Futures Commission or a similar supervisory body in
another jurisdiction.

17. The categories of specified securities may change from time to time.
Accordingly, reference should be made to Practice Notes No. 26 (Revised) to
ascertain the current position, or to the Department if there is any doubt in
relation to a particular situation. The Practice Note also provides information
concerning the circumstances where associated parties are considered to be
involved.

Specified purposes

18. For the purposes of section 15E, the term “specified purpose” is
defined in section 15E(8) to have, subject to section 15E(9), the same meaning
as in the SDO. The SDO definition is contained in section 19(16) and is as
follows:

““specified purpose”, in relation to the borrowing of stock by any

person, means-

(a) the settling of a sale of Hong Kong stock wherever effected,

whether by the person himself or another person;

(b) the settling of a future sale of Hong Kong stock, whether

agreed or not when such stock borrowing is effected and
whether by the person himself or another person;

(c) the replacement, in whole or in part, of Hong Kong stock

obtained by the person under another stock borrowing;

(d) the on-lending of the stock borrowed to another person who

effects a stock borrowing in respect of such stock on-lent; or

(e) such other purpose as the Collector may, in writing, allow

either generally or in any particular case.”

Section 15E(9) widens the meaning of the definition for Profits Tax purposes
by providing that, so far as is relevant, any reference to Hong Kong stock in the
SDO definition is to be construed as including a reference to specified
securities.

19. To cater for the purpose for which the majority of Repos are entered
into, the Collector accepts, under the authority provided in paragraph (e) of the
SDO definition, that stock obtained by a buyer for the purpose of liquidity
management is for a “specified purpose” (see paragraphs 40 to 42 of Stamp
Office Interpretation and Practice Notes No. 2 (Revised)).

COLLATERAL SECURITIES

20. As was pointed out earlier, the provision of collateral is an integral

part of SBLTs (from the borrower to the lender) and Repos (from the buyer to
the seller). While cash is typically used in the case of Repos, SBLTs may
involve the transfer of stock from the borrower to the lender as collateral, with
the borrower remaining entitled to the economic benefits of the stock, and the
re-transfer of this stock back to the borrower at the end of the borrowing period.
Provided that this is the case and the SBLT itself is for a specified purpose,
then the transfers of the collateral (i.e. both from and back to the borrower) and
the passing on of any distributions or making of any compensatory payments in
respect of the collateral will be treated for tax purposes in an identical manner
as those in relation to the original SBLT transaction (i.e. the stock loan which
necessitated the stock collateral in the first place). In short, the provision of
collateral securities to the lender and the subsequent re-transfer to the borrower
can be regarded as constituting a reverse SBLT which falls within the
provisions of section 15E.

TAXATION TREATMENT

21. The Profits Tax treatment of the more common property transfers
and payments associated with stock borrowing and lending agreements is
discussed in the following paragraphs.

Borrowed stock

22. Section 15E(2) sets out the position of the lender (seller in the case
of a Repo), other than in respect of the borrowing fee (see paragraph 25 below),
under a stock borrowing and lending agreement in relation to the transactions
by which stock is transferred from the lender to the borrower (from the seller to
the buyer in the case of a Repo) and subsequently the transactions by which
stock of the same description or any reasonable equivalent is transferred back.
In essence, the subsection provides that, to the extent that a stock return is
made in respect of the borrowed stock, the lender is treated as if the stock
borrowing and stock return had not been made and as having held the borrowed
stock during the relevant borrowing period.

23. Accordingly, the lender is to disregard any chargeable profit (apart

from the borrowing fee) which would otherwise arise in respect of both the
disposal of the stock to the borrower and the subsequent re-acquisition. It also
follows that a lender who normally values stock for accountancy purposes at
current market value should continue to value the borrowed stock in this way
during the borrowing period. As such, where the borrowing period bridges
the end of an accounting period the difference between the opening value and
the value at the end of the accounting period should be recorded by the lender,
subject to source principles, as a profit or loss, as the case may be, for Profits
Tax purposes.

24. As regards the borrower, the disposal of borrowed stock for a

specified purpose in the normal course of a business carried on in Hong Kong
will give rise to a profit or loss. The subsequent disposal of replacement stock
to the lender will similarly give rise to a profit or loss. In calculating the
profit or loss, section 15E(5) provides in effect that the market value of the
borrowed stock at the time of the borrowing is to be taken both as the cost of
the borrowed stock and as the sale price of the replacement stock. Subject to
source principles, the profits will be taxed or losses allowed.

Borrowing fees

25. The fee payable by the borrower to the lender in respect of a stock
borrowing is in the nature of a service fee and is treated as income in the hands
of the lender and as expense for the borrower. General principles determine
whether the fee is chargeable or deductible for Profits Tax purposes, as the case
may be.

Actual distributions in respect of borrowed stock

26. Section 15E(3) provides in effect that where a lender receives from a
borrower in relation to borrowed stock a distribution, right, option or identical
property (i.e. the “distribution” is passed on by the borrower to the lender), the
lender is treated for tax purposes as if the distribution had been received
directly by the lender in respect of a continued holding of the borrowed stock.
Accordingly, the nature of the distribution will determine its taxability. For
example, a dividend would be exempt, whilst the chargeability of interest
would depend on matters such as its source and whether special provisions of

the Ordinance apply to the recipient. The tax treatment of the amount
received by the lender therefore is not affected by the fact that it has come
other than from the issuer of the stock; it is treated as having the same nature
and source for tax purposes as the original distribution.

27. With regard to the borrower, where a distribution is received in

respect of borrowed stock (e.g. if the borrower is still holding the borrowed
stock at the time a distribution is made) and it is then passed on to the lender
(or a payment of equal value is made to the lender), the receipt and subsequent
action are in effect ignored for Profits Tax purposes. In other words, as far as
the borrower is concerned, receipt of the actual distribution does not give rise
to any chargeable profit and the subsequent passing on of it, or payment of
equal value, to the lender does not create an allowable deduction.

Compensatory payments

28. Section 15E(4) applies where the borrower has not received the
actual distribution and has therefore made a payment of equal value (a
compensatory payment) to the lender. This is the more likely circumstance as
a borrower would not generally continue to hold the borrowed stock, but would
instead deliver it to a purchaser in respect of a short sale or on-lend it to a
subsequent borrower. This subsection again puts the lender in the same
taxation position as would have been the case if the lender had retained
ownership of the borrowed stock and received the original distribution. The
nature of the original distribution will determine the tax treatment of the
compensatory payment in the hands of the lender.

29. Section 15E does not address the position of the borrower in relation
to compensatory payments. Accordingly, the question of deductibility is
determined under sections 16 and 17 of the Ordinance, i.e. the amount will
qualify for deduction if it can be characterized as an outgoing or expense
incurred by the borrower in the production of profits which are chargeable to
Profits Tax and is not of a capital nature.

30. The above principles also apply in relation to compensatory

payments made by the lender to the borrower in respect of a reverse SBLT, i.e.
for distributions on collateral securities provided by the borrower to the lender
under the terms of the stock borrowing and lending agreement.

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Loan rebate fees and price differentials

31. A loan rebate fee in relation to an SBLT is payable by a lender to a

borrower when cash collateral is given by the borrower to the lender in respect
of the borrowed stock. The fee is generally calculated with reference to the
amount of cash involved, inter-bank interest rates and the length of time the
cash collateral is held by the lender. Similarly, a price differential in relation
to a Repo (included in the repurchase price paid by the initial seller to the
initial buyer) is usually calculated with reference to the purchase price paid by
the initial buyer, inter-bank interest rates and the length of time the cash is held
by the initial seller. Thus, rebate fees and price differentials are considered to
be, in substance, interest and are treated accordingly.

32. Reflecting the conditions governing the deductibility of interest laid

down in section 16(2) of the Ordinance, a loan rebate fee or price differential
paid by a lender to an overseas counterparty not carrying on business in Hong
Kong will not generally qualify for deduction unless the recipient is an
overseas financial institution as defined in section 16(3). However, in
practice the Department will accept that where the recipient is acting as a
principal and is a securities dealing and underwriting firm regulated in at least
one overseas jurisdiction by a supervisory body similar to the Hong Kong
Securities and Futures Commission, it can be recognized as an overseas
financial institution for the purposes of sections 15E and 16(2). Recognition
will also be granted if the recipient is an affiliate owned 50% or more, directly
or indirectly, by such a securities firm.

ASSESSMENTS

33. Where a person has entered into a stock borrowing and lending
agreement and at the close of the year of assessment not all transactions under
the agreement have taken place (e.g. a stock return has not been made because
the borrowing period has not finished), the Assessor can, by virtue of section
15E(6), raise the assessment for the year concerned on the basis that section
15E is applicable. If it is subsequently found that the section is not applicable,
the assessment can be adjusted accordingly under section 15E(7).

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ACCOUNTING TREATMENT

34. The taxation treatment of property transfers and cash flows

associated with stock borrowing and lending agreements reflects the
Department’s understanding of generally accepted accounting practice in
relation to such agreements. Briefly, the Department understands that the
following conventions would generally apply:

• the lender (seller in the case of a Repo) continues to reflect

the borrowed stock (securities subject to repurchase in the
case of a Repo) as an asset on its balance sheet;

• the borrower (buyer in the case of a Repo) continues to reflect

the collateral given to the lender as an asset on its balance
sheet;

• if either the borrowed stock or collateral is normally valued at

current market value, then the party reflecting the asset on its
balance sheet will include either income or loss, as the case
may be, in its profit and loss statement in respect of any
difference in values between the beginning and end of the
period;

• if actual distributions are received by the borrower and passed

on to the lender (as opposed to the borrower making
compensatory payments in respect of distributions not
received), the receipt and passing on of such distributions will
not be reflected in the borrower’s profit and loss statement;

• compensatory payments in respect of distributions are

reflected as expenses in the profit and loss statement of the
borrower and as income in the profit and loss statement of the
lender;

• borrowing fees are reflected as expenses in the profit and loss

statement of the borrower and as income in the profit and loss
statement of the lender; and

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 • loan rebate fees (price differential payments in the case of a

Repo) are reflected as interest expenses in the profit and loss
statement of the lender and as interest receipts in the profit
and loss statement of the borrower.

If the accounting treatment in any particular case differs from the general
understanding set out above, and the matter is not self-evident from the notes to
the accounts, this must be drawn to the Assessor’s attention in the tax
computation submitted.

35. This Practice Note has been prepared with regard to the fact that the
relevant legislation was introduced with a view to promoting the development
of Hong Kong as a major financial centre. The positions taken by the
Department are generally intended to be consistent with the substance of the
transactions involved and their treatment within the industry. Consequently,
this Practice Note should not impose undue restrictions on the parties ordinarily
engaged in SBLT and Repo businesses. At the same time, the Department
will not accept that its contents can in any way restrict action to counter tax
avoidance. This Practice Note will be reviewed in the light of experience.
Should situations encountered so dictate, changes will be effected.

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