Hong Kong’s enhanced tax deduction regime for research and development (R&D) represents a significant strategic opportunity for businesses seeking to reduce their tax burden while investing in innovation. Since its introduction in the 2018/19 tax year, this “super tax deduction” has fundamentally changed the cost-benefit calculation for R&D investment in Hong Kong.

This comprehensive guide examines how Hong Kong’s enhanced R&D tax deductions work, which activities and expenses qualify, and how businesses can strategically leverage these incentives to maximize tax savings and competitive advantage.

Understanding Hong Kong’s Enhanced R&D Tax Deduction Framework

The enhanced R&D tax deduction regime was introduced through the Inland Revenue (Amendment) (No. 7) Ordinance 2018, enacted on 2 November 2018. The legislation amended the Inland Revenue Ordinance (IRO) to add Section 16B and Schedule 45, establishing a two-tiered enhanced deduction system for qualifying R&D expenditure incurred on or after 1 April 2018.

This marked a breakthrough in Hong Kong’s taxation system as it was the first time the Inland Revenue Department (IRD) allowed deductions of 300%/200% on certain operating expenditure, signaling the government’s commitment to transforming Hong Kong into a regional innovation hub.

The Two-Tiered Deduction Structure

Hong Kong’s R&D tax incentive operates on a two-tiered structure with different deduction rates based on expenditure type and amount:

Expenditure Type	Amount Range	Deduction Rate	Cap
Type B	First HK$2 million	300%	No cap
Type B	Balance over HK$2 million	200%	No cap
Type A	All amounts	100%	N/A

Example calculation: If a company incurs HK$5 million in qualifying Type B R&D expenditure:

• First HK$2 million: HK$2M × 300% = HK$6 million deduction
• Remaining HK$3 million: HK$3M × 200% = HK$6 million deduction
• Total deduction: HK$12 million (from HK$5 million actual expenditure)
• At 16.5% corporate tax rate, this saves approximately HK$1.98 million in taxes

Type A vs Type B Expenditure: Critical Distinctions

Understanding the difference between Type A and Type B expenditure is crucial for maximizing tax benefits, as only Type B expenditure qualifies for the enhanced 300%/200% deduction rates.

Type B Expenditure (Enhanced Deduction)

Type B expenditure qualifies for the enhanced tax deduction and includes only three specific categories:

Category	Description	Key Requirements
1. Staff Costs	Expenditure relating to employees engaged in qualifying R&D activities	• Must be in-house employees (not directors) • Directly and actively engaged in R&D • Based on duties performed, not job title • Excludes freelancers and external personnel • Overseas employees who usually work outside HK excluded
2. Consumables	Expenditure on consumable items used directly in qualifying R&D activities	• Must be used directly in R&D • Items consumed during the R&D process • Examples: laboratory materials, testing supplies, prototyping materials
3. Payments to DLRIs	Payments to designated local research institutions for outsourced R&D	• Must be to a designated local research institution • Includes HK universities/colleges • Other institutions designated by Commissioner for Innovation and Technology • For outsourced qualifying R&D activities

Type A Expenditure (Standard Deduction)

Type A expenditure receives the standard 100% tax deduction and includes all other qualifying R&D expenditure not falling under Type B, such as:

• Machinery and equipment used for R&D
• Capital expenditure on R&D facilities
• Depreciation of R&D assets
• Payments to non-designated research institutions
• Overhead costs allocable to R&D
• Directors’ remuneration for R&D work

Qualifying R&D Activities Under Section 16B and DIPN 55

The Inland Revenue Department published Departmental Interpretation and Practice Notes No. 55 (DIPN 55) on 11 April 2019, providing detailed guidance on what constitutes a qualifying R&D activity under Section 16B of the IRO.

Definition of Qualifying R&D Activity

According to Section 4(1) of Schedule 45, a qualifying R&D activity must:

1. Fall within the description in section 2(a), (c) or (d) of Schedule 45
2. Be wholly undertaken and carried on in Hong Kong
3. Relate to the trade, profession, or business of the taxpayer

The IRD acknowledges this definition has a wide scope, but emphasizes that R&D needs to exceed minor or incremental upgrades. An R&D activity can be described as “an activity working for tomorrow to develop new products, new lines and improvements to present production.”

Key Characteristics of Qualifying Activities

According to DIPN 55, qualifying R&D activities must involve:

• Scientific or technological uncertainty: The activity must seek to resolve uncertainty about achieving an advance in science or technology
• Substantial improvement threshold: Changes must be significant enough that the result is “better” than the original, not merely minor or routine upgrading
• Novel approach: Mere adaptation of an existing product or process to a particular customer’s need will unlikely constitute substantial improvement
• Systematic investigation: The work must be conducted systematically to achieve advancement

Excluded Activities

Section 4(2) of Schedule 45 explicitly excludes the following from qualifying R&D activities:

Excluded Activity	Explanation
Efficiency surveys	Studies aimed at improving operational efficiency without advancing science or technology
Feasibility studies	Preliminary studies assessing viability of projects
Management studies	Studies of business management practices
Market research	Research into market conditions and consumer preferences
Sales promotion	Activities aimed at promoting sales of products or services
Application of publicly available knowledge	Applying known research findings to a plan or design with anticipated outcome and without scientific/technological uncertainty
Non-scientific/non-technological development	Work developing non-scientific or non-technological aspects of new or improved materials, devices, products, processes, systems, or services

Important DIPN 55 Clarifications

Patent registration not required: Registration of patents is not a prerequisite for an activity to be regarded as an R&D activity. The focus is on the nature of the work, not the outcome.

Trade secrets can qualify: If a particular advance in science or technology has already been made by others but details are not readily available (e.g., a trade secret), work to achieve such an advance can still be regarded as qualified R&D activity.

Industry-neutral: The R&D enhanced deduction is available for all industries provided the necessary requirements are met. There are no sector-specific restrictions.

The Hong Kong Location Requirement: Critical Compliance Issue

One of the most critical requirements for qualifying for enhanced R&D deductions is that the R&D activities must be wholly undertaken and carried on in Hong Kong. This location requirement has significant implications for business strategy.

Type B Expenditure: Strict Hong Kong Requirement

For Type B expenditure to qualify for the enhanced 300%/200% deduction, the relevant R&D activity must be wholly carried out in Hong Kong. There is no partial qualification – if any portion of the R&D work occurs outside Hong Kong, the entire expenditure loses eligibility for enhanced deduction.

Type A Expenditure: Apportionment Allowed

Where Type A expenditure is incurred for an R&D activity performed outside or partly outside Hong Kong, the deduction for the expenditure is subject to apportionment. This provides some flexibility for businesses with cross-border R&D operations.

Overseas R&D: Limited Deduction Available

According to DIPN 55, R&D expenses paid by a Hong Kong company to overseas group companies or subcontractors could qualify for a 100% normal tax deduction (Type A) if both of the following conditions are satisfied:

1. The R&D expenses paid to subcontracted overseas entities do not exceed 20% of the total R&D costs
2. The R&D expenses paid to overseas companies is not more than HK$2 million

These strict limits incentivize companies to locate their R&D operations in Hong Kong to maximize tax benefits.

Intellectual Property Rights and Ownership Requirements

Section 16B of the IRO contains an important ownership requirement that businesses must understand to qualify for R&D deductions.

Full Vesting Requirement

No deduction is allowed if the rights generated from the R&D activity (e.g., intellectual property such as patents, copyrights, trade secrets, or know-how) are not fully vested in the enterprise claiming the deduction.

This means:

• The Hong Kong company must retain full ownership of IP created through R&D
• Arrangements where IP rights are assigned to related entities may jeopardize deduction eligibility
• Careful structuring is required for group companies conducting R&D
• Licensing arrangements must be reviewed to ensure they don’t compromise ownership

Strategic Implications

This requirement has significant implications for multinational groups with centralized IP holding companies. Businesses may need to restructure IP ownership to ensure the Hong Kong entity conducting R&D retains the resulting IP rights, or accept reduced tax benefits if IP is held elsewhere.

Documentation and Compliance Requirements

DIPN 55 emphasizes the importance of proper documentation to support R&D tax deduction claims. The IRD expects taxpayers to maintain comprehensive records demonstrating:

Essential Documentation

• R&D project descriptions: Detailed documentation of the scientific or technological objectives, uncertainties being addressed, and systematic approach being taken
• Time records: For staff costs, records showing how employees’ time was allocated to qualifying R&D activities (based on actual duties performed, not job titles)
• Expenditure records: Detailed accounting records breaking down Type A and Type B expenditure, with supporting invoices and payment documentation
• Location evidence: Documentation proving R&D activities were wholly undertaken in Hong Kong (e.g., laboratory logs, meeting records, work location records)
• IP ownership documentation: Evidence that rights generated from R&D activities are fully vested in the claiming entity
• DLRI certifications: For outsourced R&D, evidence that the institution is designated by the Commissioner for Innovation and Technology

Supplementary Form S3

Taxpayers claiming R&D deductions must complete Supplementary Form S3 when filing their profits tax return. The form requires detailed information about:

• Total R&D expenditure broken down by Type A and Type B
• Description of R&D activities undertaken
• Location where R&D was performed
• Number of employees engaged in R&D
• Details of payments to designated local research institutions

Strategic Planning Considerations for Businesses

1. Optimize Expenditure Classification

Businesses should carefully structure their R&D operations to maximize Type B expenditure, which qualifies for enhanced deductions:

• Direct staffing: Use in-house employees (not directors or contractors) for R&D work where possible
• Consumables management: Track and document consumable items used directly in R&D
• Outsourcing strategy: When outsourcing R&D, use designated local research institutions rather than commercial vendors or overseas entities

2. Location Strategy

The Hong Kong location requirement makes it essential to:

• Establish R&D facilities and laboratories in Hong Kong
• Ensure R&D personnel are based and working in Hong Kong
• Document that all R&D activities occur within Hong Kong’s jurisdiction
• Carefully manage any cross-border collaboration to maintain full Hong Kong location for enhanced deduction eligibility

3. IP Structure Optimization

Given the full vesting requirement, businesses should:

• Review existing IP ownership structures within corporate groups
• Consider whether IP should be held by the Hong Kong entity conducting R&D or accepted trade-offs in tax efficiency
• Structure new R&D projects with IP ownership in mind from the outset
• Obtain professional advice on balancing R&D deductions with overall group IP and tax strategy

4. Cross-Border R&D Management

For businesses with international R&D operations:

• Keep overseas R&D costs within the 20% and HK$2 million thresholds if seeking any deduction
• Clearly separate and document Hong Kong-based versus overseas R&D activities
• Consider relocating R&D work to Hong Kong to access enhanced deductions
• Implement robust transfer pricing documentation for cross-border R&D arrangements

5. Enhanced Record-Keeping Systems

Implement systems to capture the documentation required for R&D claims:

• Time tracking systems for R&D personnel showing specific activities
• Project management tools documenting R&D objectives, uncertainties, and approaches
• Financial systems separating Type A and Type B expenditure
• Document management systems for IP ownership evidence

Interaction with Global Minimum Tax (Pillar Two)

Starting in 2025, Hong Kong multinational groups with global revenue of EUR 750 million or more may be subject to a 15% minimum effective tax rate under the OECD’s Pillar Two global minimum tax rules.

Impact on R&D Deductions

The enhanced R&D deductions could be affected by Pillar Two rules:

• Top-up tax potential: If R&D deductions reduce Hong Kong’s effective tax rate below 15%, a top-up tax may be triggered in other jurisdictions
• Qualified refundable tax credits: The treatment of R&D incentives under Pillar Two depends on whether they qualify as refundable tax credits or standard deductions
• Strategic reconsideration: Large multinationals may need to reassess the value of R&D deductions if they result in top-up taxes elsewhere

Businesses subject to Pillar Two should:

• Model the interaction between R&D deductions and global minimum tax
• Consider whether R&D incentives remain attractive when Pillar Two top-up is factored in
• Evaluate alternative structures or jurisdictions for R&D investment
• Seek professional advice on optimizing global tax positions

Common Pitfalls and How to Avoid Them

Failing to Distinguish Type A and Type B Expenditure

Pitfall: Many businesses fail to properly categorize their R&D expenditure, missing out on enhanced deductions for Type B costs or incorrectly claiming enhanced rates for Type A expenditure.

Solution: Implement detailed expenditure tracking systems that categorize costs at the point of incurrence. Train finance teams on the specific definitions and requirements.

Inadequate Documentation of “Directly and Actively Engaged” Staff

Pitfall: Claiming staff costs based on job titles rather than actual duties performed, or failing to maintain time records proving direct R&D engagement.

Solution: Implement time tracking systems showing actual R&D activities. Base claims on contemporaneous records of duties, not retrospective assessments or job descriptions.

Assuming All Innovation Qualifies as R&D

Pitfall: Treating product improvements, customization work, or minor upgrades as qualifying R&D when they don’t meet the “substantial improvement” or “scientific/technological uncertainty” thresholds.

Solution: Apply the DIPN 55 tests rigorously. Document the scientific or technological uncertainty being addressed and why the improvement is substantial, not routine.

Cross-Border R&D Without Proper Structure

Pitfall: Conducting R&D partly outside Hong Kong without realizing this disqualifies Type B expenditure entirely, or exceeding the 20%/HK$2 million limits for Type A overseas costs.

Solution: Structure R&D projects to be wholly in Hong Kong for Type B costs. Carefully monitor overseas R&D spending against the thresholds. Consider relocating activities to Hong Kong.

IP Rights Not Vested in Claiming Entity

Pitfall: R&D conducted by Hong Kong entity but IP rights assigned to group holding company or other related entity, disqualifying deductions.

Solution: Review IP ownership arrangements before incurring R&D expenditure. Restructure if necessary to ensure Hong Kong entity retains IP rights, or accept the loss of deduction.

Outsourcing to Non-Designated Institutions

Pitfall: Paying for outsourced R&D to commercial laboratories or non-designated institutions, assuming this qualifies for Type B treatment.

Solution: Verify that outsourced R&D providers are designated local research institutions. Maintain list of designated institutions and only use these for Type B claims.

Industry-Specific Applications

Technology and Software Development

Technology companies can benefit significantly from R&D deductions for:

• Development of new algorithms and software architectures
• Resolving technical uncertainties in system design
• Creating substantially improved software products or platforms
• Research into artificial intelligence, machine learning, and data analytics

Key consideration: Routine software development, bug fixes, and customization work typically don’t qualify. Focus on projects with genuine technological uncertainty and substantial advancement.

Manufacturing and Engineering

Manufacturers can claim deductions for:

• Development of new manufacturing processes with scientific/technical uncertainty
• Substantial improvements to existing production methods
• Materials science research for new or improved products
• Automation and robotics research (beyond routine implementation)

Key consideration: Distinguish between routine process optimization (not qualifying) and R&D addressing genuine technological challenges.

Pharmaceuticals and Biotechnology

Life sciences companies typically have extensive qualifying R&D:

• Drug discovery and development activities
• Clinical trial research conducted in Hong Kong
• Development of new diagnostic methods or medical devices
• Biotechnology research and genetic studies

Key consideration: Ensure clinical trials and research are conducted in Hong Kong to qualify for enhanced deductions. Collaborate with Hong Kong universities (designated institutions) where possible.

Financial Services and Fintech

Financial institutions can claim for:

• Development of innovative fintech solutions
• Blockchain and distributed ledger technology research
• Advanced risk modeling and analytics systems
• Cybersecurity technology development

Key consideration: Implementation of existing technologies doesn’t qualify. Focus on development of genuinely novel solutions addressing technological uncertainty.

Maximizing Your R&D Tax Benefits: Action Plan

Step 1: R&D Activity Assessment (Month 1)

• Review all current projects to identify qualifying R&D activities
• Apply DIPN 55 tests to determine which activities meet the threshold
• Document scientific/technological uncertainties being addressed
• Identify excluded activities (market research, routine upgrades, etc.)

Step 2: Expenditure Classification (Month 1-2)

• Analyze R&D costs and categorize as Type A or Type B
• Review staff allocation to identify employees directly engaged in R&D
• Assess consumable usage and tracking systems
• Identify opportunities to shift from Type A to Type B expenditure

Step 3: Structural Review (Month 2-3)

• Verify all qualifying R&D is wholly conducted in Hong Kong
• Review IP ownership arrangements and vesting requirements
• Assess whether outsourced R&D uses designated local research institutions
• Evaluate opportunities to relocate R&D activities to Hong Kong

Step 4: Systems Implementation (Month 3-6)

• Implement time tracking for R&D personnel
• Establish project documentation systems for R&D activities
• Create financial reporting to separate Type A and Type B costs
• Develop document management for IP ownership evidence

Step 5: Compliance and Claiming (Ongoing)

• Complete Supplementary Form S3 accurately with supporting documentation
• Maintain contemporaneous records throughout the tax year
• Review and update R&D classifications as projects evolve
• Consider engaging tax professionals for complex situations

Recent Developments and Future Outlook

2025 Tax Year Considerations

As of 2025, businesses should be aware of:

• Pillar Two implementation: Global minimum tax rules affecting large multinationals may impact the value of R&D deductions
• Increased IRD scrutiny: As more businesses claim enhanced deductions, expect more detailed IRD reviews and documentation requests
• Designated institution expansion: Monitor announcements of newly designated local research institutions to expand outsourcing opportunities

Potential Future Enhancements

Industry observers have suggested potential future improvements to Hong Kong’s R&D regime:

• Expansion of qualifying activities or relaxation of location requirements
• Introduction of R&D tax credits in addition to deductions
• Simplified documentation requirements for small and medium enterprises
• Enhanced incentives for specific priority sectors

Businesses should stay informed of legislative developments and budget announcements that may affect R&D tax incentives.

This article provides general information about Hong Kong’s R&D tax deduction regime as of 2025. The tax treatment of specific situations may vary based on individual circumstances. Businesses should consult qualified tax professionals for advice tailored to their specific situation and maintain up-to-date knowledge of IRD guidance and legislative changes.