Shareholder loan or equity: when tax arises even before the money is received

The Hong Kong court recognized a fixed return under a shareholder loan as interest, even though its payment depended on future revenues from a Chinese development project

On 29 July 2026, the Court of First Instance in Sinolink Shanghai Investments Limited v. Commissioner of Inland Revenue considered three fundamental issues of international taxation:

• whether income under a shareholder loan constitutes interest or income from an equity investment;
• whether interest income may be taxed before actual payment;
• how to determine the source of such income if the lender is in Hong Kong and the financed project is in Mainland China.

The court upheld the position of the Hong Kong Inland Revenue Department: the income was interest, already accrued in favor of the company and derived from a Hong Kong source.

What happened and why it matters for those working with Hong Kong

A group of companies invested in a development project in Mainland China through a joint venture. One of the investors provided financing to the JV in the form of a shareholder loan.

The Investment Agreement provided for:

• a fixed rate of 20% per annum;
• interest accrual from the date of execution of the agreement;
• payment of accrued interest after the project had funds available for distribution;
• priority of interest over distribution of profits among shareholders.

Separately, the investor was entitled to remuneration in the amount of 2% of the investment sum for performing project manager functions.

In its financial statements, the company recorded income under the shareholder loan as interest income. At the same time, for tax purposes it argued that this was not ordinary interest, but in substance income from participation in the Chinese investment project.

In the company’s view, the shareholder loan was merely a legal form used because of regulatory restrictions on the project structure.

Why the court found the payments to be interest

The court primarily proceeded from the legal rights and obligations set out in the contract.

The instrument had the classic features of debt financing:

• a defined principal amount;
• a fixed return of 20% per annum;
• interest accruing from a specific date;
• accrued interest having priority over distribution of profits among shareholders.

Therefore, the fact that payment depended on the availability of funds available for distribution did not, by itself, transform the interest into income from participation in capital.

The court effectively distinguished between two events:

1. the arising of the right to interest income;
2. the due date for its actual payment.

Future project profits were merely the source of funds for repaying already accrued interest. They did not determine the creditor’s right to the income itself.

Substance, as often, prevailed over form.

Why tax arose before the money was received

Interest income may be regarded as accrued even if it has not yet been actually paid, and even if it is not yet immediately payable. What is decisive is whether the person has acquired a right to that income, not whether the money has been received into a bank account.

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or example, if HKD 2 million of interest is accrued under a contract during the year, but it will be paid only after the sale of real estate two years later, taxable income may arise already in the year of accrual!

As a result, a company may find itself in a situation where:

• the income has already been recognized;
• tax is already being assessed;
• the actual payment has not yet been received;
• the company still has no cash from this transaction to pay the tax.

Thus, deferral of payment does not always mean deferral of taxation.

Why Hong Kong was recognized as the source of income

The project itself and the real estate were located in Mainland China. However, the court analyzed not the location of the financed asset, but the transaction that directly generated income for the particular taxpayer.

That transaction was the provision of the shareholder loan in Hong Kong.

The court noted that the Chinese JV owned and managed the development project. The lending company received interest not from the sale of real estate, but as a result of providing financing.

Accordingly:

• the Chinese project generated the funds for debt repayment;
• the shareholder loan created the legal right to receive interest;
• the financing was provided in Hong Kong.

Therefore, the interest was recognized as income sourced in Hong Kong, subject to Hong Kong profits tax.

Why the source mattered

Hong Kong applies a territorial principle of taxation. As a general rule, profits sourced in Hong Kong are taxable, whereas income sourced outside Hong Kong may not be subject to Hong Kong profits tax.

That is why it was in the company’s interest to prove that the income arose from the Chinese investment project.

If the interest had been recognized as foreign-source, a different tax regime could potentially have applied. At the same time, the payment could have been subject to Chinese withholding tax.

It is also now necessary to take into account the Foreign-Sourced Income Exemption (FSIE) regime, which has been in force in Hong Kong since 2023. Certain foreign income of companies within multinational groups, including interest, dividends and other passive income received in Hong Kong, may be taxable if the company does not satisfy the prescribed exemption conditions, including the requirement of sufficient economic substance.

However, the FSIE regime did not apply directly in Sinolink, as the dispute concerned much earlier tax periods.

Form or economic substance?

This decision does not mean that a court will always prefer the name of the agreement over the economic substance of the transaction.

In many countries, tax authorities may recharacterize a shareholder loan as equity if:

• the borrower is objectively unable to repay the funds;
• there is no maturity date;
• interest is not actually paid;
• the financing is subordinated;
• the return depends entirely on the profitability of the business;
• an independent lender would not have provided financing on such terms.

This is especially relevant for intra-group financing and transfer pricing. Not only the interest rate is examined, but also the borrower’s very ability to raise the relevant amount as debt.

However, in Sinolink, the contractual rights, the economic characteristics of the instrument and the accounting treatment consistently pointed to a loan.

The company was effectively trying to retain the advantages of a creditor — fixed return, accrual of interest and payment priority — while obtaining the tax treatment of an equity investment.

The court did not accept that position.

Practical takeaways for international structuring

When documenting shareholder financing, at least four issues should be checked separately:

1. Classification of the instrument. Is there an unconditional obligation to repay the principal and pay interest?
2. Arm’s-length terms. Would an independent lender provide such an amount on similar terms?
3. Timing of income recognition. Has the right to interest already arisen, even if payment is deferred?
4. Source of income. What specific activity generated the interest and where was it carried out?

If the parties truly want to provide for income from participation in capital, this must be properly reflected in the economic substance and documentation of the relevant instrument. Such income may depend on actually received profits, may not accrue as an unconditional debt, and may involve the investor’s real participation in loss risk.

However, such a structure has another side: no guaranteed return, lower payment priority, and a higher risk of losing the investment.

The main takeaway from this case is simple:

You cannot structure a fixed return and a creditor’s priority right, record the income as interest in the financial statements, and then, for tax purposes only, call it income from an equity investment. For an operating company in Hong Kong, this is a very important factor in planning international structuring.

Contracts, accounting, the actual conduct of the parties and the tax position must tell the same story.

The material is based on the decision in Sinolink Shanghai Investments Limited v. Commissioner of Inland Revenue and KPMG Hong Kong’s overview. This article is for informational purposes only and does not constitute legal or tax advice.