THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND ADMINISTRATORS

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1 THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND ADMINISTRATORS International Qualifying Scheme Examination HONG KONG TAXATION JUNE 2012 Suggested Answer The suggested answers are published for the purpose of assisting students in their understanding of the possible principles, analysis or arguments that may be identified in each question 1

2 SECTION A 1. David Chow is employed as the marketing manager of Elegance Fashion Ltd (Elegance HK), a company carrying on business in Hong Kong. Elegance HK is listed on the Hong Kong Stock Exchange and has a wholly-owned subsidiary in the Mainland China, Elegance Garment Factory Ltd (Elegance China), which manufactures the products for Elegance HK. David is also one of the directors of Elegance China. He has approached you for advice and has provided you with the following information relating to the year ending on 31 March 2012: Employment / Office 1. His salary from Elegance HK was $360,000 for the year. He also received commission income of $220, He received a director s fee of $100,000 from Elegance China. He normally attends board meetings in Mainland China. When he cannot make the meetings in person, he uses video-conferencing from the Hong Kong office. He has paid income tax in the Mainland of $12,000 equivalent in respect of his director s fee. 3. Apart from his duties as a director, he is also required to travel to Mainland China regularly to ensure that the quality of the products meets the customers requirements, and to visit the production facilities with prospective and existing customers. He roughly spends about 100 days per year in the Mainland. 4. He rented a car from a motor car company at a monthly rent of $3,000 and paid petrol costs amounting to $42,000 for the year. He obtained the full refund of car rental and petrol costs from Elegance HK. The Inland Revenue Department agreed that 50% of the car was used for employment purposes. 5. He is enrolled in Elegance HK s medical insurance scheme. Elegance HK paid insurance premium of $2,100 for his medical cover. During the year, David has claimed medical reimbursement of $4,500 from the insurance company. 6. On 10 January 2012, he was granted a share option to subscribe for 50,000 shares in Elegance HK at $1 each by Elegance HK. He paid $5,000 for the option. He assigned his option right for 30,000 shares to his colleague for $150,000 on 2 February On 15 March 2012, he exercised the option to subscribe for the remaining 20,000 shares. He disposed of all these shares in the market on 31 March The market value per share on respective dates was as follows: 10 January 2012 $5 2 February 2012 $7 15 March 2012 $9 31 March 2012 $8 2

3 7. He joined the company s recognised occupational retirement scheme and has made a contribution of $18,000 to the scheme during the year. 8. He enrolled in a diploma course in marketing offered by a local university. He paid a tuition fee of $50,000 in August He completed the course in January 2012 and obtained a refund of $10,000 from the Continuing Education Fund. Property 9. David is the sole owner of a residential property in Shatin which was transferred to him by his parents in David let out the property on the following terms: (i) Lease term: Two years from 1 July (ii) Rent: $8,000 per month. (iii) Rental deposit: $16,000 payable at the start of the lease. (iv) Lease premium: $24,000 payable at the start of the lease. (v) Rates and government rent: $1,500 and $900 payable per quarter by the owner (ignore any rates concession). (vi) Building management fee: $850 payable by the tenant to the building management office. 10. David and his family members live in a property in Tai Po, which was jointly owned by David and his wife, Katherine Wong, in equal share and was the first property in Hong Kong acquired by them five years ago. They financed the purchase of the property by a bank loan secured by a mortgage over that property. Interest expense of $138,000 was paid during the year. Dependents 11. David is married and his wife, Katherine Wong, is a housewife. Katherine worked as a part-time tutor for the Open University of Hong Kong and earned remuneration of $60,000 for the year. She has made a mandatory contribution to the MPF scheme of $3,000. Katherine is a Christian and she has donated all her net salary of $57,000 to a church which is an approved charitable institution. 12. David and Katherine have a baby, born on 10 February David s parents, aged 70 and 75 during the year, have been living in an elderly residential care home in Shenzhen, Guangdong Province, since April David visits them once every month and paid their residential care fee of $120,000 for the year ended 31 March Katherine s parents, aged 50 and 58 during the year, reside in Hong Kong. Katherine is their only child and she supported their living by giving them $5,000 per month towards their maintenance. 3

4 REQUIRED: 1. (a) Prepare the Hong Kong salaries tax computation for David and Katherine for the year of assessment 2011/12, using the most advantageous method and assuming that they would claim whatever deduction and allowance applicable to them. Provide brief explanations for when an item is not included in the computation you prepared. Ignore provisional tax and one-off tax reductions. Ans (a) Mr. and Mrs. Chow Salaries tax computation - joint assessment Year of Assessment 2011/12 Mr. Chow Mrs. Chow $ $ Salary 360,000 60,000 Commission 220,000 Refund of car rental ($3,000 x 12) 36,000 Refund of petrol costs 42,000 Share option - exercise [($9-$1) x 20,000 - $2,000] 158,000 - assignment ($150,000 - $3,000) 147,000 Assessable income 963,000 60,000 Less: Allowable outgoings agreed by the assessor ($18,000 + $21,000) 39, ,000 Less: Self-education expense ($50,000 - $10,000) 40,000 Net assessable income 884,000 60,000 Joint net assessable income 944,000 Less: Concessionary deductions Approved charitable donation 57,000 Home loan interest ($50,000 + $50,000) 100,000 Contribution to recognised retirement scheme ($12,000 + $3,000) 15, , ,000 Less: Personal allowances Married person's allowance 216,000 Child allowance 60,000 Child allowance - additional 60,000 Dependent parent allowance 18, ,000 Net chargeable income 418,000 Tax at progressive rates 59,060 Tax at standard rate (15%) 115,800 Tax payable (ignore tax reduction of $12,000 proposed in the 2012/13 budget) 59,060 4

5 Explanation on non-inclusion of: Insurance premium / insurance refund The insurance premium paid by Elegance HK is not taxable as the employer is discharging its sole and primary liability for which no person was surety. The medical refund received by David is not taxable as it arises from the insurance policy in his capacity as a beneficiary rather than from his employment. Elderly residential care expense For the deduction of elderly residential care expense, the care home must be licenced/registered under the applicable Ordinances in Hong Kong (section 26D(5)). The care home in Shenzhen is unlikely to be registered in this context. David s office income (non-hk source see (c) (ii) below) Explanation on using joint assessment in computation instead of separate assessment: Since Katherine s net assessable income is less than the aggregate amount of concessionary deduction and basic allowance, it may be advantageous for the couple to elect under section 10(2)(a) to be jointly assessed, so that the excessive amount of deductions could be utilised by David. 1. (b) Calculate the Hong Kong property tax payable by David for the year of assessment 2011/12. Ignore provisional tax. Ans (b) Property tax Computation Year of assessment 2011/12 $ Rent ($8,000 x 12) 96,000 Lease premium ($24,000 x 12/24) 12,000 Assessable value 108,000 Less: Rates ($1,500 x 4) (6,000) 102,000 Less: 20% statutory deduction (20,400) Net assessable value 81,600 Tax payable at 15% 12,240 5

6 1. (c) Advise David on the following issues, with reference to the Inland Revenue Ordinance and the Avoidance of Double Taxation Arrangement signed between Hong Kong SAR and Mainland China where appropriate: (i) whether David is liable to pay PRC income tax in the Mainland in respect of his employment income from Elegance HK for services rendered during visit to the Mainland; (ii) whether his director s fee received from Elegance China is taxable in Hong Kong assuming he is liable to pay PRC tax on his director s fee; (iii) whether he could deduct any PRC tax paid in his Hong Kong salaries tax computation; and (iv) whether it would be advantageous for David and Katherine to be assessed under personal assessment for the year of assessment 2011/12. Computation of the tax payable under personal assessment is NOT required. Ans (c) (i) Pursuant to Article 14 of the Arrangement for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income (the Arrangement) signed on 21 August 2006, a Hong Kong resident will be exempt from individual income tax in the Mainland if: - he is present in the Mainland for not more than 183 days in any 12-month period commencing or ending in the taxable year concerned; - his remuneration is not paid by a Mainland employer; and - his remuneration is not borne by a permanent establishment in the Mainland. Given that David only spent around 100 days per year in the Mainland and that his salary was paid by the Hong Kong company and not borne by the Mainland subsidiary, he should be exempt from tax in the Mainland in respect of his salary income from employment. (ii) For directorship, the source of office is the place where the company is centrally managed and controlled (McMillan v Guest). Normally, the company is centrally managed and controlled in the place where the directors meetings are held and decisions are made. David is a director of Elegance Garment Factory Ltd, a company carrying on manufacturing business in Mainland China. The directors meetings were held in Mainland China. Hence, the office is sourced outside Hong Kong and income from it is not chargeable to Hong Kong salaries tax under section 8(1)(a). 6

7 (iii) As the director s fee is not taxable in Hong Kong (see (ii) above) and David s income from Elegance HK is not subject to tax in the Mainland, the issue of double taxation does not arise. No tax credit or deduction of tax paid would be applicable in computing his Hong Kong salaries tax. (iv) Property tax is charged at the standard rate of 15% on the net assessable value of the Shatin property. David and Katherine would have fully utilized all concessionary deductions and personal allowances under salaries tax already. There is no extra deduction (e.g. interest expenses, unutilized donation, etc.) available under personal assessment. If they are assessed under personal assessment, the net assessable value aggregated to the total income would be charged at the higher progressive tax rate of 17%. Hence, it would not be advantageous for the couple to be assessed under personal assessment. 1 (d) Analyse the salaries tax implications of the motor car expenses incurred by David and the refund received from his employer (see note 4), and recommend ways in which the benefit could be provided to him in a more tax efficient manner. 1 (d) For an expense to be deductible under salaries tax, it must not be domestic, private or capital in nature and must be wholly, exclusively and necessarily incurred in the production of the assessable income (section 12(1)(a)). In practice, the Inland Revenue Department (IRD) allows the apportionment of an expense if it is separable and identifiable. Hence, David would be able to claim deduction of 50% of the car rental and petrol costs as agreed by the IRD (see part (a)). While the full refund of the car rental and petrol costs from the employer is taxable, he is able to claim 50% of the expense incurred as deduction under salaries tax. Effectively, he is subject to tax on 50% of the refund. On the other hand, any benefit received by an employee could be non-taxable by virtue of section 9(1)(a)(iv) if the employer is discharging its sole and primary liability for which no one was surety, and that the benefit is not convertible into money. Hence, Elegance HK may enter into a contract with the motor car company directly for the renting of car and provide this for David s use instead of refunding the rental payment. It may also provide a fuel card registered in the company s name and allow David to charge all fuel expenses to the card. In these ways, the employer would be discharging its sole and primary liability. The whole benefit received, including the portion related to David s personal and private use, would not be taxable. 7

8 SECTION B 2. Greenwich Ltd carries on a trading business in Hong Kong. The company has earned net income of $2,700,000 for the year ending on 31 March 2012, which was arrived at after charging and crediting, inter alia, the following items: Note $ Income: Rental income 1 360,000 Interest income 2 16,000 Dividend income 27,000 Expenses: Bad debts 3 33,000 Depreciation expenses 210,000 Interest expenses 4 269,500 Legal and professional fee 5 134,200 Repairs and maintenance 6 97,000 Taxation 7 654,200 Notes: 1. The company owns an office premises in Quarry Bay which was let at a monthly rent of $30,000. Property tax on the rental income has been paid (see note 7). 2. Interest income: Interest on long-term qualifying debt instruments Interest on time deposits placed with HSBC in Hong Kong* $ 5,000 11,000 * The deposits were used to guarantee the bank overdraft facility (see note 4 below) 3. Bad debts expenses: Increase in general allowance (at 2% on trade debts outstanding) Increase in specific allowance (legal action in progress) Recovering of trade debts written off in Interest expenses: Overdraft interest to Hang Seng Bank (secured by time deposits) Loan interest to Bank of Asia (secured by a mortgage over the director s quarters) Surcharge for late payment of tax 5. Legal and professional fees: Audit fee Recovery of trade debts Others (allowable) 43,000 20,000 (30,000) 165,500 72,000 32,000 80,000 7,000 47,200 8

9 6. Repairs and maintenance: Replacement of carpet Renovation of showroom Maintenance of office equipment Replacement of a LCD television 7. Taxation: Property tax paid for 2011/12 Profits tax paid and provision for 2011/12 $ 24,000 50,000 15,000 8,000 43, , Total depreciation allowances for the year have been agreed with the assessor to be $423,000. REQUIRED: 2. (a) Prepare the Hong Kong profits tax computation for Greenwich Ltd for the year of assessment 2011/12. Ignore provisional tax and one-off tax reductions. Ans (a) Greenwich Ltd Profits tax computation Year of assessment 2011/12 Basis period: Year ended 31 March 2012 (section 18B(1)) $ $ Profit per accounts 2,700,000 Add: Depreciation 210,000 Increase in allowance for doubtful debts 43,000 Surcharge for tax payment 32,000 Replacement of LCD projector 8,000 Renovation of showroom ($50,000 x 4/5) 40,000 Taxation expenses 654, ,200 3,687,200 Less: Dividend (27,000) Interest on qualifying debt instruments (5,000) (32,000) 3,655,200 Less: Depreciation allowance (423,000) Assessable profit 3,232,200 Profits tax payable at 16.5% 533,313 Less: Property tax paid (43,200) 490,113 9

10 2. (b) Analyse the proper tax treatments for the following: (i) rental income and property tax paid [notes (1) and (7)]; (ii) interest income [note (2)]; (iii) interest expenses [note (4)]; and (iv) repairs and maintenance [note (6)]. Ans (b) (i) Rental income and property tax paid [note (1) and (7)] Under section 2, business is defined to include letting and sub-letting by a corporation and hence the rental income from property letting is subject to profits tax. At the same time, under section 5(2)(a) property tax can be exempt if the property is owned by a corporation carrying on business in Hong Kong and the property is used for business purposes or the rental income is subject to profits tax. If no exemption is made, property tax paid could be offset against the profits tax payable under section 25. As Greenwich Ltd has paid property tax for the year of assessment 2011/12, tax paid could be offset against the final profits tax payable. Property tax and profits tax paid or payable are not deductible under section 17(1)(g). (ii) Interest income [note (2)] Interest income from long-term qualifying debt instruments is exempt under section 26A(1)(h). Interest income on time deposits placed with HSBC in Hong Kong is taxable under section 15(1)(f) because Greenwich Ltd is carrying on a business in Hong Kong and the interest income was sourced in Hong Kong under the provision of credit test. The Exemption Order does not apply in this case as the deposits were used to guarantee the bank overdraft facility and the overdraft interest is deductible. (iii) Interest expenses [note (4)] Bank overdraft interest is deductible because it was incurred in the production of chargeable profits (section 16(1)(a)) and the money was borrowed from a financial institution (section 16(2)(d)). There is no restriction on the deduction of interest expenses under section 16(2A). Although the overdraft facility was secured by the time deposits, interest income from the deposits is taxable in Hong Kong. Furthermore, there is no interest flowing back to a connected person under section 16(2B). 10

11 Loan interest is also deductible because section 16(1)(a) and 16(2)(d) are fulfilled and the deduction is not restricted by section 16(2A) or 16(2B). Surcharge for late payment of tax is a penalty and not an expense incurred in the production of chargeable profit. It is therefore non-deductible. (iv) Repairs and maintenance [note (6)] Carpet is an implement, utensil and article as prescribed by Inland Revenue Rule 2. The cost of its replacement is deductible under section 16(1)(f). Capital expenditure on the renovation of a non-domestic building or structure can be deducted over five years of assessment under section 16F. Hence, only $10,000 out of $50,000 can be deducted for the year of assessment 2011/12. The maintenance charge for office equipment is a normal business expense incurred in the production of chargeable profits, and is deductible under the general deduction rule of section 16(1). Replacement of the LCD television is capital expenditure incurred on plant and machinery. Capital expenditure is not deductible under section 17(1)(c). Instead the company may claim an initial allowance at 60% on the cost and an annual allowance at 20% on the reducing value. 11

12 3. Vincent Chen is from Taiwan. He was employed by Millions Investment Ltd (Millions), a company carrying on business in Hong Kong, with effect from 1 April 2010 for a contract term of three years. During the period of his employment with Millions he lived and worked in Hong Kong. On 31 March 2012, his employment was terminated unilaterally by Millions without notice and he received the following sums: (1) $960,000 (Sum A) equivalent to his salary under the remaining period of his contract (12 months); (2) $960,000 (Sum B) equivalent to one year s salary; (3) $500,000 payment for agreeing not to work for Millions major competitors for one year; (4) $60,000 payment in lieu of leave; and (5) $75,000 housing allowance for three months. Vincent negotiated his terms of employment in Taiwan. The employment contract was signed by him when he reported for duty on 1 April Under the employment contract, both parties are required to provide three months notice to the other party for early termination of employment. Vincent is entitled to the payment of one additional year of salary should the employment contract be terminated pre-maturely by Millions. His remuneration was credited to his bank account maintained with Bank of North Asia in Hong Kong. He was provided with company quarters in Taikoo Shing rent-free by Millions. After his contract was terminated, his was asked to move out from the quarters within one week. Vincent decided that he would go back to Taiwan instead of finding another job in Hong Kong. He has already paid his Hong Kong salaries tax for the year of assessment 2010/11 and provisional tax for 2011/12. Hence, he left Hong Kong on 20 April 2012 without attending to his taxation matters. On 16 May 2012, he received the individual tax return which was redirected to him by Millions and a week later he received the notice of estimated assessment for the year of assessment 2011/12 dated 5 May 2012, which was also redirected to his Taiwan address by Millions. He was shocked to note that the Inland Revenue Department has assessed all his termination payments to salaries tax. Furthermore, the salaries tax is due on 10 June Today is 29 May

13 REQUIRED: Advise Vincent of the following: 3. (a) The taxability of the various sums received by him for the termination of his employment. Ans (a) Section 9(1)(a) provides that income from employment includes any wages, salary, leave pay, fee, commission, bonus, gratuity, perquisite, or allowance, whether derived from the employer or others. Applying the general principles, income is taxable if it is derived from the employment, it is for services rendered or to be rendered, and it represents money or money s worth. Genuine compensation payments are not taxable. In Fuchs, Walter Alfred Heniz v CIR (2011), the Court of Final Appeal decided that income chargeable to tax is not confined to income earned in the course of employment but embraces payments made in return for acting as or being an employee, as a reward for past services, or as an inducement to enter into employment and provide future services. Vincent is entitled to three months advance notice of termination of his contract but his employment was terminated unilaterally by Millions without notice. The payment of Sum A is likely to be a compensation for early termination and the deprivation of Vincent s right to receive adequate notice, although the sum is more generous than that which Vincent is strictly entitled to (i.e. three months) under the employment contract. The fact that the payment of Sum A is not specifically provided for in the contract adds weight to this argument, which could be regarded as a genuine compensation for the loss of right to receive a proper three-month notice in accordance with the contract and not payment for services rendered. Vincent is entitled to the payment of one additional year of salary should his employment contract be terminated pre-maturely by Millions. Sum B is substantial compensation which is enforceable in law if his employment is terminated early. Following the Fuchs case, this is likely to be an inducement for Vincent to sign the contract and relocate to work in Hong Kong for the term of his employment. The sum was made in satisfaction of the rights which had accrued to the taxpayer under the contract of employment and is an amount derived from his employment. It is not a sum paid in consideration of the abrogation of the taxpayer s right under the employment contract. In fact, Vincent has surrendered no rights. Payment for giving up the right to work for the competitors for one year is compensation for deprivation of rights and is not a payment for past or future services. The sum of $500,000 is non-taxable. 13

14 Leave pay is specifically listed as taxable income under section 9(1)(a). Payment in lieu of leave is arising from employment and is payment for past service rendered. The housing allowance is arguably not taxable. Vincent was provided with the company s quarters during the period of his contract of employment. His employment was terminated without prior notice and he was required to move out from the quarters almost immediately after his contract was terminated. The three months housing allowance can be compensatory in nature rather than a reward for his services. There is no obligation on the part of the employer to let Vincent have a housing allowance when he was no longer employed by the company. The sum can be viewed as a compensation for Vincent s loss of the accommodation due to the termination of contract (see BR116/77). 3. (b) His obligations as an employee under the Inland Revenue Ordinance in relation to the information provided above. You should include the deadlines for him to comply with the Ordinance. Ans (b) Vincent s obligations under the Inland Revenue Ordinance include: To notify the Commissioner of Inland Revenue of his cessation to derive employment income from Hong Kong within one month of such cessation section 51(6). The deadline in Vincent s case is 30 April To notify the Commissioner of Inland Revenue of his departure from Hong Kong not later than one month before the expected date of departure section 51(7). The deadline for Vincent is, theoretically speaking, 20 March However, the Commissioner may accept shorter notice as he may deem reasonable. To notify the Commissioner of Inland Revenue of the change of his address within one month of the change section 51(8). To furnish the IRD with his tax return within the reasonable time stated in the notice section 51(1). 14

15 3. (c) The proper courses of action that he should take. Ans (c) Even though Vincent has paid provisional salaries tax for the year of assessment 2011/12 already, he is still required to submit his tax return for the same year. In particular, he has received substantial taxable termination payments for the year which obviously have not been taken into consideration in computing his provisional salaries tax. As some of the termination payments should be non-taxable, Vincent should be advised to lodge an objection in writing, stating precisely the grounds of objection, which should be received by the Commissioner within one month after the date of the notice of assessment, i.e. 5 June 2012 (section 64(1)). Today is 29 May There is a risk that the objection may be received by the Commissioner after 5 June A late objection could be accepted if the Commissioner is satisfied that it is owing to absence from Hong Kong, sickness and other reasonable cause. Vincent may state the relevant facts in the objection letter for the consideration by the Commissioner. Notwithstanding any objection or appeal, tax must be paid on or before the date specified in the notice under section 71(1). As the salaries tax is due soon, Vincent may request the Commissioner to holdover the payment of tax pending the determination of the objection under section 71(2). The Commissioner has the discretion whether or not to grant a holdover order, either with or without condition. Vincent should note that if the Commissioner grants an unconditional holdover but the tax held over is subsequently payable upon determination, interest shall be payable on the amount of tax held over. 15

16 4. Pineapple Foods Ltd (Pineapple) is wholly owned by Danny Chan. The company carries on a food processing and canning business in Hong Kong. It also holds a number of properties for investment purposes. The following transactions were entered into by the company for the year ended 31 December 2011: (1) The company acquired a piece of land in Tai Po for $10 million. The conveyance on sale was signed on 5 January The company engaged a contractor to build a two-storey building on that site at a construction cost of $6 million in May The building was completed on 20 December 2011 and immediately used for production. (2) The company let out a shopping unit in Fanling on the following terms: Rent: $20,000 per month plus 3% of the turnover of the business carried on in that unit. The maximum monthly rent is not to exceed $60,000. Deposit: $100,000 payable upon signing of the agreement. Lease term: Two years from 1 June The tenancy agreements were signed on 20 May 2011 in duplicate. (3) The company sold a residential property in Tai Wai for $7 million. The provisional sale and purchase agreement was signed on 10 October The formal sale and purchase agreement was signed on 20 October 2011, followed by the assignment deed on 20 November The property was previously acquired by the company on 15 December 2010 for $5 million. (4) Pineapple holds 20% interest in Lemon Investment Ltd (Lemon), a company incorporated in Hong Kong. Pineapple transferred all the shares in Lemon to Danny on 2 December 2011 at its book value of $300,000. The fair value of shares transferred is estimated to be $500,000. The sale and purchase contract was signed in Taiwan when Danny was on a leisure trip. REQUIRED: 4 (a) Evaluate the Hong Kong stamp duty implications arising from all the above transactions. Support your answers with stamp duty computations where appropriate. Ans (a) (1) Conveyance on the sale of immovable property in Hong Kong is chargeable to stamp duty under Head 1(1). Stamp duty is computed at the higher of the stated consideration and value of the property. Stamp duty payable is: 16

17 $10,000,000 x 3.75% = $375,000 The instrument must be stamped within 30 days after execution. (2) An agreement for the lease of immovable property is subject to stamp duty under Head 1(2). Based on the principle of contingency, if the rent payable is uncertain at the time of execution of the instrument, stamp duty is chargeable on the maximum of any specified amount. The rate for a lease term of more than one year but not more than three years is 0.5% of the average yearly rent. Stamp duty payable is: $60,000 x 12 x 0.5 = $3,600 As the tenancy agreement is executed in duplicate, the duplicate copy is stamped at $5 under Head 4. The agreements must be stamped within 30 days after execution. (3) The provisional sale and purchase agreement of residential property would be subject to stamp duty under Head 1(1A). However, it was superseded by the formal sale and purchase agreement within 14 days and the later became the dutiable instrument. Stamp duty payable is: $7,000,000 x 3.75% = $262,500 Since the property was acquired by Pineapple on or after 20 November 2010 and was disposed of with 24 months of the date of acquisition, special stamp duty is payable under Head 1(1B). The rate is 10% as the property has been held for six months or more but less than 12 months. Special stamp duty is: $7,000,000 x 10% = $700,000 If the sale and purchase agreement is duly stamped, the deed of assignment will be subject to stamp duty of $100 only under Head 1(1). All instruments must be stamped with 30 days. (4) As Lemon Investment Ltd is a company incorporated in Hong Kong, the transfer of its shares must be registered in Hong Kong and must be stamped under Head 2. The fact that the sale and purchase agreement is executed outside Hong Kong is irrelevant. A person who effects any sale or purchase of Hong Kong stock as principal or agent is statutorily required to make and execute a contract note and cause it to be stamped under section 19(1). As the consideration for the transfer is inadequate, it will be deemed to be a transfer operating as a voluntary deposition and the market value of shares will be substituted. Stamp duty payable under Head 2(3) is: $500,000 x 0.2% = $1,000 17

18 A fixed duty of $5 will be payable for the instrument of transfer. Contract notes and the instrument of transfer should be stamped within 30 days after execution if they are effected outside Hong Kong. 4 (b) For the purposes of Hong Kong profits tax, identify the type of depreciation allowance available to Pineapple Foods Ltd for transaction (1). Compute the relevant depreciation allowances for the year of assessment 2011/12. Ans (b) Pineapple Foods Ltd carries on a food processing and canning business in Hong Kong. The newly constructed factory building in Tai Po was used for its production. Hence, the building was used for one of the qualifying trades, namely, a trade consisting of the subjection of goods or materials to any process. Industrial buildings allowances will be available for Pineapple for the year of assessment 2011/12. Land cost is not qualifying expenditure. Depreciation allowances can be claimed on the cost of construction only, as follows: Initial allowance: $6 million x 20% = $1,200,000 Annual allowance: $6 million x 4% = $240,000 18

19 5. Rocky Cheung and his friend, Candy Wan, carry on a partnership business in Hong Kong under the name Rocky Candy & Co. They are considering converting the business into a corporation and wish to know the differences in the tax treatment, if any, for the following items if the business is run in the form of a corporation rather than a partnership: (1) The business is currently operated from office premises owned by Rocky. Rocky charges the company a monthly rent of $20,000 which is below the market rent. The rateable value of the premises is $360,000. There will not be any change in the amount of rent payable to Rocky if the business is converted into a corporation. (2) Rocky and Candy currently work full-time for the business. Each of them draws a monthly salary of $30,000 from the business which is considered commensurate with their duties. They would become employees of the corporation if they were to proceed with the incorporation. (3) The business currently makes a contribution to the MPF scheme at 10% of the monthly salary of Rocky and Candy. The same contribution percentage would be maintained. (4) Kelvin Cheung, Rocky s son, works as a part-time accountant for the business and receives a monthly salary of $5,000. (5) The business rents a car parking space at a monthly rent of $2,000 for the use by Rocky, who drives to work from home. (6) Rocky and Candy share any profits and loss equally after deducting all expenses mentioned above. Up till now, they have distributed almost all the profits available, and both of them are normally assessed under personal assessment. REQUIRED: Advise Rocky and Candy on the differences, if any, in Hong Kong tax treatments arising from the incorporation of their partnership business for all the payments and profits distribution mentioned above. Ans (1) Rent paid for a building occupied the purpose of producing chargeable profits is deductible under section 16(1)(b), but the rent should not exceed the assessable value of that building when the rent is paid to a partner of a partnership. 19

20 For the partnership, total amount of rent paid to Rocky ($240,000 per annum) will be deductible expense while the same amount is assessable to Rocky under property tax. The rateable value is irrelevant. For a corporation, the rent paid can also be deducted (the same amount is assessable to Rocky under property tax). Hence, there is no difference in the tax treatment. (2) Under section 17(2), no deduction is allowed for salaries or other remuneration paid to a partner or a partner s spouse by a partnership. Therefore, even though Rocky and Candy rendered services to the partnership for the purpose of producing chargeable profits and their salaries are not excessive, their salaries are not deductible in computing the assessable profits. On the other hand, the salary income received by them is not chargeable to salaries tax under section 8(2)(k). If the business is incorporated, it will become a separate legal entity. Rocky and Candy will become employees of the corporation. Salaries paid to them will be deductible under section 16(1) as expenses incurred in the production of chargeable profits. The salaries they receive will be subject to salaries tax. (3) Under section 16AA, mandatory contributions to an MPF scheme in respect of a partner in a partnership as a self-employed person are deemed to be expenses wholly and exclusively incurred in the production of chargeable profits and can be deducted up to a maximum of $12,000 per year. Despite the partnership making contributions based on 10% of the salaries of Rocky and Candy, only $12,000 can be deducted for each of them per annum. If the business is incorporated, Rocky and Candy would become employees of the corporation. Contributions made for employees can be deducted up to 15% of the total emoluments of an employee under section 17(1). Hence, the whole amount of MPF contribution made for Rocky and Candy can be deducted by the incorporated business. On the other hand, for Rocky and Candy, any sum withdrawn from the MPF scheme in respect of voluntary contributions made by the employer is chargeable to salaries tax unless it is received upon retirement, death or incapacity. If the sum withdrawn is due to termination of service, any amount received which is in excess of the proportionate benefit will also be taxable. 20

21 (4) Salaries paid to a partner or a partner s spouse are not deductible under section 17(2). The restriction does not apply to other relatives. As long as Kelvin provides accounting services to the business (services for the purpose of producing chargeable profits), his salary could be deducted under section 16(1). It makes no differences whether the business is incorporated or not. (5) As the parking space is for Rocky s car which is used by him for travelling from home to office, it is for private use only and the rental is not a business expense. A partner s personal expense cannot be deducted under profits tax. This would be treated as an appropriation of profits instead. If the business is incorporated and Rocky becomes an employee or director of the company, the rental expense could be regarded as a fringe benefit provided to the employee/director and is a cost of employing and retaining the staff. The expense would be deductible under section 16(1). There should be no salaries tax implication to Rocky as the benefit is not convertible into cash nor does it represent a discharge of Rocky s liability. (6) Currently, if Rock and Candy elect to be assessed under personal assessment, their share of partnership profits will be transferred to and dealt with under personal assessment where they can deduct concessionary deductions and personal allowances. Any partnership losses can be set off against other sources of income (e.g. rental income in the case of Rocky) under personal assessment. If the business is incorporated, the distribution of profits will be in the form of the payment of dividends. Dividend income is not taxable in Hong Kong. However, even if Rocky and Candy have elected for personal assessment, profits of a corporation cannot be transferred to personal assessment. Assessable profits will be taxable under the name of the corporation. If there is any loss, the loss could only be carried forward and set off against the company s future profits. However, any salaries or taxable benefit they obtain from the corporation will be assessable under salaries tax no matter whether they elect for personal assessment or not. 21

22 6. Mountain Ltd carries on a business of trading in electronic appliances in Hong Kong. Its products are mainly sourced in Mainland China and Thailand and sold to customers in the US. The company is solely owned by Patrick Fung who has good personal connections in the industry and is able to sell fancy products at very good price. Patrick is concerned about the huge amount of tax bills in Hong Kong. He plans to set up a new company, River Ltd, in a low tax jurisdiction outside Hong Kong. He will hold all the shares in River Ltd. Under his plan, Mountain Ltd will firstly sell the goods to River Ltd at cost plus 5%, which is about sufficient to cover its expenses incurred in Hong Kong. River Ltd will re-sell the goods to the ultimate customers at the normal mark-up of 25%. All contract negotiation, shipment and financing arrangements will continue to be performed by Mountain Ltd s staff in Hong Kong. The following information relating to the assets of Mountain Ltd for the year ended 31 December 2011 are extracted from the company s book: 1. A computer server (annual allowance at 30%) was acquired in June 2011 under a hire-purchase agreement: - Cash price: $200,000 - Down payment: $20,000 (paid on 20 June 2011) - Instalments: Balance repayable by 12 instalments of $16,000 each commencing on 20 July Two sets of desktop computers and printers (annual allowance at 30%) were acquired for $19,000 during the year. 3. An electric motor car was purchased in August 2011 for $250,000. An old motor car (annual allowance at 30%) was sold for $130, New office furniture (annual allowance at 20%) costing $80,000 was acquired during the year. 5. Tax written down values as at 1 January 2011 are: - 20% pool: $185,000-30% pool: $177,000 22

23 REQUIRED: 6. (a) Advise Patrick on the feasibility of his proposal. You should include in your answer a discussion of the relevant anti-avoidance provisions in the Inland Revenue Ordinance and how they could be applied to the case. Ans (a) By selling the goods to the newly set up company, River Ltd, at a reduced mark-up, it can be foreseen that Mountain Ltd will be earning minimal profits or even suffering a loss, given that the 5% mark-up will be about just sufficient to cover all expenses incurred by Mountain Ltd in Hong Kong. After the proposed change, Mountain Ltd s taxable profits will be substantially reduced and this may be subject to challenge by the Inland Revenue Department (IRD). Under section 20 of the Inland Revenue Ordinance, where a non-resident person carries on business with a resident person with whom he is closely connected, and the course of such business is so arranged that it produces to the resident person either no profits which are sourced in Hong Kong, or less than the ordinary profits which might be expected to arise in or derived from Hong Kong, the business done by the non-resident person in pursuance of his connection with the resident person is deemed to be carried on in Hong Kong and the non-resident person will be assessed in respect of the profits derived in the name of the resident person as if he were the agent of the non-resident person. Mountain Ltd and River Ltd are solely owned by Patrick and they are closely connected. As the proposed arrangement significantly reduces Mountain Ltd s taxable profits, the business to be carried on by the non-resident, River Ltd, may be deemed to be carrying on in Hong Kong and be chargeable to Hong Kong profits tax in the name of Mountain Ltd (see Radofin Electronics (Far East) Ltd). Furthermore, the general anti-avoidance provisions under section 61 and section 61A may also operate to defeat the scheme. Under section 61, where any transaction which reduces the amount of tax payable is artificial or fictitious, an assessor may disregard the transaction and raise an assessment accordingly. The profits from selling the goods to ultimate customers would then be chargeable to tax in the name of Mountain Ltd. Even though the proposed arrangement may not be fictitious for the purposes of section 61, section 61A could also apply if the transaction has the effect of conferring a tax benefit on a person and the transaction is entered into with the sole or dominant purpose of obtaining a tax benefit. In 23

24 such a case, the assistant commissioner may raise an assessment as if the transaction had not been entered into or carried out, or in any other manner that he considers appropriate to counteract the tax benefit. Given that the profit margin made by Mountain Ltd would be very low compared with a normal sale to the ultimate customers, the sales is not at arm-length and this conferred a substantial tax benefit on the taxpayer. Tax benefit means the avoidance or postponement of the liability to pay tax or the reduction in the amount of tax. Mountain Ltd may need to demonstrate that the proposed arrangement has genuine commercial purposes other than the avoidance of tax. Furthermore, as all contract negotiation, shipment and financing arrangement will continued to be carried out by Mountain Ltd, this could not justify the low profit margin to be earned by Mountain Ltd in Hong Kong. Hence, there is a high risk that Patrick s proposed arrangement would be counteracted by the IRD applying anti-avoidance provisions. If he wishes to implement the proposal, he should ensure that some activities are undertaken by River Ltd in addition to merely paper work such that the mark-up can be justified as a reasonable one. Specifically, River Ltd may consider taking up some functions and risks such as being responsible for negotiating sale contracts with ultimate customers, storage of goods, and assuming credit risk, foreign exchange exposure and product liability, etc. These activities should be conducted outside Hong Kong or River Ltd will be considered to be carrying business in Hong Kong and subject to profits tax under section

25 6. (b) Calculate the depreciation allowances which Mountain Ltd is entitled to for the year of assessment 2011/12. For asset(s) where depreciation allowance was not claimed by Mountain Ltd, identify the alternate tax treatment available. Ans (b) Desktop computers and printers qualify as prescribed fixed assets and the acquisition costs can be deducted immediately in the year of purchase under section 16G. An electric motor car qualifies as an environment-friendly vehicle and the capital expenditure incurred can be deducted in the year of assessment 2011/12 under section 16I. Depreciation allowances on other fixed assets are computed as follows: Pooling system Year of assessment 2011/12 20% pool 30% pool Allowances $ $ $ W.D.V. b/f 185, ,000 Add: New additions 80,000 Less: Initial allowance (60%) (48,000) - 48, , ,000 Less: Sale proceeds - (130,000) 217,000 47,000 Less: Annual allowance (43,400) (14,100) 57,500 W.D.V. c/f 173,600 32, ,500 Computer sever acquired under hire-purchase Cost 200,000 Less: Initial allowance ($20,000 + $180,000 x 6/12) x 60% (66,000) 66, ,000 Less: Annual allowance (30%) (40,200) 40,200 W.D.V. c/f 93, ,700 END 25