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 DECEMBER 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. Lifestyle Limited carries on a manufacturing and trading business in Hong Kong. The company s income statement for the year ended 31 March 2012 showed net income of $7,200,000 which is after taking into account the following items: Income: Note $ Dividend from a Hong Kong listed company 16,000 Interest income 1 85,000 Proceeds from assignment of rental income 2 900,000 Profit on disposal of patent 3 140,000 Expenses: Bad debts 4 208,000 Contribution to retirement scheme 5 1,543,000 Depreciation 473,000 Donation 6 50,000 Exchange differences 7 41,000 Interest expenses 8 142,000 Legal and professional fees 9 100,000 Profits tax 785,000 Notes to the accounts: 1. Interest income: $ Interest on deposits placed with Hang Seng Bank in Hong Kong 32,000 Interest on deposits placed with HSBC in Singapore 48,000 Interest on tax reserve certificate 5,000 85, The company let a commercial unit in Kwun Tong to a tenant at $30,000 per month from April 2011 onwards for a fixed term of three years, and assigned the right to receive rental income under the lease to a finance company for $900,000. This amount was immediately recognised in the income statement. 3. The company acquired a patent 10 years ago for use in the production process at a cost of $300,000. The patent was disposed during the year for $440,000 and a gain of $140,000 was recognised in the accounts. 4. Bad debts expenses: Increase in allowance for doubtful trade accounts for which recovery action has been taken in vain 70,000 Increase in allowance for doubtful accounts based on 2% of the trade debts outstanding 26,000 Trade debts written off 112, ,000 2

3 5. Contribution to recognised retirement scheme: Contribution for employees (at 10% of salaries) 1,260,000 Contribution for directors (at 20% of directors fees) 300,000 Refund from the scheme for employees who have left the company (17,000) 1,543, The company has donated products with book value of $50,000 to an elderly care home which is an approved charity in Hong Kong. 7. Exchange differences: Exchange loss on conversion of foreign currency time deposits 22,000 Exchange loss on collecting trade debts 19,000 41, Interest expenses: Bank interest paid to HSBC in Hong Kong* 97,000 Loan interest paid to a shareholder (unsecured) 45, ,000 * The borrowing was secured by the deposits placed with the same bank in Singapore (see note 1 above) and personal guarantees given by the shareholders. At all material times, the borrowing was greater than the amount of deposits. 9. Legal and professional fees: Fees for annual audit and tax filing 60,000 Legal fees for new lease (see note 2 above) 3,000 Other (allowable) 37, ,000 Additional note: Total depreciation allowances agreed with the Assessor for the year are $330,000. Additional information: The company plans to set up a branch in Mainland China to sell its products in the Mainland. While the solicitation and negotiation of contracts will be conducted in the Mainland, the production will continue be carried out in Hong Kong. The board of directors would like to know if the profits from such sales could be claimed as offshore income. The board understands that setting up a branch in the Mainland will create tax exposure under the Corporate Income Tax Law in the Mainland. However, protection or relief is available to a Hong Kong company under The Arrangement between the Mainland of China and the Hong Kong SAR for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income (Mainland/HK CDTA). 3

4 REQUIRED: 1. (a) Prepare the Hong Kong profits tax computation for Lifestyle Limited for the year of assessment 2011/12. Ignore provisional tax. Ans (a) Lifestyle Limited Profits tax computation Year of assessment 2011/12 Basis period: Year ended 31 March 2012 (Section 18B(1)) $ $ Profit per accounts 7,200,000 Add: Depreciation 473,000 Donation in kind 50,000 Profits tax 785,000 Sales proceeds of patent 300,000 Increase in general allowance for doubtful debts 26,000 Excess contribution for directors ($300,000 x 5%/20%) 75,000 Exchange loss on converting time deposits 22,000 Bank interest to HSBC 48,000 Loan interest to a shareholder 45,000 Legal fee for new lease 3,000 1,827,000 9,027,000 Less: Dividends (16,000) Interest on deposits - Hang Seng Bank (32,000) Interest on deposits - HSBC (48,000) Interest on tax reserve certificate (5,000) Profits on sale of patent (140,000) (241,000) 8,786,000 Less: Depreciation allowances (330,000) Assessable profit 8,456,000 Profits tax payable at 16.5% 1,395,240 Less: Tax reduction (75%, max $12,000) (12,000) Final profits tax payable 1,383,240 4

5 1. (b) Analyse the proper tax treatments for all items given in notes 1 to 9 above. Ans (b) Interest income Interest income received or accrued to a corporation is taxable under section 15(1)(f) if the person carries on a business in Hong Kong and the interest income is arising from Hong Kong Lifestyle Limited carries on business in Hong Kong Interest on deposit placed with Hang Seng Bank is sourced in Hong Kong and chargeable to profits tax However, interest can be exempt because the deposits were placed with a financial institution in Hong Kong and they were not used to secure any bank borrowing Interest on deposits placed with HSBC in Singapore was sourced outside Hong Kong and is not taxable Interest on tax reserve certificates is exempt under section 26A(a) Assignment of rental income Sum received by a person as consideration in respect of the transfer of a right to receive taxable rental income is deemed to be a taxable trading receipt under sections 15(1)(m) and 15A unless the ownership of the property is also transferred $900,000 received by Lifestyle Limited is taxable Disposal of patent The cost of purchasing the patent should have been deducted under section 16E(1) when it was acquired 10 years ago The sale proceeds are deemed to be a taxable receipt under section 16E(3) Effective 2011/12, the taxable receipt is restricted to the deduction previously claimed, i.e. $300,000 only Bad debts expenses Trade debts written off are deductible under section 16(1)(d) if they are proved to have become bad and were included as taxable trading receipts Allowance based on 2% of trade debts outstanding is not regarded as incurred and cannot be deducted Where recovery action has been taken on trade debts in vain, it can be estimated to the satisfaction of the assessor that they have become bad and are deductible Contribution to retirement scheme Annual contribution to recognised retirement scheme can be deducted up to 15% of the total emolument of the employee by virtue of section 17(1)(h) 5

6 Contribution for the employees is not excessive and can be deducted in full Contribution for the directors has to be reduced to the 15% limit Refund from recognised retirement scheme is deemed to be taxable receipts under section 15(1)(h) to the extent that the relevant contribution has been allowed as a deduction Donation Donation to approved institution must be in money, not in kind Donation of products is not money and cannot be deducted under section 16D Exchange differences Time deposits are capital investment of a company (CIR v Li & Fung); exchange loss on conversion of foreign currency deposits is capital in nature and not deductible Exchange loss on collecting trade debts is revenue loss and deductible Interest expenses To be deductible, interest expenses must be incurred in the production of chargeable profits under section 16(1)(a) Bank interest paid to HSBC is interest on money borrowed from a financial institution and satisfies the condition under section 16(2)(d) Under the secured loan test, the borrowing was secured by deposits placed in Singapore generating non-taxable interest income Deduction has to be reduced by the amount of tax-free interest income by virtue of section 16(2A); only $49,000 ($97,000 - $48,000) can be deducted The shareholder loan was borrowed from a person other than a financial institution and section 16(2)(c) has to be considered Since the shareholder is likely not to be liable to profits tax for the interest income received, the condition under section 16(2)(c) cannot be fulfilled and no deduction is allowed Legal and professional fees Fees for annual audit and submission of tax return were incurred in the normal course of business to discharge normal legal obligations of a taxpayer and with a view to earn profit; they are deductible expenses Fee for preparing new tenancy agreement is of a capital nature and non-deductible 6

7 1. (c) Advise the board on the Hong Kong issues relating to the plan of setting up a branch in the Mainland and the protection or relief available under the Mainland/HK CDTA. Ans (c) Under section 14(1), a person is chargeable to profits tax if he carries on a business in Hong Kong and the profits arise in or are derived from Hong Kong Only operations which directly produce the profits are relevant; one should focus on the effective causes for earning the profits, activities that are antecedent or incidental can be ignored Although the sales contracts are effected outside Hong Kong, it is likely that the IRD would regard the production process in Hong Kong to be the profit-making activities All the profits from selling the goods to customers in the Mainland would likely be chargeable to Hong Kong profits tax Under Article 7 of the Arrangement between the Mainland of China and the Hong Kong SAR for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income, the profits of a Hong Kong enterprise shall be taxable only in Hong Kong unless the enterprise carries on business in the Mainland through a permanent establishment situated therein However, in such a case only the profits attributable to that permanent establishment may also be taxed in the Mainland The term permanent establishment is provided in Article 5 to mean a fixed place of business through which the business of an enterprise is wholly or partly carried on It also includes especially a place of management; a branch; an office; a factory; a workshop; a mine, an oil or gas well, a quarry or any other place of extraction of natural resources If Lifestyle Limited sets up a branch in the Mainland selling its products, this likely constitutes a permanent establishment and the profits attributable to the branch will be subject to corporate income tax in the Mainland To eliminate any double taxation, tax paid in the Mainland by a Hong Kong resident shall be allowed as a credit against Hong Kong profits tax under Article 21 if the profit is subject to Hong Kong profits tax. However, the amount of the tax credit shall not exceed the amount of Hong Kong tax on such profits computed in accordance with the tax laws and regulations in Hong Kong 7

8 SECTION B 2. Henry Bao is the Vice-president - Engineering of Sapphire Limited (Sapphire), a company carrying on business in Hong Kong. He provides you with the following information relating to the year ended 31 March 2012: 1. He received a monthly salary of $50,000 for the year, and a discretionary bonus of $85, He was provided with company quarters at a nominal rent of $3,000 per month. He also paid the management fee of $13,200 for the year. 3. He received a holiday package for his home trip to Taiwan, which was purchased by Sapphire from Wing On Travel Agency for $10,000. The package can be redeemed for cash after deducting a handling charge of $2, He engaged a domestic helper at a monthly salary of $5,000 which was paid by Sapphire on his behalf. 5. He was enrolled in Sapphire s MPF-exempt retirement scheme. During the year, he has made contribution at 5% of his monthly salary to the retirement scheme. 6. He was also enrolled in Sapphire s group medical insurance scheme. During the year, he obtained a medical refund of $8,000 from the insurance company, and another $3,000 which was not covered by the insurance from Sapphire pursuant to the terms of his employment. 7. On 1 April 2011, he was awarded 50,000 shares in Sapphire. The shares were vested on him immediately with a sales restriction period of one year from the date of the award. On 10 December 2011, he received dividend income of $5,000 from these shares. He sold all these shares in the market on 15 May On 2 February 2012, he was granted an option to subscribe for 100,000 shares in Sapphire at a $3 per share. This share option was granted without condition. He sold one half of the option on 9 March 2012 and received $180, During the year, Henry paid a membership subscription of $1,900 to the Hong Kong Institution of Engineers. He also paid $3,000 to attend continuing professional development seminars organised by the Institution. 10. Henry is married and his wife, Annie, is a housewife. They have a son, aged 20, attending university in the US. Annie s parents, aged 57 and 63, reside in Hong Kong. Annie paid them $6,000 per month in support of their living. In September 2012, Henry was approached by a head-hunter and was offered a three-year contract to work in a company based in Singapore. Henry resigned from Sapphire effective from 1 December 2012 and will permanently leave Hong Kong by early January He has not yet exercised the remaining share option mentioned in note 8 above. 8

9 Sapphire s shares were quoted on the stock exchange at the following prices on the following dates: 1 April 2011 $ February 2012 $ March 2012 $ April 2012 $ May 2012 $ November 2012 $6.50 REQUIRED: 2. (a) Prepare the Hong Kong salaries tax computation for Henry Bao for the year of assessment 2011/12. Ignore provisional tax. Ans (a) Henry Bao Salaries tax computation Year of assessment 2011/12 $ $ Salary ($50,000 x 12) 600,000 Bonus 85,000 Holiday journey 10,000 Salary of domestic helper ($5,000 x 12) 60,000 Medical refund 3,000 Share award (50,000 x $6 x 0.95) 285,000 1,043,000 Rental value [($1,043,000 - $1,900) x 0.1] 104,110 Less: Rent suffered ($3,000 x 12 + $13,200) (49,200) 54,910 Share option gain - Assignment 180,000 1,277,910 Less: Membership subscription (1,900) Self-education expenses (3,000) (4,900) 1,273,010 Less: Contribution to retirement scheme (12,000) 1,261,010 Less: Personal allowances Married person's allowance (216,000) Child allowance (60,000) Dependent parent allowance - aged 63 (36,000) Dependent parent allowance - aged 57 (18,000) (330,000) Net chargeable income 931,010 Salaries tax payable at progressive rates 146,271 Less: Tax reduction (75%, max $12,000) (12,000) Final salaries tax payable 134,271 9

10 2. (b) Advise Henry on the Hong Kong salaries tax treatment of the share-based benefits received by him (notes 7 and 8), including the possible treatment of dividends received during the sales restriction period and the share option which has not yet been exercised, by reference to the assessing practice of the Inland Revenue Department. Ans (b) Shares obtained through share-based remuneration are taxable perquisites under section 9(1)(a) forming part of a taxpayer s employment income According to DIPN No. 38, the 50,000 shares awarded to Henry will be assessed to tax at the time of grant by the employer because the shares were immediately vested in him (the upfront approach) Market value at the time of grant will be used for valuation purposes A 5% discount in valuation generally will be allowed as there is a one-year sale restriction period Dividends received during the restriction period are regarded as investment income and are not taxable For the share option, any gain realised on its exercise, assignment or release will be subject to salaries tax under section 9(1)(d) For the assignment of one half of the option on 9 March 2012, the taxable amount is the consideration received; the market value is irrelevant With a view to finalising the salaries tax liability of a person who is departing permanently from Hong Kong, the IRD will, as a concession, allow him to elect to have the liability ascertained on the basis of a notional exercise of the option Any tax liability can be finalised on the basis of the gain that would have been realised if the option had been exercised on a day within seven days before the date of submission of the person s tax return for the final assessment applicable to the year of assessment in which he permanently departs from Hong Kong As a further concession, the IRD will accept an election made within three months from the date of permanent departure from Hong Kong if it has not been made before departure; the date of departure will be taken as the date of the notional exercise for calculating the gain in such case No further liability will arise when the option is actually exercised, assigned or released after his departure from Hong Kong However, if it transpires that the gain in respect of the actual exercise, etc. is less than the amount assessed in respect of the notional exercise, the IRD will favourably consider any application for appropriate amendment and re-assessment 10

11 3. Benson Wong is the sole beneficial owner of Ocean Limited, which in turn wholly owns Reef Limited and partly owns Coral Limited. All companies are incorporated in Hong Kong. The group structure is as follows: Benson Wong 100% Ocean Limited 100% 80% Reef Limited Coral Limited REQUIRED: Analyse the Hong Kong stamp duty implications arising from the following transactions which have taken place during the year ended 31 December You should compute the stamp duty payable where applicable and clearly identify the relevant charging heads. 3. (a) On 1 February 2012, Ocean Limited sold Property A, a shopping unit in Causeway Bay, to Reef Limited for a consideration of HK$20 million. Reef Limited financed the purchase consideration by borrowing $10 million from the Bank of East Asia. On 1 March 2012, Reef Limited let out Property A for a term of two years at a fixed monthly rent of $50,000 plus a variable rent computed at 1% of the turnover of the shop. The total monthly rent is not to exceed $70,000. The lease was executed in duplicate. Ans (a) The conveyance of immovable property in Hong Kong is chargeable to stamp duty under Head 1(1) Reef Limited is wholly owned by Ocean Limited and they fall within the definition of associated bodies corporate; exemption from stamp duty can be sought under section 45 for the transfer between associated bodies corporate 11

12 Corporations are associated if one is the beneficial owner of not less than 90% of the issued share capital of the other Section 45(5A) provides that exemption shall not apply if the instruments are executed in connection with an arrangement under which part of the consideration is provided by a person other than an associated body corporate of the transferor or transferee Although the consideration was partly provided by the bank, the Collector of Stamp Revenue accepts that exemption will not be denied if the loan is made in the ordinary course of the bank s business and the bank does not obtain any rights over the property other than as security An agreement for the lease of immovable property in Hong Kong is subject to stamp duty under Head 1(2) Based on the contingency principle, if the consideration payable under an instrument is uncertain at the time of its execution, stamp duty is chargeable on the maximum of any specified amount Rate for a lease of more than one year but less than three years is 0.5% Stamp duty payable is: $70,000 (maximum) x 12 x 0.5% = $4,200 The duplicate copy is stampable at $5 under Head 4 3. (b) On 5 April 2012, Reef Limited executed a deed to transfer Property B, a residential property in Quarry Bay which has been held by Reef Limited for five years, to Coral Limited at a consideration of $7 million. The market value of the property was $7.5 million on that date. On 20 October 2012, Coral Limited signed a provisional sale and purchase agreement to sell Property B to a third party at the fair market value of $9 million. The formal sale and purchase agreement was signed on 1 November 2012 and the assignment deed was executed on 1 December Ans (b) Reef Limited and Carol Limited are not associated bodies corporate and no exemption is available As the stated consideration is below market value, the transaction is treated as a voluntary deposition inter vivos and stamp duty is charged at the full market value Stamp duty payable under Head 1(1) is: $7.5 million x 3.75% = $281,250 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: $9 million x 3.75% = $337,500 12

13 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) Since the property was acquired by Coral Limited 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: $9 million x 10% = $900, (c) On 3 December 2012, Ocean Limited sold 15% of its shareholding in Reef Limited to a third party at a consideration of $15 million. Ans (c) Transfer of shares in a Hong Kong company must be registered in Hong Kong and hence chargeable to stamp duty under Head 2(1) Stamp duty payable is: $15 million x 0.2% = $30,000 A fixed duty of $5 is payable for the instrument of transfer under Head 2(4) After the disposal of the 15% interest in Reef Limited, Ocean Limited and Reef Limited ceased to be associated bodies corporate Section 45(4)(a) provides that a stamp duty exemption will be withdrawn if the transferor and the transferee cease to be associated due to a change in shareholding in the transferee within two years following the date of transfer Hence, stamp duty must be paid for the conveyance of Property A from Ocean Limited to Reef Limited Stamp duty is: $20 million x 3.75% = $750,000 The Collector shall be notified within 30 days of such cessation 13

14 4. Barry Tong received a notice of estimated profits tax assessment in respect of his sole proprietorship business, Barry & Co., in which profits of $1,000,000 was assessed for the year of assessment 2011/12. The notice was dated 20 November Barry has not submitted a tax return for the year and he noted that the estimated profit was more than his actual profit earned. Therefore, he came to your office for advice. After meeting Barry, you have ascertained the following information: 1. The accounting profits of Barry & Co. for the year ended 31 March 2012 was $550,000. This figure was arrived at after charging the following items: (i) salary paid to Barry of $360,000; (ii) mandatory contribution to MPF scheme for Barry of $18,000; and (iii) donation of moon cake costing $8,000 to an elderly centre operated by Tung Wah Group of Hospitals, an approved charitable institution. 2. Barry also carries on a partnership business (named Leung Tong Kee ) with Fanny Leung, sharing profits or losses equally. During the year ended 31 December 2011, the agreed tax loss of the partnership is $340, Barry solely-owned a property in Lam Tin which was acquired in January 2011 and let out for rental income from 1 March 2011 onwards for a term of two years at a monthly rent of $12,000. A lease premium of $50,000 was received from the tenant. Barry paid Government rent and mortgage loan interest of $4,300 and $97,000 respectively for the year ended 31 March 2012 in respect of this property. He also spent $7,000 to replace the window damaged by typhoon in September Barry is single and ordinarily resides in Hong Kong. His mother, aged 70, resides in a registered elderly care home. During the year, her residential fee of $80,000 was paid by Barry. REQUIRED: 4. (a) (i) Without any computation, explain whether it is advantageous for Barry Tong to elect for personal assessment for the year of assessment 2011/12. Ans (a) (i) Because there is a share of partnership loss and unrelieved mortgage interest expense on the rental property, it is clear that Barry Tong will be better off in electing for personal assessment. 14

15 4. (a) (ii) Calculate the Hong Kong tax liability for Barry Tong under personal assessment for the year of assessment 2011/12. Ans (a) (ii) Barry Tong Personal assessment Year of assessment 2011/12 $ Net assessable value (see note 1) 135,200 Assessable profit (see note 2) 924,000 Total income 1,059,200 Less: Interest expense (97,000) Elderly residential care expense (72,000) 890,200 Less: Share of partnership loss (170,000) 720,200 Less: Basic allowance (108,000) Net chargeable income 612,200 Tax at progressive rates 92,074 Less: Tax reduction (12,000) Final tax charged under personal assessment 80,074 Note 1: Net assessable value Rent ($12,000 x 12) 144,000 Lease premium ($50,000 x 12/24) 25,000 Assessable value 169,000 Less: 20% statutory deduction (33,800) 135,200 Note 2: Assessable profit Accounting profit 550,000 Add: Barry s salary 360,000 MPF contribution 6,000 Donation 8, ,000 15

16 4. (b) Advise Barry any penalties applicable to him and what he should do with the notice of assessment received. Ans (b) As Barry has not submitted a tax return, he failed to comply with the requirement under section 51(1) and is guilty of an offence under section 80(2) He will be subject to a fine at level 3 ($10,000) and a further fine of treble the amount of tax which has been or would have been undercharged in consequence of such non-compliance However, the Commissioner may compound the offence If no prosecution has been instituted under section 80(2), the Commissioner may seek to impose additional tax under section 82A to an amount not exceeding three times of the tax undercharged Barry should note that the assessable profit of his sole-proprietorship business is in fact greater than (instead of lower than) the estimated profits as certain expenses are not deductible under profits tax He should be advised to lodge an objection immediately, and in any event not later than one month after the date of notice of assessment (section 64(1)), i.e. 20 December 2012 In this case where the estimated assessment was issued due to the absence of a tax return, the objection will not be valid unless the duly completed tax return is also submitted The objection should contain the ground of objection, i.e. that the estimated assessment is not in accordance with the amount disclosed in the tax return submitted 16

17 5. Cambridge Trading Limited (Cambridge) carries on a trading business in Hong Kong and its trading profits are chargeable to Hong Kong profits tax. In addition to trading, it has entered into a number of agency contracts with overseas customers by providing sourcing and other services in return for commission income. All these contracts were concluded by the staff in Hong Kong. Under these contracts, Cambridge is responsible for locating suppliers to manufacture the goods for the clients, monitoring the production, maintaining quality control and arranging the shipment of goods. Cambridge has in turn engaged agents in Mainland China and Thailand to perform these services outside Hong Kong. Cambridge s major roles are to negotiate and enter into contract with the customers, liaise with the overseas agents and monitor the status of these projects. Upon delivery of the finished goods to the overseas customers, Cambridge is paid a commission equal to 7% of the value of the export sales. Cambridge remunerates the overseas agents at 5% of the value of the goods in consideration for their services. The management of Cambridge is of the view that the commission income received from these agency contracts should not be subject to profits tax in Hong Kong as the relevant services which earned the income were performed by the agents outside Hong Kong. As a separate issue, Cambridge is considering the purchase of certain designs to be used in some of the products in trading to enhance their competitiveness in the market. The management understands that acquisition of intellectual property right currently receives favourable tax treatment, but is also subject to certain constraints. With a view of getting the maximum tax relief, they wish to know more about the relevant provisions before proceeding with the purchase. REQUIRED: 5. (a) Advise the management on how the source of the commission income is to be determined and evaluate if the income will be chargeable to Hong Kong profits tax. Ans (a) Section 14(1) imposes three conditions for a profit to be chargeable to Hong Kong profits tax, namely: - a person must carry on a trade, profession or business in Hong Kong; - a profit is derived from that trade, profession or business; and - the profit is arising in or derived from Hong Kong 17

18 Cambridge carries on a business in Hong Kong and has earned commission income from the business carried on in Hong Kong; the income will be taxable if it is sourced in Hong Kong In determining the locality of profits, the board guiding principle laid down in CIR v Hang Seng Bank is that one looks to see what the taxpayer has done to earn the profit in question and where he has done it In ING Baring Securities (Hong Kong) Limited v CIR, the court emphasised the need to grasp the reality of each case, focusing on effective causes without being distracted by antecedent or incidental matters; the focus is on establishing the geographical location of the taxpayer s profit-producing transactions as distinct from activities antecedent or incidental to those transactions Cambridge provided buying services to its overseas customers in return for the commission income; for service income, the source is the place where the services are performed which give rise to the service fees (paragraph 45(e) of DIPN No. 21) The overseas agents were responsible for locating suppliers to manufacture the goods, monitoring the production, maintaining quality control and arranging shipment of goods; all these activities were performed outside Hong Kong and without them Cambridge would not be able to earn the commission income Cambridge negotiated and entered into agency contracts with its customers in Hong Kong, liaising with the overseas agents and monitoring the status of the projects There is an important distinction between the taxpayer managing its business in Hong Kong and performing its profit-producing activities outside Hong Kong; only the latter is relevant in determining the source of income The activities performed by Cambridge in Hong Kong, although commercially essential to the operations and profitability of the company, could be regarded as antecedent or incidental to and not the profit-making activities On this basis, the 7% commission earned by Cambridge should be sourced outside Hong Kong and non-taxable The facts in this question resemble those in the Li & Fung (Trading) Limited case in which the Court of Appeal has decided that the commission income was not taxable However, the IRD has indicated that the courts did not have the opportunity to consider the entire facts of the case, and therefore the judgment does not have wider application to other source cases The Court of Final Appeal in Ngai Lik Electronics Co Ltd v CIR clearly stated that sourcing and agency activities in Hong Kong might give rise to assessable profits 18

19 The IRD may contend that the relevant profit-producing activities were Cambridge entering into the contractual arrangements in Hong Kong with its customers and agents; furthermore, without its supervision and management, Cambridge would not be able to carry out the buying contracts and earn the commission income It is therefore open for the IRD to argue that the overseas agents earned the 5% commission income for their operations performed outside Hong Kong, whereas Cambridge earned the remaining 2% commission for the supervision and management services performed by the staff in Hong Kong 5. (b) Advise the management on the new legislation relating to the purchase and disposal of registered design, including the related anti-avoidance provisions. Ans (b) Effective from the year of assessment 2011/12, expenditure incurred in the purchase of copyright, registered design and registered trademarks for use in the production of chargeable profits can be deducted under section 16EA The design must be registered, which could be made either in Hong Kong or overseas The design must be used in Hong Kong by the taxpayer. In this case as the trading activities are carried out in Hong Kong, the design is likely to be used in Hong Kong. Deduction is by five equal amounts over five years of assessment, starting from the year in which the expenditure is incurred, provided that the registered design is owned at the end of the basis period for that year If the registered design has an expiry period of less than five years, the purchase cost can be deducted in equal amount over the number of remaining years of protection A proportionate part of the expenditure is deductible if it is used partly for producing chargeable profits The deduction also includes legal and valuation fees incurred on the acquisition of the design Upon disposal, the proceeds are treated as trading receipts and the difference is deductible if the sales proceeds are less than the unallowed expenditure, and taxable if the sales proceeds are greater than the unallowed expenditure (but restricted to amount already deducted) No deduction is allowed if the design is acquired wholly or partly from an associate; is under sale and license back arrangement; is licensed for use wholly or principally outside Hong Kong by a person other than the taxpayer; or where the whole or predominant part of the consideration was financed directly or indirectly by a non-recourse debt 19

20 6. River Limited commenced business in Hong Kong ten years ago. Initially it prepared its accounts to 31 December annually. In 2010, it changed its accounting date to 30 June. On 30 April 2012, the company ceased business. The adjusted profits before depreciation allowance for the relevant years are as follows: Year ended 31 December 2009 $2,300,000 6 months ended 30 June 2010 $1,500,000 Year ended 30 June 2011 $870, months ended 30 April 2012 $120,000 As at 30 June 2011, the reducing values of the pooling system are as follows: 20% pool $230,000 30% pool $170,000 The following information is extracted from the company s records: 1. On 10 July 2011, the company acquired an electric car for $300,000. It was subsequently sold on 5 March 2012 for $210, On 15 August 2011, the company acquired a second-hand photocopier for $30,000 (asset ranking for depreciation allowance at 20%). 3. On 30 April 2012, the company sold all the assets under the 20% pool to Lake Limited, a fellow subsidiary, for a consideration of $280, The motor vehicles under the 30% pool were not sold at the time of cessation. The market value of the vehicles was $120,000 as of 30 April REQUIRED: 6. (a) Analyse the adjusted profits before depreciation allowance of River Limited for the years of assessment from 2009/10 to 2012/13, showing clearly the basis period for each year of assessment. Identify the year of change and explain the basis of assessment for this year. Would your answer be different if the change in accounting date in 2010 was due to the alignment of the accounting date of River Limited with that of the holding company? Ans (a) Year of assessment 2009/10 Basis period: 1 January 2009 to 31 December 2009 Adjusted profits: $2,300,000 20

21 Year of assessment 2010/11 (Year of change) Basis period: 1 July 2009 to 30 June 2010 Adjusted profits: $2,300,000 x 6/12 + $1,500,000 = $2,650,000 Year of assessment 2011/12 Basis period: 1 July 2010 to 30 June 2011 Adjusted profits: $870,000 Year of assessment 2012/13 Basis period: 1 July 2011 to 30 April 2012 Adjusted profits: $120,000 The year of change is the year of assessment 2010/11, where the company fails to make up an account to the corresponding day in the following year of assessment section 18E(1)(a) The Commissioner is empowered to compute the profits for the year of change and the preceding year on such basis as he think fit Assessment is normally based on a 12-month period; for the year of assessment 2010/11, profit for six months from 1 July 2009 to 31 December 2009 would be included and hence assessed twice As a concession, the IRD may limit the basis period to a period of less than 12 months if the change of accounting date is for compelling reasons and is not tax-motivated If the change of the accounting date in 2010 was due to the alignment of the accounting date with that of the holding company, it is possible that the IRD may accept a basis period of six months from 1 January 2010 to 30 June 2010, and the adjusted profit will be $1,500,000 only 21

22 6. (b) Calculate the tax reliefs or charges for River Limited for the year of assessment 2012/13 based on the information given. Advise if any aspects of your computation may need to be adjusted if (i) the assets sold to the fellow subsidiary are found to be appreciably below the market value of the relevant assets; and (ii) the motor vehicles in the 30% pool were sold for $100,000 in November Ans (b) Depreciation allowances on plant and machinery 20% Pool 30% Pool $ $ W.D.V. b/f 230, ,000 Add: Photocopier 30,000 Less: Initial allowance (60%) (18,000) - 242, ,000 Less: Sale proceeds (280,000) Market value of vehicles - (120,000)* Balancing charge (38,000) Balancing allowance 50,000* * see explanation below The electric car qualified as environmentally-friendly vehicle and the purchase cost of $300,000 can be deducted under section 16I(2) On subsequent disposal, the sale proceeds of $210,000 is taxable under section 16I(2A) Where assets qualifying for depreciation allowance are sold and both the buyer and seller are persons over both of whom some other person has control, the Commissioner shall determine the true market value for the sale price of such assets for the purposes of calculating the balancing allowance or charge, if the sale price does not represent the true market value (section 38B); the assets sold to Lake Limited (which is a fellow subsidiary of River Limited) at an under-value may need to be adjusted upwards to the true market value When the business has ceased and there is no sale, the Commissioner will estimate the open market value of the vehicles and deem the amount to be received immediately prior to the cessation (section 39D(4)) If the sale is made within 12 months of the cessation, the taxpayer may claim adjustment of any balance allowance or charge (section 39D(5)); hence, balancing allowance for River Limited would be adjusted to $70,000 when the vehicles were sold in November 2012 END 22