Professional Level Options Module, Paper P6 (HKG)

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1 Answers

2 Professional Level Options Module, Paper P6 (HKG) Advanced Taxation (Hong Kong) December 2017 Answers Cases are given in the answers for educational purposes. Unless specifically requested, candidates are not required to quote specific case names to obtain the marks. Only the general principles involved are required. The suggested answers are in the nature of general comment only. They are not offered as advice on any particular matter and should not be taken as such. No reader should rely on the suggested answers as the basis for any decision. The examiners expressly disclaim all liability to any person in respect of any direct, indirect, incidental, consequential or any other damages relating to the use of the suggested answers. 1 Report to Shareholding Group Ltd (SGL) To: The Board of Directors of SGL From: Tax adviser Date: 8 December 2017 Subject: Business restructuring We refer to our discussion with you on the proposed restructuring of the assets of Success Co Ltd (Success) and the related tax issues arising therefrom. As requested, we provide below our comments on the respective issues. Two-storey building (i) Tax depreciation allowances Success has owned and used the building in the production of assessable profits. Therefore, it is eligible for industrial building allowance (IBA) or commercial building allowance (CBA), depending on the usage of the building (or part thereof). Under s.40(1) of the Inland Revenue Ordinance (IRO), industrial building or structure means, among other things, any building or structure used for the purposes of a trade which consists of the manufacture of goods or materials or the subjection of goods or materials to any process. In addition, any building or structure used for the purposes of a trade which consists of the storage of goods or materials is also treated as an industrial building or structure. However, if the trade itself is not one of storage, the building used for storage is not an industrial building. Based on the above principles, the ground floor of the building, used as a factory, is eligible for IBA as goods are manufactured in the premises. The fact that part of the floor will be used as an office does not affect the IBA to be claimed on the whole floor provided the qualifying cost attributable to the non-qualifying office area does not exceed 10% of the total qualifying expenditure. In the absence of a detailed calculation, the percentage of floor area for the office to total floor area would be a reasonable estimate of the proportion of the qualifying expenditure. Where more than 10% of the floor area is occupied for a non-qualifying purpose, the total qualifying expenditure needs to be apportioned based on the office area, and that part of the expenditure attributable to the office area will qualify for CBA, rather than IBA. For the first floor which is used as a warehouse, the use is not a qualifying trade for IBA purposes as storage is not the trade of Success. The storage of goods is only incidental to Success s trade. However, Success is entitled to CBA for any building (i.e. the first floor) which is not an industrial building (s.40(1)), and is used in the production of profits chargeable to profits tax. In principle, the land cost and profit component is not included in the qualifying expenditure for IBA and CBA, and only the construction cost should be taken. However, there is an exception where the industrial building is purchased from a property developer, when the purchase price (instead of the construction cost) can be used. Note that this exception only applies to an industrial building. So the purchase price attributable to the ground floor will first be apportioned into land and building, and the portion attributable to the ground floor will then be calculated, as follows: $90,000,000 x $40,000,000/$60,000,000 x 10,000 sq. ft./20,000 sq. ft. = $30,000,000 For the first floor which qualifies for CBA, the amount of qualifying expenditure equals the capital expenditure incurred on the construction of the building (s.33a(1)); calculated as follows: $40,000,000 x 10,000 sq. ft./20,000 sq. ft. = $20,000,000 Therefore, the depreciation allowance to which Success is entitled for all relevant years of assessment is calculated as follows: IBA (ground floor) $ Qualifying expenditure (QE) 30,000,000 Initial allowance (20% on QE) 6,000,000 Annual allowance (4% on QE) 1,200,000 13

3 CBA (first floor) $ QE 20,000,000 Initial allowance NIL Annual allowance (4% on QE) 800,000 (ii) If the building is sold Profit or loss on sale There may be a profit or loss arising from the sale of the building. Under s.14 of the IRO, if profits arise from a trade, profession or business carried on in Hong Kong and the profits so derived are sourced in Hong Kong, profits tax will be imposed, unless the profits arise from the sale of a capital asset. Whether profits from the sale of properties can be regarded as capital in nature and thus excluded from assessable profits depends on whether the sale constitutes a trade or not. This issue has remained contentious, subject to the merits of each case. The Inland Revenue Department (IRD) usually examines the case by reference to the so-called badges of trade, which include: (1) Subject matter of the transaction the subject matter in this case is property in Hong Kong. Property may be used for personal enjoyment (e.g. for self-occupation), for long-term income-generating purposes (e.g. for leasing), or for short-term speculation (e.g. for trading). It is generally considered that a property which does not yield an income or personal enjoyment to its owner is more likely to be held for trading purposes. In this case, Success has put the property to an income-generating purpose, albeit for a relatively short time. (2) The length of ownership the shorter the period of ownership, the more likely that the transaction is trading. In this case, the building was acquired only a year ago. Such a period of ownership would normally be too short to argue for a capital investment, unless evidence exists to prove otherwise. (3) The frequency or number of similar transactions the higher the frequency, the more likely that the transaction is trading. This piece of information is currently unknown and would need to be determined. (4) Supplementary work done if additional work has been performed to enable the building to be sold at a better profit, a trading intention would be implied. Again, this is currently unknown and would need to be determined. (5) Circumstances leading to the sale in terms of timing, Success might argue that the decision to sell the building was driven by the group s risk management policy due to the litigation risk. (6) Motive any motive behind the acquisition and leading to the quick disposal is of relevance to determine whether a profit-making motive exists. In addition to the above six badges, the IRD would normally look at other factors such as the funding of the acquisition cost and the utilisation of the sale proceeds. Success bought the property with the intention of using it for the purpose of its manufacturing and trading business which in usual commercial meaning presumably does not include purchasing the property with a view to resale at a profit. Hence in principle the property is a capital asset to Success. However, the short ownership will incline the IRD not to see the property as a capital asset but as trading stock. If the IRD takes such a position, any profit would be prima facie subject to tax and the burden of proof will be on Success to prove that the property was purchased other than for a trading purpose. Balancing adjustments Tax depreciation allowances (IBA and CBA) will have been claimed on the building, so a balancing adjustment will arise in the year of disposal. As the building will be sold for more than its original cost, which is higher than its tax written down value, a balancing charge will arise, equivalent to the total tax depreciation allowances (IBA and CBA) previously claimed. (iii) If the building is demolished and the land is sold Success will still not be entitled to a balancing allowance in respect of the demolition of the building, because the reason for its demolition is for purposes unconnected with or not in the ordinary course of trade or business. In the case of a profit arising on the disposal of the land, the tax position is the same as for the disposal of the building, i.e. it will depend on whether or not the sale is considered to constitute trading. (iv) Transfer of inventory Where a person is to cease its business, upon selling its trading stock to another person who carries on or intends to carry on business in Hong Kong, the value of the inventory can be taken to be the amount realised on the sale (s.15c). In this case, if Success ceases its business after the sale, and if SGL is carrying on business in Hong Kong, and so chargeable to profits tax on any profits from the sale of the same inventory, then the transfer price will be acceptable for the purpose of s.15c, subject to the possible challenge mentioned below. Within reason, therefore, both parties are free to allocate a value to the inventory which need not necessarily equate to its market value. In the case of Success, any profit on the sale of the inventory will be taxable, and any loss will be tax deductible. It is therefore to its advantage if the inventory is sold at a price below the market value. From a tax perspective, however, in the 14

4 (v) case of a transfer of goods between associated enterprises (like Success and SGL), the IRD expects the price for the transfer to be comparable to that which would be transacted by independent enterprises dealing with a comparable transaction in comparable circumstances. This is referred to as the arm s length principle. Selling the inventory not in accordance with the arm s length principle will result in the tax liabilities of the associated enterprises to be distorted. In this case, Success disposing of the inventory at 30% below the market price will give rise to an understatement of its assessable profits. The IRD has the authority under the rules generally known as the general anti-avoidance rules (mainly ss.61 and 61A, and in common law The Ramsay Principle) to make adjustments to bring the understated revenue in line with the arm s length price. These general anti-avoidance rules, if invoked, prevail over s.15c. On the other hand, if SGL pays less than the market price to buy the inventory, there may be an understatement of cost of goods sold, leading to an overstatement of its assessable profits (assuming that the same inventory is used for trading by SGL the profits from which trading are assessable to profits tax in Hong Kong). Even if a tax adjustment is made to Success to increase the tax revenue, the IRD has no obligation to make a corresponding adjustment to SGL, potentially leading to double taxation for the whole group. It would, therefore, be advisable to transfer the inventory at its market price. Transfer of accounts receivable The transfer of accounts receivable at cost would appear to have no tax impact as long as it represents the market value. Receivables represent unpaid prices for goods sold, and will have already been assessed to profits tax when the receivables arose. Therefore, any transfer of receivables will, in principle, not affect Success s income statement. However, any allowance for doubtful accounts which has been provided for by Success before the transfer which is not also transferred will need to be reversed in the income statement. If a tax deduction has been claimed when the allowance was created, this reversed income will be assessable. If this is the case, then it would be advisable for Success to transfer the accounts receivable at their net value (i.e. after offsetting any allowance for doubtful accounts). In the event that an additional allowance for doubtful accounts is made in the accounts of SGL subsequent to the transfer of the accounts receivable, the allowance will not be deductible for tax purposes on the basis that these receivables have not been included in SGL s assessable receipts in the first place. It is therefore again advisable that Success ensures all the potential uncollectables are adequately allowed for before the transfer. We trust that the above addresses all the Hong Kong profits tax implications arising from the proposed transactions. Should there be any questions, please let us know. End of report 2 Kelvin (a) Taxability and reporting of termination payments Termination payments made by an employer to an employee are assessable to salaries tax if they constitute income arising from the employment. Income from employment includes income from services rendered, including a payment made for services rendered in the past, or to be rendered in the future. In Walter Alfred Heinz Fuchs v CIR (2011), the Court of Final Appeal ruled that income chargeable under s.8(1) is not confined to income earned in the course of employment but embraces payments made in return for acting as or being an employee, or as a reward for past services, or as an inducement to enter into employment and provide future services. It is clear that the salary and accrued vacation pay (totalling $250,000) are income from employment and assessable. The Inland Revenue Department s (IRD s) position generally is that redundancy payments will be assessable, except statutory payments which are calculated and paid pursuant to the requirements of the Employment Ordinance. Based on this approach, the redundancy payment of $500,000 would be treated as tax-free by the IRD. Following the Fuchs case, the payment in lieu of notice provided for under Kelvin s contract of employment is income from employment and assessable. The position of the payment of $300,000 for agreeing not to compete is less certain. This is clearly not a payment for services. Also, it is not being paid pursuant to an express provision as set out in the contract of employment and hence not an income from employment. It is strongly arguable that this payment should be tax-exempt, but as a matter of practice the IRD is likely to seek to tax this amount. Even so, Company X (Co X) can reasonably take the position that this amount is not assessable to salaries tax. The payment of $350,000 in recognition of Kelvin s contribution to the development of Co X s business, in essence, constitutes a payment for the services which have been rendered by Kelvin, and on this basis would be taxable. In summary, of the six elements of the termination payment, the salary, vacation pay, payment in lieu of notice and recognition payment (totalling $1,050,000) are assessable and must be reported to the IRD. On the other hand, the remaining payments (totalling $800,000) are tax-exempt and do not need to be reported to the IRD. 15

5 (b) Acquisition and lease of property The first point to determine is whether by acquiring the property and letting it for rental income, Kelvin is thereby carrying on a business or not. Case law shows that in most cases, unless other related activities are carried out, the mere letting of property by an individual does not constitute the carrying on of a business. In such cases, the rental income will be chargeable to property tax only and not profits tax. Based on the information given, Kelvin is not carrying on a business by merely letting the property. If Kelvin acquires the property in Shatin in his own name and receives rental income, he will be subject to property tax at the standard rate on the net assessable value of the property under s.5(1) of the Inland Revenue Ordinance. Net assessable value as defined under s.5b includes any consideration payable in money or money s worth in respect of the right to use the land and/or buildings, as reduced by rates and a statutory allowance of 20% of the assessable value of the property after the deduction of any rates paid by Kelvin. There is no deduction of the actual expenses incurred in respect of the property including the loan interest, service fees paid to his agent or other expenses incurred in connection with refurbishing the property and providing the necessary furniture. If Kelvin wishes to claim a deduction of loan interest, he would have to elect for personal assessment. Under personal assessment, all his assessable income from various sources is aggregated, including rental income from property. It is specifically provided that when property income is included under personal assessment, the related loan interest can be deducted against the property income. This is the only way to obtain a tax deduction for the loan interest incurred if the property is owned in Kelvin s own name. However, the deduction is limited to the net assessable value of the property, i.e. 80% of the total rental received. If Kelvin acquires the property in the name of a limited company, s.5(1) is still applicable on the basis that the company will still be considered as owner of the property. Any rental income will be assessed to property tax and calculated in the same manner as for an individual. However, according to s.2, business is defined to include the letting or sub-letting of property by a corporation. Moreover, under s.14, any person who carries on a trade, profession or business in Hong Kong and derives assessable profits in Hong Kong will be assessed to profits tax. Therefore, in the case of a company the rental income will also be assessed to profits tax. The double taxation of a limited company which is subject to both property tax and profits tax is eliminated by the application of s.5(2)(a). Under this section, any corporation which is assessed to profits tax in respect of rental income can apply for an exemption from property tax in relation to the same rental income. It is advisable for a limited company to claim this exemption so that the rental income is only assessed to profits tax. If no such exemption has been allowed, s.25 allows the property tax paid to be offset against the profits tax chargeable and any excess to be refunded. Profits tax under s.14 is imposed on assessable profits, taking into account all relevant expenses and outgoings incurred in the production of the assessable profits (s.16). A limited company is therefore able to deduct the service fees paid to the agent (to the extent reasonable in producing the rental income) and loan interest as they are incurred to produce the chargeable rental income. Moreover, as the loan will be obtained from a bank and is not secured by any deposit, the conditions in s.16(2)(d) should be satisfied; and the restrictions in ss.16(2a), (2B) and (2C) should not apply. The expenses incurred on refurbishing the property are capital in nature and non-deductible under s.17(1)(c). However, the company will be entitled to commercial building allowance on the expenditure incurred on refurbishing the property as well as the qualifying cost of construction or residual value (undepreciated cost of construction) of the building, and a depreciation allowance for plant and machinery in respect of the cost of the furniture. In a situation where total deductible expenditure exceeds total income, the excess can be carried forward as a loss to subsequent years and be eligible for deduction against any future taxable income. Compared to holding the property in Kelvin s own name, although the applicable tax rate for a company (16 5%) is higher than that applicable to an individual (15%), the company s taxable profits should be lower, possibly even zero, as more expenses are allowable and no limitation is imposed on the tax deductibility of the loan interest incurred. However, any loss incurred by the company is not eligible to be included under personal assessment to offset other income earned by Kelvin, because an incorporated company is a separate legal person for tax purposes. Irrespective of whether the property is acquired in Kelvin s name or in the name of a limited company, the acquisition and lease of the property will be subject to stamp duty. Under Head 1(1A) of the Stamp Duty Ordinance, the agreement for the sale and purchase (AFS) of the property is liable to ad valorem duty (AVD). The AVD payable at Scale 1 rates is 7 5% on $12 million, i.e. $900,000. Where the property is a residential property (RPPT) and the purchaser or transferee is a Hong Kong permanent resident (HKPR) who buys the RPPT on his/her own behalf (i.e. the person is both the legal and beneficial owner) and owns no other RPPT in Hong Kong at the time of purchase, AVD at Scale 2 rates of 3 75% will apply, in which case the AVD payable will only be $450,000. In Kelvin s case, since he is a HKPR, if he acquires the RPPT on his own behalf, whether Scale 1 or Scale 2 rates apply will depend on whether he owns any other RPPT in Hong Kong at the time of the purchase. The formal assignment executed in conformity with the stamped agreement will only be liable to duty at the fixed rate of $100. The law stipulates that both parties to the transaction are jointly and severally liable to pay the stamp duty, but in market practice, the purchaser is normally the person to pay. Tutorial note: On 4 November 2016, the Government announced that the Stamp Duty Ordinance would be amended to increase the AVD rates for RPPT transactions to a flat rate of 15%. Unless specifically exempted or provided otherwise, any instrument executed on or after 5 November 2016 for the sale and purchase or transfer of RPPT will be subject to the proposed new AVD rate. However, the proposed new AVD rate does not apply to an agreement/conveyance for a RPPT where the purchaser/transferee is a HKPR acting on his/her own behalf and does not own any other RPPT in Hong Kong at the time of acquisition of the subject property. Scale 2 rates will apply to such an agreement/conveyance on sale. 16

6 In addition, special stamp duty (SSD) will be payable if the RPPT had been acquired by the seller on or after 27 October 2012 and is resold by that seller within 36 months. The applicable rate of SSD depends on the holding period of the property by the seller, the longer the holding period the lower the rate of duty. SSD is also jointly and severally payable by both the purchaser and the seller. It is unclear when the property was acquired by the seller, so Kelvin should be advised to obtain more information from the seller, in order to ascertain whether the RPPT will fall within the SSD regime. If it will, he might seek to negotiate and agree with the seller as to which party will pay and bear the SSD, and to have this specified in the AFS. Furthermore, buyer s stamp duty (BSD) is imposed on an AFS or a conveyance on sale of RPPT acquired by any person (including individuals and companies), except a HKPR who acquires the RPPT on his/her own behalf. BSD applies to companies which acquire RPPT, regardless of whether they are controlled by a HKPR or have any shareholders or directors who are HKPR. BSD is payable at a flat rate of 15% on the higher of the stated consideration or market value of the RPPT. The buyer or transferee is liable to pay the BSD, in addition to the existing AVD on the property transaction. In Kelvin s case, if he acquires the RPPT in his own name, BSD will not apply. However, if the RPPT is acquired in the name of a limited company, BSD of $1 8 million ($12m x 15%) will be payable. The lease agreement in respect of the property will be chargeable under Head 1(2) in the First Schedule and must be stamped within one month. As the lease will be for less than three years, the stamp duty payable will be 0 5% of the yearly rent of $420,000, i.e. $2, Blessings Ltd (a) Compliance obligations Blessings Ltd is Mr Chen s current employer, and thus is required to fulfil the following compliance reporting obligations in respect of Mr Chen s resignation from his employment: (1) An employer is required to notify the Commissioner of Inland Revenue (CIR) in writing of the cessation of employment of an employee at least one month before the date of cessation (s.52(5)). The official cessation date of Mr Chen s employment is 30 June Therefore, Blessings Ltd is obliged to inform the CIR of the cessation of Mr Chen s employment by 31 May 2017, which is one month before cessation. However, given that his last date in the office is 15 May 2017, and the employer is aware that he will leave Hong Kong before the end of May 2017, it is in practice more appropriate to file the cessation notification much earlier than 31 May 2017, together with the notification of departure. (2) When an employee is about to leave Hong Kong after the cessation of employment for a period longer than one month and the employer is aware of such an intended departure, the employer is required to notify the CIR in writing of the departure and the expected date of departure at least one month before the intended departure (s.52(6)). Since Blessings Ltd is aware of Mr Chen s intention to leave Hong Kong before the end of May and the departure is likely to be for more than one month, it is obliged to report Mr Chen s intended departure and the expected date of that departure to the Inland Revenue Department (IRD). This report should be filed at least one month before Mr Chen s intended departure date, i.e. by 30 April Given that the details of the departure can be combined with the cessation notice which is due by 31 May 2017, it would be reasonable for Blessings Ltd to file the combined notification of cessation and departure by 30 April Failure to report the departure of an employee without a reasonable excuse may result in a penalty. (3) When an employer has given notice of the expected departure of an employee (under s.52(6)), the employer must not pay to or on behalf of the employee any money or money s worth, without the CIR s written consent, within one month of giving the notice (s.52(7)). Given that Blessings Ltd is aware of Mr Chen s intended departure from Hong Kong for more than one month and assuming the combined notification of cessation and departure is filed on 30 April 2017, it is obliged to retain any payment to be made to Mr Chen until 30 May 2017 unless (or until) he has cleared all his Hong Kong tax liabilities and the CIR gives consent to the employer to release the money. In complying with the retention requirement, Blessings Ltd is protected from any action which may be brought against it by Mr Chen for non-payment. Failure to comply with these obligations would cause Blessings Ltd to be subject to a fine at level 3, i.e. $10,000. In the circumstances, the request by Mr Chen to receive his last month s salary and other terminal payments before the end of May should not be honoured unless he has cleared all his Hong Kong tax liabilities and the company receives the letter of release from the IRD. Tutorial note: A shorter period of notice of cessation may be accepted if the employer is not aware of the date of cessation at least one month before it occurs or in the case of departure from Hong Kong, the CIR deems it reasonable. However, neither of these circumstances is relevant to the scenario specified in this question. (b) Consultancy proposal Based on the discussion between Mr Chen and his supervisor, it is likely that the company established by Mr Chen will be regarded by the IRD as a Type I service company and the provisions of s.9a will be applied to determine whether the new appointment constitutes a contract for service (i.e. an independent contractor), or a contract of service (i.e. an employment). If s.9a applies, the arrangement will be looked through such that the relationship between Blessings Ltd and Mr Chen will continue to be treated as an employer employee relationship. Any payment made to the service company will be deemed as 17

7 employment income received by Mr Chen who will provide the services to Blessings Ltd in return for the income. Accordingly, salaries tax will be imposed on Mr Chen based on the total amount of the service fee receivable by the service company (instead of on the salary which would be payable by the service company to Mr Chen). As the service company is being looked through, it will be exempt from profits tax in respect of the fee received, and correspondingly, no expense deduction will be allowed to the service company. For s.9a to successfully apply, the following conditions must be satisfied: (i) (ii) There is an agreement in this case, the service contract between Blessings Ltd and the service company will be the relevant agreement. There is a relevant person in this case, Blessings Ltd will be the relevant person who carries on business in Hong Kong and who will enter into a service contract with the service company. (iii) There is a relevant individual in this case, Mr Chen will be the relevant individual who will provide the services to the relevant person (Blessings Ltd) pursuant to the service contract. (iv) The remuneration for the relevant individual s service is paid to a service company which is under the control of the relevant individual in this case, the remuneration for the services will be paid to the service company, which will be wholly owned and controlled by Mr Chen. (v) There is a tax benefit arising from the deduction of employment expenses claimed by the service company, and these expenses would not have been deducted under salaries tax if paid by Mr Chen. If the above conditions are satisfied, prima facie the arrangement will be regarded as a disguised employment between Mr Chen and Blessings Ltd. However, s.9a can have no application to deem such an employer employee relationship if ALL of the following criteria in relation to the appointment terms are satisfied: (1) The remuneration for the service should not include any of the employment-like fringe benefits stipulated in s.9a(3)(a), one of which is annual leave. In this case, Mr Chen will be entitled to 20 days of annual leave in a year but no other fringe benefits. (2) The relevant individual (Mr Chen) also carries out similar services for persons other than the relevant person (Blessings Ltd). In this case, Mr Chen is the individual designated to provide the services to Blessings Ltd. However, if Mr Chen or his service company will also provide similar services to other parties, this factor will be satisfied. (3) The performance of any services by the relevant individual (Mr Chen) is not subject to any control or supervision commonly exercised by an employer. No information on this point is given in the question. (4) The remuneration is not paid or credited periodically or calculated on a basis commonly used in employment contracts. The service fee will be payable to Mr Chen on a bi-annual basis, which does not appear to be a common basis for employment remuneration. (5) The relevant person (Blessings Ltd) does not have the right to terminate the services of the relevant individual (Mr Chen) as if in the capacity of an employer. Again, there is no information on this point. (6) The relevant individual (Mr Chen) is not held out to the public to be an officer or employee of the relevant person (Blessings Ltd). In this case, Mr Chen will continue to use his existing business card, indicating that he will continue to represent himself as an employee of Blessings Ltd even after the proposed consultancy arrangement. Given that not all of the above criteria are satisfied, it is likely that the disguised employer employee relationship between Blessings Ltd and Mr Chen will remain. However, there is still an escape clause under s.9a(4) allowing a genuine service company to escape from the deeming provision. If the CIR is satisfied that in substance Mr Chen is not holding an office or employment, the escape clause will apply. For this purpose, the common criteria (integration test, control test, and economic reality test) leading to the distinction between a contract of service (i.e. an employment) and a contract for service (i.e. an independent contractor) will be examined. With sufficient evidence, Mr Chen may genuinely be accepted as an independent consultant. Otherwise, a disguised employer employee relationship will be deemed by the IRD and Mr Chen will continue to be treated as an employee of Blessings Ltd and subject to salaries tax. 4 Parent Co group (a) Hong Kong profits tax position of HK-1 HK-1 has been set up to provide intra-group financing services. Funds are to be borrowed from a group company in the Netherlands (O/S-1) and on-lent to other group companies in Hong Kong. All transactions are interest-bearing and the interest rates are determined to enable HK-1 to earn a spread. (i) Loan interest income received by HK-1 from HK-2 or/and HK-3 HK-1 will extend interest-bearing loans to HK-2/HK-3 and earn interest income. Interest income derived by a company carrying on business in Hong Kong is generally deemed by s.15(1)(f) (if not charged by s.14(1)) to be assessable profits subject to profits tax, provided that the interest is derived from a source in Hong Kong. Based on Departmental Interpretation and Practice Note (DIPN) 13, the Inland Revenue Department (IRD) used to adopt the provision of credit 18

8 test to ascertain the source of interest income, i.e. the place where the credit is first made available to the borrower. In this case, if the money comprising the loan to HK-2/HK-3 is first made available to HK-2/HK-3 in Hong Kong, the loan interest would be regarded as sourced in Hong Kong and taxable on HK-1. However, the IRD has expressed the view that the provision of credit test will be restricted to the situation when the loan is extended from idle surplus cash and the interest earned is in the nature of passive income. Based on the Orion Caribbean case, the IRD may possibly apply the operations test to determine the source of interest income if the IRD considers that the lending of money is in fact in the nature of a money-lending transaction. In the case of HK-1, the loan to HK-2/HK-3 is financed by the loan from O/S 1, and the interest charge is arranged to enable HK-1 to earn a small spread. More importantly, the purpose of setting up HK-1 is the intra-group financing business. It is therefore probable that HK-1 would be regarded as carrying on a money-lending business. In which case, the nature of the interest income is similar to that of a trading income, and its source would be determined by the place where the operation takes place to earn the profit (in this case, the place where the loan is negotiated, concluded and effected). If the loan arrangement between HK-1 and HK-2/HK-3 is negotiated, concluded and effected in Hong Kong, the loan interest income from HK-2/HK-3 would be sourced in Hong Kong and taxable in Hong Kong. The newly enacted s.15(1)(ia) and (la) (effective from 1 April 2016) clarify that interest income received by a corporation, other than a financial institution, which arises through or from the carrying on of an intra-group financing business in Hong Kong will have a Hong Kong source regardless of whether the money concerned is made available outside Hong Kong. In other words, the new law confirms that the operations test (not the provision of credit test) applies to determine the source of interest income earned by a money-lending business. In the case of HK-1, given that it is carrying on a money-lending business, all the interest earned from lending would be taxable in Hong Kong, regardless of whether the borrowers are group companies in Hong Kong or overseas, or where the loan was provided. The 2016 law amendment also includes a concessional tax rate of 8 25% under s.14c to s.14f applicable to a taxpayer who is a qualifying corporate treasury centre (QCTC). To qualify as a QCTC (s.14(d)(2)), HK-1 must be a standalone corporate entity carrying on business as a corporate treasury centre and engaging solely in corporate treasury activities (subject to the safe harbour rules or the CIR s determination). HK-1 must also be centrally managed and controlled in Hong Kong and carry out the corporate treasury activities in Hong Kong. Corporate treasury activity includes an intragroup financing business, corporate treasury service, or any corporate treasury transaction (s.14c(1)). In principle, HK-1 borrows money from and lends money to its associated corporations in its ordinary course of business and thus should be regarded as an intra-group financing business, hence it will qualify as carrying out corporate treasury activities. However, based on DIPN 52, the IRD may also take into account other factors such as the frequency and size of transactions, the number of associates dealt with, the arm s length principle interest rate, the system of laying out and recovering the amount, and the regularity and frequency of payment. Some benchmarks are laid down in DIPN 52 but it is emphasised that failing to reach the benchmarks would not necessarily lead to a failure to be accepted as an intra-group financing business. Tutorial note: DIPN 52 states that generally the IRD would accept that a corporation is carrying on an intra-group financing business if it has no less than four borrowing or lending transactions each month, with each of the transactions exceeding HK$250,000 and the borrowing or lending transactions are with no less than four associated corporations in the relevant basis period. If HK-1 qualifies as a QCTC, the interest income would be taxed at the concessionary tax rate of 8 25%, i.e. half of the standard 16.5% rate. (ii) Loan interest payment to O/S-1 To finance the loans to HK-2/HK-3, HK-1 will obtain a loan from O/S-1 at market interest rates. HK-1 earns a spread out of the borrowing and lending. The tax deductibility of the interest payment to O/S-1 will depend on: (1) whether the loan interest expense is incurred in the production of assessable profits (s.16(1)(a)); and (2) whether the interest on the borrowing, being a loan from a person other than a financial institution, is taxable in Hong Kong in the hands of the recipient, i.e. O/S-1 (s.16(2)(c)); or (3) if s.16(2)(c) is not satisfied, whether the interest on the borrowing used in the course of intra-group financing satisfies all the conditions under s.16(2)(g). As explained in part (i), the loan interest from HK-2/HK-3 is likely to be taxable in the hands of HK-1. Therefore, the loan interest expense charged by O/S-1 on the source of finance will be incurred in the production of assessable profits and thus condition (1) above is satisfied. However, condition (2) would likely not be fulfilled for the reason that O/S-1 is not likely to be taxable in Hong Kong in respect of the loan interest received from HK-1 (unless O/S-1 is challenged by the IRD as carrying on business in Hong Kong with the interest regarded as HK-sourced, which is not likely in this case). As a result, the interest payment from HK-1 to O/S-1 will not be tax deductible for profits tax purposes under s.16(2)(c). Given that HK-1 carries on an intra-group financing business and the loans extended by O/S-1 to HK-1 are applied in this financing business, HK-1 could still be eligible for an interest deduction if all conditions under s.16(2)(g) are satisfied, as follows: (i) interest is incurred on money borrowed from a non-hong Kong associated corporation; 19

9 (ii) interest in the hands of the lender (O/S-1) has been or will be taxed overseas at a rate greater than or equal to 16 5% (or 8 25% if HK-1 qualifies as a QCTC and is taxed at 8 25%); and (iii) interest is received by O/S-1 as the beneficial owner and is not passed on to any other person under any contractual or legal obligation, unless the interest is obliged to be passed on under a genuine arrangement at arm s length (e.g. due to genuine security on the loan or sub-participation). Tutorial note: The beneficial ownership requirement is to prevent an interest deduction being given to a lender which is a conduit, agent or administrator acting on behalf of other interested parties. There are also anti-avoidance provisions under ss.16(2cc) and (2CD) to counteract the use of an intra-group financing business for the main purpose of utilising a tax loss. (b) Effectiveness of the financing proposal The financing proposal will be tax effective provided that HK-1 is taxed on the interest income from HK-2/HK-3 and is eligible for a tax deduction for the interest paid to O/S-1. Given that HK-1 is newly set up for the main purpose of providing intra-group financing, it is recommended that the benchmarking criteria for an intra-group financing business as stipulated in DIPN 52 are observed. O/S-1 must be taxed in the Netherlands at a rate no lower than 16 5% (or 8 25% if HK-1 is a QCTC), and there should not be any contractual arrangement under which O/S-1 distributes the interest income to Parent Co or other parties (including as dividends). If possible, HK-1 should solely engage in intra-group financing activities to a degree substantial enough, so it may elect to be a QCTC. If approved as a QCTC, HK-1 will be taxed at 8 25% only and maximum tax effectiveness will be achieved. 5 Roger and One Co Ltd (Co-1) (a) Stamp duty implications arising from the acquisition of the shares in Two Co Ltd (Co-2) The shares of a Hong Kong company are Hong Kong stock as defined in s.2(1) of the Stamp Duty Ordinance (SDO). Therefore the parties effecting the sale and purchase of the shares must prepare and stamp contract notes for the sale and purchase and an instrument of transfer: s.19(1) and Heads 2(1) and 2(4) respectively. Duty on the contract notes under Head 2(1) is 0 2% of the consideration or market value if applicable; and duty under Head 2(4) on the transfer is $5. Stamp duty should be paid on the total consideration (assuming it is market value) of $35 million including the $17 million shareholder s loan assigned (s.24(1)). The fact that a separate assignment deed is executed for the loan assignment is not relevant to the amount of stamp duty payable. The SDO stipulates that all the facts and circumstances affecting the liability of any instrument to stamp duty must be fully and truly set forth in the instrument (s.11). This means that the share transfer document should contain a reference to the related assignment of the shareholder s loan, because this will affect the calculation of the stamp duty payable. If the parties prepare separate documents without proper and full disclosure with an intent to defraud the Government, they would commit an offence. Total duty on the contract notes under Head 2(1) is $70,000 ($35 million x 0 2%); and the duty for the instrument of transfer is $5. It is the usual practice for the vendor and purchaser to each be liable to pay one-half of the duty. (b) Tax compliance risks Based on the tax due diligence, it would seem that Co-2 has maintained a satisfactory level of Hong Kong tax compliance in terms of profits tax return filing and tax payments. There is no record of tax queries raised by the Inland Revenue Department (IRD) in prior years. This may indicate that the tax returns have been prepared to a very good standard and/or no major and contentious tax adjustments have been made in the tax returns filed. However, this position may not be relied upon unless the shareholder of Co-2 undertakes that all tax related records and information have been fully disclosed and made available during the tax due diligence. The seller has also agreed to warrant/guarantee that all assessments prior to the acquisition date were finalised. Unfortunately, this guarantee is not effective in practice, since an assessor is empowered under s.60(1) of the Inland Revenue Ordinance (IRO) to raise any assessment within six years after the end of the year of assessment in which the transaction or event occurs. In the case of fraud or wilful evasion, the six-year time limit prescribed for raising an assessment is extended to ten years. The power also extends to additional assessments in respect of any year of assessment for which an assessment has already been issued, if the assessor is of the opinion that the taxpayer has been under-assessed for that year of assessment. Moreover, under s.70 of the IRO, an assessment is final and conclusive only if: no valid objection or appeal has been lodged; the objection or appeal has been withdrawn or an appeal has been dismissed; the assessment under an objection has been agreed; or the assessment is determined upon objection or appeal and no further appeal has been lodged. In the event that an additional assessment is issued to Co-2, it is the responsibility of Co-2 s management to respond to the IRD. Practically, it would be difficult for the seller (being the ex-shareholder of Co-2) to take part and handle any disputes with the IRD on behalf of Co-2. It is also not in the best interests of Co-2 if the conduct of any tax dispute is placed in the hands of persons who are no longer the current management of the company. Hence, the seller s undertaking in this regard is also not effective in a practical sense. 20

10 Therefore, instead of asking for a warranty/guarantee, Roger should ask for an indemnity from the seller to shelter or reimburse any additional tax liabilities which may arise as a result of any additional assessments being raised in respect of the pre-acquisition period within the time limit of six years, or ten years in the case of fraud or wilful evasion. (c) Transfer of Property X to Co-1 at nominal value Property X owned by Co-2 will be transferred to Co-1 at nominal value. Under Head 1 of the First Schedule to the SDO, any conveyance on sale and certain agreements for the sale/transfer of any immovable property in Hong Kong is subject to stamp duty at the ad valorem rates prescribed in Head 1(1). Ad valorem duty (AVD) at Scale 1 rates applies to the sale/transfer, ranging from 1 5% (for a value not exceeding $2 million) to 8 5% (for a value exceeding $20 million). As Property X is transferred to Co-1 at the nominal value of $1, such a transfer would be deemed under s.27(4) as a voluntary disposition inter vivos, and stamp duty will therefore be payable based on the market value of the property as determined by the Stamp Office. The time for stamping is within 30 days after the execution of the instrument. The exemption granted under s.45 for transfers within the same group of companies will not apply because the two companies (Co-1 and Co-2) are not held by a corporation but by Roger, and Co-1 is not the holding company of Co-2 or vice versa. As Property X is a commercial property, special stamp duty (SSD) under Head 1(1AA) and Head 1(1B) and buyer s stamp duty (BSD) under Head 1(1AAB) and Head 1(1C) are not applicable. In the context of profits tax, the transfer out of the office building by Co-2 would likely give rise to a balancing adjustment, if the office building is still a commercial building within the definition of the IRO at the time when its interest is sold or transferred. In this case, since the sale consideration is only $1, any excess of residue of expenditure over $1 could be claimed as a tax deduction in the form of a balancing allowance in the tax return of Co-2. On the other hand, in the tax return of Co-1, the qualifying expenditure based on which Co-1 may claim an annual allowance would be calculated based on the residue of expenditure adjusted by any initial and annual allowances granted, plus any balancing allowance granted to Co-2. As a result, Co-1 may only be able to claim a negligible amount of annual allowance based on $1. However, as Co-1 and Co-2 are under the common control of Roger, the Commissioner is empowered under s.38b to determine the true market value of the building and the amount so determined shall be deemed to be the sale price for the purpose of calculating both the balancing allowance or charge on disposal, and the qualifying expenditure for future allowances purposes. Finally, as the office building has been leased out for rental income, it will be Co-2 s capital asset. Accordingly, any loss from its sale will not be tax deductible. (d) Distribution in specie of Property Y to Roger Upon liquidation, Property Y will be distributed in specie to Co-2 s only shareholder, Roger. Because it lacks any valuable consideration, such a distribution would normally be deemed to be a voluntary disposition inter vivos (s.27(4)) and the instrument of transfer effecting such a transaction would be chargeable to stamp duty (Head 2(3)). However, a distribution in specie of a company s assets to its shareholder in the course of liquidation will not involve any change of beneficial interest in the property transferred: see Wigan Coal & Iron Co Ltd v IRC [1945] 1 All ER 392. As such, the instrument of transfer is exempt from a charge to stamp duty (s.27(5)), including AVD, SSD and BSD. 21

11 Professional Level Options Module, Paper P6 (HKG) Advanced Taxation (Hong Kong) December 2017 Marking Scheme Available Maximum 1 (i) Two-storey building Building used in the production of assessable profits 0 5 IBA or CBA 0 5 IBA granted if building used for manufacturing 1 Or used for storage for the purpose of a trade 1 Ground floor IBA 0 5 Office area not more than 10% has no effect 1 Otherwise, CBA is claimed 0 5 First floor CBA as Success is not of storage trade 1 Purchase price used for ground floor as purchased from developer 1 Construction cost used for first floor 1 Ascertainment of qualifying expenditure for IBA 1 Ascertainment of qualifying expenditure for CBA 1 Calculation of IBA 1 Calculation of CBA (ii) Sale of building Profit/loss on sale of capital asset not taxable/deductible 1 If constitutes a trade, profit is taxable 0 5 Six badges of trade and explain 6 Other factors looked at by IRD 1 Short holding of building, likely a trade and taxable 1 Balancing adjustment equivalent to allowances claimed (iii) Demolition of building and sale of land No balancing allowance 1 Demolition unconnected to trade/business 1 Profits are taxable if a trade (iv) Inventory transfer Amount realised on a cessation sale (s.15c) 1 Parties able to determine price 1 Transfer between associated enterprises, transfer pricing 1 Price comparable to independent transactions, arm s length 1 Prevails over s.15c 0 5 Tax adjustment by IRD to increase understated revenue in Success 0 5 Cost of goods sold to SGL also understated 0 5 No obligation on IRD to make corresponding adjustment 1 Advise transfer at market price (v) Accounts receivable transfer No tax impact for Success 0 5 Sales already taxed when made 1 Reversal of allowance for doubtful accounts (AFDA) is taxable if deducted previously 1 Advisable to transfer at net amount 0 5 AFDA not deductible to SGL 0 5 Receivables have not previously been assessed in SGL 1 Any uncollectables should be allowed for in Success before transfer Presentation: Appropriate format and presentation 1 Logical development 1 Effectiveness of communication