THE TAXATION INSTITUTE OF HONG KONG CERTIFIED TAX ADVISER QUALIFYING EXAMINATION PAPER 2 HONG KONG TAX SUGGESTED ANSWERS.

Transcription

1 THE TAXATION INSTITUTE OF HONG KONG CERTIFIED TAX ADVISER QUALIFYING EXAMINATION 2013 PAPER 2 HONG KONG TAX SUGGESTED ANSWERS Page 1 of 16

2 Question 1 (A) (a) Depreciation allowance schedule 20% pool (furniture) 30% pool (motor cars) Computer on hire purchase 30% Allowance $ $ $ $ 60,000 70,000 Written down value brought forward Additions 40,000 20,000 60,000 Initial allowance (IA) - at 60% (24,000) (12,000) 36,000 - $(6, ,500 x 3)x60% (11,700) 11,700 Disposals (35,000) Compensation (8,000) 76,000 35,000 48,300 Annual allowance (15,200) (10,500) (14,490) 40,190 WDV carried forward 60,800 24,500 33,810 87,890 The $5,000 monthly instalment payment includes hire purchase interest of $500. A total of $500 x 3 = $1,500 has been included as interest expenses in the accounts and such interest expenses are deductible as revenue expenses and the depreciation allowance are calculated on the capital portion of $4,500 only. (b) Lucky Limited Profits Tax Computation Year of Assessment 2012/13 Basis period: Year ended 31 December 2012 $ $ Profit before taxation 2,314,000 Add: Depreciation charge 56,000 Interest to Apple Bank Limited on overdraft 63,000 Sale proceeds of prescribed fixed asset (computer) 30,000 Interest paid to director 5,500 Retirement fund - special contribution ($800,000 x 80%) 640,000 Loan to staff written off 10,000 Increase in general provision for bad debt $(137, ,000) 2,000 Donations 160,000 Legal fee for collection of loan to staff 2,000 Profits tax 130,000 Traffic fines 7,200 Refurbishment/renovation expenditure of office Page 2 of 16

3 premises ($140,000 x 4/5) 112,000 Renovation of directors quarters 137,000 Amortized expense for office premises 30,000 1,384,700 3,698,700 Less: Dividends (11,000) Profit on disposal of fixed asset (13,000) Interest on deposits - Dai Sun Bank Limited (47,000) - Apple Bank (63,000) Limited Interest on tax reserve certificate (15,000) Exchange gain on Euro fixed deposit (12,000) Commercial building allowance ($300,000 (for office) + $137,000 (for directors quarters) x 4% (17,480) Depreciation allowance - plant & machinery (from part (a)) (87,890) (266,370) 3,432,330 Less: Charitable donations (100,000) Assessable profit 3,332,330 Profits tax at 16.5% (ignore cents) = $549,834 - The foreign currency (Euro) deposits were placed with Dai Sun Bank Limited in Hong Kong. The interest income ($47,000) thereon was sourced in Hong Kong under the provision of credit test and was therefore caught by S15(1)(f). The currency of the deposit is irrelevant. However, pursuant to the Exemption from Profits Tax (Interest Income) Order 1998, interest income from deposits placed with financial institutions in Hong Kong is exempt from payment of profits tax with effect from provided that the deposits are not used to secure or guarantee any borrowing where the interest expense satisfies the conditions for deduction under S16(2)(c), (d) or (e) and limitation under S16(2A) does not apply (Inland Revenue Amendment Ordinance 2004). In this case, as the deposits are not used to secure any borrowings, the Exemption Order applies and the interest income will be exempt. - Since the US$ deposits were placed with Apple Bank Limited in the USA, the interest income ($63,000) was sourced outside Hong Kong and is not taxable under S15(1)(f). - Interest income from the tax reserve certificate is exempted under S26A. - The taxability of the interest income derived from trade debts is determined by reference to the related trading transactions. On the basis that the trading profits derived from the sale of goods are onshore in nature and therefore taxable, the interest income ($25,000) derived from the trade debts is also taxable. - Interest payable on money borrowed for the purpose of producing chargeable profits is deductible under S16(1)(a) of the Inland Revenue Ordinance (IRO) provided that any one condition set out in S16(2) is satisfied, subject to limitations under S16(2A), (2B) and (2C). Page 3 of 16

4 - The overdraft facility is from Apple Bank Limited, a financial institution and the condition under S16(2)(d) is satisfied. However, by virtue of S16(2A), the deduction for interest expenses has to be reduced because the borrowing is secured by the US$ deposits placed by Lucky Limited and the interest income from that deposit is not taxable in Hong Kong. In this case, the deduction is reduced by the amount of tax-free interest of $63,000 and only $55,000 will qualify for deduction ($118,000 - $63,000). Therefore, $63,000 of interest expense is to be added back. - For the loan from XYZ Bank Limited, condition under S16(2)(d) is satisfied. As the loan was secured by a mortgage over the property of a director and not by any deposit, the limitation under S16(2A) does not apply. It also appears that there was no interest flow back to the borrower or any connected person. The restriction under S16(2B) therefore does not apply. The whole interest expense ($158,000) is therefore deductible. - As regards the renovation of office premises, the capital expenditure on the renovation of office premises ($140,000) is deductible in five equal installments over five years, beginning with the basis period in which the payment was actually made (section 16F). Therefore, 4/5 of the expenditure is not deductible in the year of payment and must be added back in the profits tax computation. - For the renovation of directors quarters, refurbishment allowance is not be available for capital expenditure incurred for a domestic building and therefore expenditure on the renovation of directors quarters ($137,000) is not deductible. However, commercial building allowance can be claimed on the capital expenditure incurred. (B) Under S51C of the Inland Revenue Ordinance (IRO), any person carrying on a trade, profession or business must keep sufficient records in English or Chinese of its income and expenditure, to enable the assessable income of such trade, profession or business to be readily ascertained. These records are to be kept for a period of not less than seven years after the completion of the transactions, acts or operations. Records include books of account, receipts and payments, income and expenditure together with vouchers, bank statements, invoices, receipts and other documents necessary to verify the entries in the accounts. Records also include records of assets and liabilities, goods purchased and sold, details of sellers and buyers, records of stocktakings, and records of services provided. If Lucky Limited is the owner of land or buildings, sufficient records of rental details are also required. As the period mentioned in the question is from 1 January 2000 to 31 December 2004, which is more than 7 years counted back from 31 December 2012, Lucky Limited does not need to keep those original documents and will not contravene the relevant requirements governing record keeping under the IRO. (C) (a) For the purpose of revising the cost of sales in the profits tax return filed, Lucky Limited is entitled to lodge a claim under section 70A of the Inland Revenue Ordinance to have the error or omission corrected in respect of the year of assessment 2011/12. A S70A claim must be made in writing within six years after the end of the year of assessment or within six months after the service of the notice of assessment, whichever is later. Page 4 of 16

5 The claim is accepted only if it can be established to the satisfaction of the Inland Revenue Department (IRD) that the assessment is excessive by reason of: 1. an error or omission in a return or statement submitted; or 2. an arithmetical error or omission in the calculation of the assessable profits or the tax charged. However, the assessment cannot be re-opened for an error or omission in a return or statement where that return or statement was made on the basis of prevailing practice. Whether the tax treatment is a prevailing practice or not is a question of fact, and it is normally distinguished from the basis, which is made according to the stipulated law. Based on case law, a taxpayer must demonstrate the existence of an error or omission in a return or statement, and an error for the purpose of S70A is generally referred to only as an inadvertent error and will not extend to a deliberate error. Evidence as to how the error would have come to be made will still be required to be established. In the case of Lucky Limited, it will be required to produce evidence to explain the error due to the missing purchase invoice and the reason why this cost of sales was not detected and included in its accounts in support of the profits tax return filed. It is expected that its accountant or auditor, if any, may be required to produce evidence. Provided that it can be established to the satisfaction of the IRD that the understated cost of sales was an error or omission, S70A claim of Lucky Limited will be allowed and its profits tax assessment for 2011/12 will be revised accordingly. (b) At the time when the error was discovered (20 December 2012), the statutory time limit of one month from the date of notice of assessment (1 September 2012) for lodging a valid objection against the notice of assessment has already lapsed. No objection is therefore allowed to be made unless Lucky Limited has reasonable grounds (such as directors absence from Hong Kong) to explain why it could not lodge the objection in time, in which case a late objection may be accepted. Lucky Limited is however able to hold over the provisional profits tax in respect of 2012/13 if it is anticipated that the assessable profits for 2012/13 would be, or are likely to be, less than 90% of the amount assessed to provisional profits tax. This may or may not be as a result of the understatement of cost of sales that occurred in 2011/12. The application for holdover must be made in writing and lodged with the Commissioner of Inland Revenue 28 days before the due date of payment of the provisional tax. If no application for the holdover of provisional tax is made, Lucky Limited is required to pay the tax as required at the amount demanded on the date specified in the tax demand note. However, should it be ultimately determined that the 2011/12 profits tax liability was overstated due to the error, and the notice of assessment is revised to reflect a lower profits tax liability, a tax refund will be issued by the IRD to Lucky Limited. Page 5 of 16

6 Question 2 (A) (a) No stamp duty is payable on the sale and purchase agreement of non-residential property. However, stamp duty is payable on the conveyance of Hong Kong immovable property under Head 1(1) of the Stamp Duty Ordinance. The amount of stamp duty payable on 15 December 2012 = $8,100,000 x 3.75% = $303,750 (b) The lease is stampable under Head 1(2) of the Stamp Duty Ordinance. As there is a premium in the lease agreement, the term of the lease is more than three years and there is uncertainty at the time of making the lease agreement as to the amount of annual rent paid, the amount of stamp duty on the lease is 4.25% of the premium plus 1% of the maximum annual rent that is provided in the lease agreement, which is $120,000 x 4.25% plus $20,000 x 12 x 1% = $7,500. (c) If $6.4 million is the market price at the time of transfer but the transfer is at a price ($6.8 million) higher than the market price, stamp duty payable at conveyance is still 3.75% of the consideration stated on the document of transfer, which is $6,800,000 x 3.75% = $255,000. (B) (a) The provisions relating to the prosecution of and the respective penalties for a taxpayer who has committed an offence as a result of understating or omitting the amount of chargeable income are contained in sections 80(2), 82 and 82A of the Inland Revenue Ordinance. Any person who, without reasonable excuse, makes an incorrect return by omitting or understating the taxable income is guilty of an offence (S80(2)). If the Commissioner of Inland Revenue (CIR) institutes proceedings, the court may impose a level 3 fine of $10,000 plus treble the amount of tax that has, or would have been, undercharged as a result of the omission or understatement. The CIR may compound the offence (S80(5)). Where the taxpayer is suspected of having evaded tax with fraud and wilful intention, the CIR can prosecute him (S82). Fraud and wilful evasion include: (1) an omission from a return; (2) a false entry or statement in a return; (3) a false statement in a claim for a deduction or allowance; and (4) signing a statement or return without reasonable grounds for believing that it is true. Any person who is prosecuted for fraud and wilful evasion is guilty of a misdemeanour with the following maximum penalties: (1) On summary conviction: a level 3 fine of $10,000, an additional fine of three times the tax that was, or would have been, underpaid, and imprisonment of six months. (2) On indictment: a level 5 fine of $50,000, an additional fine of three times the tax that was, or would have been, underpaid, and imprisonment of three years. There is an alternative penal section whereby the CIR or Deputy Commissioner of Inland Revenue (DCIR) may impose a penalty in the form of an additional tax on the amount of tax understated (S82A) as a result of the taxpayer s non-compliance without a reasonable excuse. The maximum amount of additional tax is treble that of the amount of tax undercharged. Assessment to additional tax is only applicable if no proceedings have been instituted for Page 6 of 16

7 making an incorrect return without reasonable excuse and the person has not been prosecuted for fraud or wilful evasion. If additional tax is raised, the taxpayer cannot be prosecuted for an offence on the same facts. Before issuing an assessment to additional tax, the CIR or DCIR shall send a notice of intention to assess additional tax to the person concerned, and advise the person to submit written representation in respect of the offence for his consideration. The notice shall specify the offence in respect of which the additional tax is being assessed. After the CIR or DCIR issues the notice of additional tax under S82A, the taxpayer, if he disagrees, may appeal against such notice to the Board of Review. (b) In D31/85, the Board of Review explained reasonable excuse as follows: We consider that the correct test to be applied in determining reasonable excuse is what one would expect a reasonable person to do in all of the circumstances. Illiteracy and ignorance of the law are not acceptable defences in a criminal prosecution. Reliance on professional advice is a reasonable excuse (BR 80/76), but that reliance must be reasonable in the circumstances (D28/84). Reliance on the bookkeeper s belief that the profits from the sale of goods to customers in China might not be subject to profits tax hardly seems to be a reasonable excuse. If the bookkeeper and Peter Ho considered that there was doubt as to the tax position, full details should have been given in the return. Question 3 (a) Ignore provisional tax Mr. Fok and Mrs Fok s Salaries Tax Assessment Year of assessment 2012/13 $ $ Mr. Fok Salary (10 months) 500,000 Bonus 180,000 Housing allowance ($20,000 x 10) 200,000 Holiday journey benefit - air ticket for wife ($6,000+$2,000)/2 - $2,000 2,000 - hotel room charges ($29,000 x 9/29) 9,000 Special allowance for business trip to Shanghai 12,000 Cash prize 10,000 Ex-gratia payment 27,000 Part-time income ($10,000 x 2) 20,000 Assessable income 960,000 Less: Subscription to one professional body (2,500) Net assessable income 957,500 Mrs. Fok Salaries income 120,000 Less: self-education expense (20,000) Net assessable income 100,000 Page 7 of 16

8 Total net assessable income (Mr. and Mrs. Fok) 1,057,500 Less: Concessionary deductions Approved charitable donations ($70,000 (husband) + $60,000 (wife)) (within 35% limit) (130,000) Elderly residential care expense Mrs. Fok s father (maximum = $76,000) (76,000) Home loan interest (100% x $180,000)(limited to $100,000) (100,000) (306,000) 751,500 Less: Basic allowance for married persons (240,000) Child allowances ($63,000 x 2) (126,000) Dependent Parent Allowance (DPA) Mrs. Fok s mother (38,000) Additional DPA Mrs. Fok s mother (38,000) (442,000) Net chargeable income 309,500 Salaries tax at progressive rates = $8,400 (first $120,000) + 17% x $(309, ,000) 40,615 Salaries tax at standard rate is not applicable ($751,500 x 15%) 112,725 Salaries tax payable 40,615 Mr. Fok s Property Tax Liability Year of Assessment 2012/13 Property in Wanchai Annual rental 250,000 Less: rates ($3,000 x 4) (12,000) Assessable income 238,000 Less:20% statutory allowance (47,600) Net assessable value 190,400 Property tax 28,560 Property in Mongkok Annual rental 400,000 Less: rates ($4,500 x 4) (18,000) Assessable income 382,000 Less:20% statutory allowance (76,400) Net assessable value 305,600 Property tax 45,840 Mrs. Fok s Property Tax Liability Year of Assessment 2012/13 Property in Aberdeen Assessable income = annual rental 180,000 Less:20% statutory allowance (36,000) Net assessable value 144,000 Page 8 of 16

9 Property tax 21,600 Statement of Loss for Mrs. Fok s Flower Shop for the year of 2012/13 Agreed loss for the year 2011/2012 (120,000) Profits tax payable = NIL The following is for information only and is not required by the examination question: - Since CDC China Limited is managed and controlled in Shanghai, the directorship is a foreign office. The director s fee accrued to Mr. Fok from the foreign office is therefore not taxable under Hong Kong Salaries Tax. The related share option gain is not subject to salaries tax. - The cash prize for best employee is taxable as it was derived from the employment. - The compensation of $500,000 for early retirement is not taxable as it did not arise from the employment and is not regarded as a payment in lieu of notice. - The sum of $3,000,000 received from the company s retirement fund is non-taxable. - The ex-gratia payment of $27,000 is taxable. - The gold coin, being a gift from the colleagues, is not taxable. (b) Advantages that may be obtained by electing for personal assessment include: (1) Individual taxpayers who have sole income subject to either profits tax or property tax can take advantage of the personal allowances and lower tax rates in personal assessment. (2) Taxpayers who are subject to either profits tax or property tax can claim home loan interest for their own residence and expenses, if any, relating to elderly residential care under personal assessment. (3) Taxpayers who have a business loss in the year can immediate utilize the business loss to set-off their other income by electing for personal assessment. (4) Taxpayers who are subject to property tax and have paid mortgage interest to finance the purchase of the property can claim deduction of the mortgage interests under personal assessment. (5) Taxpayers who have donated more than 35% of their salaries and/or business income to approved charities and have additional property rental income can claim the deduction of the excess donations under personal assessment. Mr. and Mrs. Fok have paid mortgage interests for their rented-out properties. Such payments of mortgage interests can be deducted (up to the net assessable value (NAV) figures of individual properties if the mortgage interest payment is greater than the NAV figure) if they elect for personal assessment. Furthermore, Mrs. Fok s flower shop business suffered a business loss and that loss can be immediately utilized to set off the couple s other income if they elect for personal assessment. Therefore, it is highly likely that by electing for personal assessment, Mr. and Mrs. Fok can reduce their overall tax liabilities. Page 9 of 16

10 Question 4 (a) According to the Goepfert case and Departmental Interpretation and Practice Note (DIPN) No. 10, the source of an employment is in general determined with reference to the following factors: (i) the place where the contract of employment was negotiated, and entered into, and is currently enforceable, (ii) the residence of the employer; and (iii) the place where the employee s remuneration is paid to him/her. In Charlie s case, there is no argument that his employment during the period from 1 April 2012 to 31 March 2013 was EITHER still with Silicon Valley Inc. OR with Silicon Valley (Shanghai) Limited (a company incorporated in China). In either case, the contract of employment was negotiated and entered into in a place outside Hong Kong. Also, the contract of employment was enforceable in a place outside Hong Kong. The residence of the employer in either case was NOT Hong Kong. Although Charlie s remuneration was paid to him in Hong Kong, this factor is not a decisive one when ascertaining the source of employment. Therefore, it is highly likely that Charlie s employment during the period from 1 April 2012 to 31 March 2013 would be considered a non-hong Kong employment by the Inland Revenue Department. If Charlie had a non-hong Kong employment, only his income related to services rendered in Hong Kong during the period from 1 April 2012 to 31 March 2013 would be subject to Hong Kong salaries tax. Should it be the case that Charlie had performed services in Hong Kong during the said period, his total salary would be time-apportioned for the purpose of computation of Hong Kong salaries tax payable. If it is the case that Charlie had not performed any services in Hong Kong, Charlie would be exempted from Hong Kong salaries tax. According to the information provided in the question, Charlie occasionally brought work-related documents to and from the Shanghai and Hong Kong offices. Whether such activities in Hong Kong are considered part of the employment services is to be decided having due regard to the facts associated with the employment in question. In the past, different decisions were made by the Board of Review. For example, a Board of Review decision suggested that such activities by the taxpayer were purely gratuitous and were not duties of the taxpayer s employment. However, another Board of Review decision which ruled that the taxpayer could not be exempted from Hong Kong salaries tax unless he did not carry out any services in Hong Kong. The fact that Charlie carried the work-related documents in order to save the company s time for document transfers and courier expenses could arguably be not gratuitous. Then, these activities would be regarded as services rendered in Hong Kong. If it is ruled that Charlie did perform some employment-related services in Hong Kong, he might check whether he was entitled to claim the 60-day exemption if he visited Hong Kong for not more than 60 days during the relevant year of assessment. If this is case, Charlie would be fully exempt from Hong Kong salaries tax even he had performed such services in Hong Kong. Based on the information provided in the question, Charlie came to Hong Kong for 50 days. If Charlie s trips to Hong Kong are considered visit(s), he would be entitled to the 60-day exemption. The term visit is not defined in the Inland Revenue Ordinance and such word should be interpreted with reference to its ordinary meaning. The fact that Charlie held a Hong Kong permanent resident identity card, maintained bank accounts in Hong Kong and kept a Hong Kong driving licence is not decisive in concluding that he is a resident of Page 10 of 16

11 Hong Kong (rather than a visitor to Hong Kong). However, it is likely that the fact that Charlie s returned to Hong Kong on 1 April 2013 to start a long-term residence would weaken his argument for being a visitor to Hong Kong in the year of assessment 2012/13. If the Inland Revenue Department is of the view that Charlie is a visitor to Hong Kong during the period from 1 April 2012 to 31 March 2013, Charlie will be exempted from Hong Kong salaries tax for the services rendered in Hong Kong during his 50 days of visit. On the other hand, if Charlie is NOT regarded as a visitor to Hong Kong, 50/365 of his annual income from his employment during the period from 1 April 2012 to 31 March 2013 would be subject to Hong Kong salaries tax. It is worth mentioning that should 50/365 of Charlie s income be subject to Hong Kong salaries tax, Charlie is further entitled to claim exemption under section 8(1A)(c) of the Inland Revenue Ordinance if he has paid PRC tax on his employment income. As Charlie did pay PRC Individual Income Tax (IIT) on his salary, it is likely that Charlie could exclude in his Hong Kong salaries tax assessment the part of his income that had already been subject to PRC IIT with the tax so charged having been paid. However, this exclusion of income only covers Charlie s monthly basic salary and does not cover his monthly overseas allowance which has not been taxed by the Chinese tax authority. 50/365 of such monthly overseas allowance would still be subject to Hong Kong salaries tax. (b) Under the Inland Revenue Ordinance, a person s residence status is not relevant in determining whether the person is chargeable to profits tax in Hong Kong. The basic test for Hong Kong profits tax chargeability is whether the person carries on a trade, profession or business in Hong Kong from which a Hong Kong-sourced profit is derived. A few issues are to be considered (i) there must be a trade, profession or business being carried on; (ii) the trade, profession or business is being carried on in Hong Kong; and (iii) the profit derived therefrom is sourced in Hong Kong. Whether a transaction or an activity constitutes a trade, profession or business is not always easily ascertainable. Section 2 of the IRO defines trade as including every trade and manufacture and every adventure and concern in the nature of trade. The general approach is to look at the intention of the person at the time of the transaction. Normally, an analysis in the light of badges of trade is adopted: (i) Subject matter of the realisation In the case of John, the subject matter is shares listed on the Hong Kong and US stock exchages. Listed shares are generally accepted as a common subject of trading, but there are also a number of tax cases that tend to support the proposition that share trading is close to gambling, instead of being a trade/profession/business. (ii) Length of period of ownership John s portfolio has an average holding period equal to or less than 25 days. This supports the intention of short-term trading. (iii) Frequency or number of similar transactions by the same person John and Peter communicate nearly every day, with Peter s monitoring the share trading transactions and a monthly statement is compiled by Peter for John s review. All these demonstrate the high frequency of trading activities done through John s securities account in Hong Kong through Peter s efforts and monitoring. (iv) Supplementary work on or in connection with the property realised basically no supplementary work has been done on the shares before they are sold, but there is ancillary work done by Peter in support of John s share trading activities in Hong Kong such as collecting and sending to John the market news and analysts reports. Page 11 of 16

12 (v) Circumstances that were responsible for the realisation In the case of share trading, the realisation must be propelled by profit maximisation or loss minimisation. (vi) Motive One can easily observe that a profit making motive is closely associated with John s share trading activities through John s securities account in Hong Kong. In view of the above analysis in relation to badges of trade, it is obvious that John s buying and selling of listed Hong Kong and US shares would likely constitute a trade. However, there are a number of tax cases in relation to individuals buying and selling shares. Most of the decisions in these cases are that speculative transactions in shares by an individual do not amount to a trade, although it is understood that each case needs to be considered on its own merits. The court considered in a tax case that speculation was like gambling. This implies that speculation had generally been found not to amount to a trade unless such speculative activities are undertaken by a person with some special knowledge of the particular activity or industry which was the subject of the speculation. In John s case, it is likely that John could be regarded as carrying on a trade or business through Peter as John relies on the special knowledge and professional expertise in share trading of Peter who is a registered stockbroker in Hong Kong. Assuming that John s share trading activities in Hong Kong is ruled by the Inland Revenue Department to constitute a trade or business, the second issue to be considered is whether the trade or business is being carried on in Hong Kong. In the case of John, he never conducts any business activities in Hong Kong in person. However, one may not, based on this piece of information only, conclude that John did not carry on a trade or business in Hong Kong. In general, if a person has a permanent establishment in Hong Kong (either a fixed presence in Hong Kong or through the presence of an agent in Hong Kong who has a general authority to act on his behalf), he/she would be considered to be carrying on a trade or business in Hong Kong. According to Inland Revenue Rule 5(1), a permanent establishment includes a physical place of business i.e. a branch, management or other place of business, and also an agent. An agent in Hong Kong would constitute a permanent establishment of the non-resident if the agent (i) habitually exercises a general authority to negotiate and conclude contracts on behalf of his principal; or (ii) has a stock of merchandise from which he regularly fills orders on behalf of his principal. Once it has been established that the non-resident has a permanent establishment in Hong Kong then, in accordance with Inland Revenue Rule 5(1), the assessable profits of the non-resident would be ascertained in accordance with Inland Revenue Rule 5(2). In the case of John (a non-resident for the purpose of Hong Kong profits tax), the fact that he allows his brother, Peter, to operate his securities account in Hong Kong with full authority and discretion demonstrates that a general authority has been given to Peter to negotiate and conclude contracts on John s behalf. In such circumstances, it is highly likely that John would be regarded as having a permanent establishment in Hong Kong via Peter as John s agent. The last issue to be considered is whether John will be chargeable to profits tax in Hong Kong. This depends on whether the profits derived from the share trading activities are sourced in Hong Kong. In general, the source of profits is determined by applying the operation test. In other words, one has to determine where the operations from which the profits in question arose were taking place. The interpretation and application of this test in different situations may vary. In the case of trading in listed shares, Departmental Interpretation and Practice Notes (DIPN) 21 (revised 2012) suggests that the source of such profit is where the shares are Page 12 of 16

13 listed since this is where the share transfers will be registered. In the case of John, as profits are earned partly from trading in Hong Kong listed shares and partly from trading in US listed shares, it would likely be the case that profits arising from the trading in Hong Kong listed shares would be considered to be sourced in Hong Kong and taxable; whereas profits arising from the trading in US listed shares would be considered to be offshore and not taxable. Question 5 (a) Vehicle A is definitely eligible for tax deduction. Where an eligible environment-friendly vehicle is only used partly in the production of chargeable profits (like Vehicle A), the tax deduction shall be adjusted proportionately to the extent to which the vehicle is used in the production of chargeable profits. Buyers of second-hand vehicles are entitled to the tax deduction as long as the vehicle is an eligible environment-friendly vehicle (in the case of Vehicle B) at the time of purchase. The commencement date for the purposes of section 16I of the Inland Revenue Ordinance in relation to environment-friendly vehicles is 18 June The tax deduction is not limited to environment-friendly vehicles purchased on or after 18 June Eligible environment-friendly vehicles already in use by a business before 18 June 2010 (like Vehicle C) are also eligible for the deduction. The reducing values/written down values of the eligible vehicles under the depreciation allowance regime will be treated as specified capital expenditure for which deduction will be given accordingly. According to section 16K of the Inland Revenue Ordinance, a taxpayer shall make an election in writing and lodge it within one month after the date of the relevant notice of assessment. If the taxpayer makes such an election in the Tax Return, the Inland Revenue Department would consider it when a tax assessment is made. Vehicles acquired under hire-purchase arrangements (like Vehicle D) are not eligible for the tax deduction. Taxpayers acquiring eligible environment-friendly vehicles under hire-purchase arrangements are still entitled to the usual depreciation allowances. Vehicle E is not qualified for tax deduction under section 16K but it can claim depreciation allowance for plant and machinery as a 30%-pool newly acquired asset item. (b) If a taxpayer ceases its operation, whether permanently or temporarily, the vehicle concerned should be taken as being sold immediately before the cessation of operations and the taxpayer shall be chargeable to tax as if it had received the sale proceeds on that date. If the environment-friendly vehicle is sold, destroyed or stolen within 12 months from the date of cessation of operation, the taxpayer may apply for an adjustment to the sale proceeds so as to reflect the actual sales income, insurance moneys and other compensation. (B) Property tax is charged for each year of assessment on the owner of land and/or buildings situated in Hong Kong at the standard rate on the net assessable value of such land and/or buildings: section 5(1) of the Inland Revenue Ordinance. In so far as common parts are concerned, owner in respect of any land and/or buildings is defined to include a corporation registered under section 8 of the Building Management Ordinance. Therefore, an Assessor of Page 13 of 16

14 the Inland Revenue Department is empowered to issue a 2011/12 property tax return to The Incorporated Owners of Bedford Garden ; and The Incorporated Owners of Bedford Garden is required, on behalf of all owners of the building, to report the property income and pay the property tax. Land and/or buildings includes piers, wharves and other structures, and buildings includes any part of a building as defined in S7A. The assessable value of a property for each year of assessment shall be the consideration, in money or money s worth, payable in that year to, to the order of, or for the benefit of, the owner in respect of the right of use of that property in accordance with S5B(2). In the present case, the roof is part of a building; and the licence fee falls within the definition of assessable value, namely, the consideration paid by the company for the use of the roof to erect an advertising neon sign thereon. Even though the licence fee is not paid directly to the owners of the common parts, it is used for the purpose of meeting the management expenses. The licence fee can therefore be regarded as having been paid to the order of, or for the benefit of, the owners. As such, the owners (i.e. all the owners of the individual flats and also The Incorporated Owners of Bedford Garden ) will be chargeable to property tax in respect of the licence fee for the year of assessment 2011/12. Question 6 (a) The main motive of setting up a service company with limited liability like the one that Mr. Fu has set up is to minimize his total tax liabilities. The setting up of a service company has the following effects: 1. The income that Mr. Fu currently receives is subject to Salaries Tax. Under the proposed arrangement, the same income received by the service company is now subject to Profits Tax. The main expenses of the service company will be the salary and fringe benefits for Mr. Fu. Mr. Fu will be employed by the service company. He will be subject to Salaries Tax for his income and taxable fringe benefits from the newly set-up service company (Fu Limited). 2. The main advantage of forming a service company is to take the advantage of the difference in the rules of deducting expenditure under Profits Tax and under Salaries Tax. Private and personal expenditure items that are not deductible under Salaries Tax (under section 12 of the Inland Revenue Ordinance) can be deducted under Profits Tax (under section 16 of the Inland Revenue Ordinance). Such expenditure can be easily argued to be part of the remuneration package that is used to secure the service of an employee (like Mr. Fu) and incurred for business purposes. 3. However, care should be exercised in controlling the way such expenditure is incurred. Such expenditure can result in taxable fringe benefits of Mr. Fu under Salaries Tax. To avoid this, instead of providing cash allowance or cash reimbursement to Mr. Fu, the expenditure should be incurred directly by the service company (Fu Limited). As Mr. Fu is the owner of the service company, such arrangements are, in most, if not all, cases, totally under his control. 4. In the proposed arrangement, there are two factors that are disadvantageous to Mr. Fu: Firstly the current tax rate for a limited company is a flat rate at 16.5% which is higher than most of the progressive tax rates under Salaries Tax. Secondly, unlike Salaries Tax, there is neither a concessionary deduction nor a Page 14 of 16

15 personal allowance available in computing the profits tax liability of the service company. The usual way to overcome these two issues is to have the service company pay Mr. Fu a remuneration that is sufficiently large to utilize his personal allowances and concessionary deductions and to allow Mr. Fu to make use the lower progressive tax rates under Salaries Tax. (b) The Inland Revenue Department can counteract the avoidance of tax through a service company arrangement by applying section 9A of the Inland Revenue Ordinance. Departmental Interpretation and Practice Note No. 25 explains the practice of the Inland Revenue Department and labels this type of service company arrangement as a Type I service company. Section 9A(1) applies to any arrangement under which remuneration for an individual s (Mr. Fu) services is paid by a business (ABC Movie Limited) to a company controlled by the individual himself or by persons associated with the individual (Fu Limited). In particular, if S9A(1) applies, the Inland Revenue Department can totally nullify the effect of forming a service company that is used to disguise an employment. Details are as follows: 1. This section deems the remuneration paid to the service company to be employment income derived by Mr. Fu and is thus taxable under salaries tax. 2. The income paid to Mr. Fu by the service company is not taxable under salaries tax and the profit/loss made by the service company (Fu Limited) is ignored. 3. ABC Movie Limited has to fulfil the obligations as an employer of Mr. Fu under S52 of the Inland Revenue Ordinance, such as reporting to the Inland Revenue Department the deemed remuneration paid to Mr. Fu. There are, however, chances that Mr. Fu can genuinely form a service company to which S9A(1) may not be applicable and through which he provides professional services as movie art director to ABC Movie Limited and other similar movie production companies. Section 9A(3) of the Inland Revenue Ordinance prescribes conditions that exclude the operation of S9A(l). There are six conditions listed in S9A(3) and normally all these six conditions must be satisfied for a service company arrangement to be accepted by the Inland Revenue Department so that S9A(1) is not to be applied. These conditions are factors that distinguish an employment contract (contract of service) and an independent professional contract (contract for service): 1. There is no employment type income paid to the service company (Fu Limited) by ABC Movie Limited, such as annual leave, passage allowance or sick leave. 2. There is no provision in the agreement restricting the services provided by Mr. Fu to companies other than ABC Movie Limited. 3. Mr. Fu is not under the control of ABC Movie Limited similar to that of an employer-employee relationship. 4. The remuneration paid to the service company (Fu Limited) is not paid in a way or calculated on a basis similar to that used in a contract of employment. 5. The service provided by Mr. Fu to ABC Movie Limited cannot be terminated in a manner similar to the dismissal of an employee under a contract of employment. Page 15 of 16

16 6. Mr. Fu is not held out to the public to be an officer or employee of ABC Movie Limited. If not all of the above conditions are satisfied, an exemption from the operation of S9A(1) is still available under S9A(4) where the Commissioner of Inland Revenue is satisfied that at all relevant times, the carrying out of the services in question did not in substance amount to the holding of an office or employment by Mr. Fu with ABC Movie Limited. Based on the facts provided in the examination question, it appears that Mr. Fu cannot meet all six criteria and S9A will probably apply. ****END**** Page 16 of 16