Professional Level Options Module, Paper P6 (HKG)

Transcription

1 Answers

2 Professional Level Options Module, Paper P6 (HKG) Advanced Taxation (Hong Kong) June 2016 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 the directors of Welldone Ltd To: The directors, Welldone Ltd From: Tax adviser Date: 8 June 2016 Subject: HK offshore claim and PRC transfer pricing adjustment We refer to our earlier meeting discussing the tax position of Welldone Ltd (Welldone), in particular, the offshore claim in respect of its PRC sales, and the double taxation issues arising from the transfer pricing adjustment made by the PRC tax authorities. We provide our advice on the respective issues as follows: (i) Chargeability of the profits from sales made in the Hong Kong and PRC markets Under the Hong Kong tax regime, to be chargeable to profits tax, various cumulative conditions have to be satisfied. These conditions are: (1) a business is carried on in Hong Kong; (2) the profits are from that business; and (3) those profits arise in or are derived from Hong Kong (s.14(1)). In Welldone s case, conditions (1) and (2) are both satisfied and condition (3) is therefore critical. Unfortunately, there is no statutory definition for the term arise in or derived from, one has to look to case law for the interpretation. Hong Kong operates on a territorial concept. To determine the source of profits, the broad guiding principle is that one looks to see what the taxpayer has done to earn the profits and where this has been done: the Hang Seng Bank case and HK-TVB International case. The Inland Revenue Department (IRD) sets out what the IRD regards as the general principles in Departmental Interpretation and Practice Note (DIPN) No. 21 (paragraphs 6 to 17) which literally confirms the principles stated by the courts in the aforesaid Hang Seng Bank case, HK-TVB International case, and other subsequent cases, e.g. the Kwong Mile case and the ING Baring case. In general, it is the direct profit-generating activity which determines the source of profit. Any antecedent and incidental activities such as pre-sale preparation and post-sales delivery are not relevant to the determination of source, despite the fact that these activities might be significant from a commercial perspective. Depending on the nature of the profit, different source tests apply to determine the source of profits, making reference to the relevant direct profit-generating activity. In the event that the offshore profit-generating activities are conducted by agents, the agency principle (International Wood Products case, ING Baring case, Li & Fung case) recognises that the agents activities overseas are attributable to the taxpayer in Hong Kong as if the taxpayer conducted the activities overseas. Indeed, the Court of Final Appeal in the ING Baring case expands the agency principle by taking into consideration activities carried out by a third party for the benefits of the taxpayer when determining the source of profits in that case. In the case of trading profits (as in the case of Welldone), the profit-generating activity is considered to be the place where the purchase and sale contracts are negotiated, concluded and effected (commonly referred to as the contract effected test ). Both the purchase and sale would be analysed in order to determine the source of the profit from the trade. Based on DIPN No. 21, if both the purchase and sale are carried out (termed as effected in DIPN No. 21) in Hong Kong, the profit is accordingly sourced in Hong Kong and 100% taxable. If both the purchase and sale are carried out offshore Hong Kong, the profit is regarded as offshore-sourced and not taxable in Hong Kong. However, if either the purchase or sale is sourced in Hong Kong, the IRD s initial presumption is that the trading profit is regarded as Hong Kong-sourced and 100% taxable in Hong Kong. Purchases/sales made from/to suppliers/customers in Hong Kong would be presumed to be sourced in Hong Kong, unless proved otherwise. There is no apportionment for trading profits. Based on the information provided, Welldone purchased products from its associate in the UK and made sales in both the Hong Kong and PRC markets. To date, insufficient information has been provided as to how the purchases were negotiated, concluded and effected, but assuming that the activities leading to the negotiation, conclusion and execution of the purchase contract were performed outside Hong Kong, it is possible that the purchase would be regarded as effected outside Hong Kong. In respect of the sales, given that the sales in the HK market were made by the sales team in Hong Kong, it would be beyond doubt that these sales are Hong Kong-sourced. In the circumstances, the profits earned from the sales made in the HK market would be considered as Hong Kong-sourced and fully taxable in Hong Kong. As for the sales made in the PRC market, provided that the PRC branch is given full authority to negotiate, conclude and effect the sales in the PRC, there is a high probability that these sales would be regarded as sourced outside Hong Kong. In conclusion, the overall position depends on where the activities for the purchasing were carried out and whether such activities played an important part in deriving profits from the trade. If the purchasing activities carried out outside Hong Kong are accepted as being important in deriving the profit from the trade, the profit from the PRC sales would likely be 15

3 offshore-sourced and non-taxable in Hong Kong, while the profit from the Hong Kong sales remains Hong Kong-sourced and taxable. However, if the purchase is regarded as effected in Hong Kong, or if the PRC sales by the branch are regarded as effected in Hong Kong, Welldone would be fully taxable in Hong Kong on all of its profits made from both the Hong Kong and PRC markets. In order for us to further investigate Welldone s tax position, we suggest you provide us with further details about the operations carried out in purchasing and selling the goods sold in the PRC market. (ii) Tax assessment for 2014/15 In order to accelerate the collection of tax revenue, the IRD adopts an assess-first-audit-later system so that assessments are raised based on tax returns filed, and cases are selected for post-assessment scrutiny and audit. Under the Inland Revenue Ordinance (IRO), the IRD is empowered to raise any assessment within six years after the end of the year of assessment for which the profits assessed by the assessment are chargeable to tax (s.60(1)). 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. Based on the six-year time limit, the latest date for issuing an additional assessment, if applicable, for the 2014/15 assessment year will be 31 March In the case of Welldone, the IRD s enquiry into the purchase and sale operation is in order to ascertain whether the offshore claim made in 2014/15 in respect of the profit earned from the PRC sales is or is not justified. If not, Welldone would be regarded as under-assessed, and an additional assessment will be issued to recover the tax undercharged. A penalty may also be raised in the absence of a reasonable excuse for excluding the amount of profits claimed to be not chargeable from the company s assessable profits. In the event that an additional assessment is issued, and the company disagrees with the assessment, a valid objection can be lodged against the assessment under s.64(1) of the IRO. An objection will only be valid if all of the following conditions are fulfilled: (1) The objection is lodged in writing addressed to the Commissioner. (2) The objection states precisely the grounds for the objection. (3) The objection is received by the Commissioner within one month after the date of the notice of assessment, unless the Commissioner extends the permitted period or accepts a late notice of objection based on a reasonable cause. Subject to sufficient evidence, Welldone may also ask for a holdover of the tax in dispute, until the objection is settled. By lodging the objection, Welldone s rights are protected so that it can continue the dispute with the IRD until the objection is finally settled. (iii) Double taxation relief in respect of the PRC transfer pricing adjustment In the context of a double taxation arrangement (DTA), DIPN No. 45 classifies double taxation into economic double taxation and juridical double taxation. Economic double taxation arises where two companies residing in one of the corresponding DTA sides are taxed on the same profit or income while there is no relief granted by either side for the tax imposed by the other side. Juridical double taxation usually occurs when a company is being taxed on the same profit or income in two different countries (or DTA sides), without either side providing relief for tax imposed by the other side. Pursuant to the DTA between the PRC and Hong Kong, Welldone has its head office in Hong Kong (one DTA side) and a permanent establishment (via the branch) in the PRC (the other DTA side). Double taxation may arise if the profits which are taken to have arisen in one side (e.g. the PRC) are adjusted upwards to increase the tax payable in that side (PRC) without a corresponding downward adjustment to the profits taken into account and taxed by the other side (Hong Kong). In simple terms, the same amount of profit or income is being taxed in both sides, a case of juridical double taxation. If the PRC tax authority insists on re-allocating the profit from Hong Kong to the PRC and imposes PRC tax on the profit amount of $300,000 instead of the allocated profit of $200,000, Welldone will primarily suffer double taxation on $100,000. The PRC tax authority is empowered by Article 7 (Business Profits Article) of the PRC HK DTA to impose tax on profits attributable to the permanent establishment through which Welldone carries on business in the PRC. However, if the same profits have been subject to profits tax in Hong Kong, the IRD in Hong Kong is obliged to provide relief to Welldone (under s.50 of the IRO and Article 23 (Methods for Elimination of Double Taxation Article)). Should the need arise, the Hong Kong and PRC tax authorities are empowered by Article 25 (Mutual Agreement Procedure Article) to consult each other in order to reach an agreement to resolve the double taxation problem. In summary, in response to the transfer pricing adjustment made by the PRC tax authority to the PRC branch s profits, Welldone may get relief from the double taxation in any of the following forms: (1) the IRD agreeing that the profit attributable to the PRC branch should have been $300,000 and allowing a tax credit for the additional PRC tax paid; or (2) the PRC tax authority being convinced that its adjustment is incorrect and accordingly reducing the additional tax payable; or (3) the IRD and the PRC tax authorities reaching a mutual agreement on the tax position. 16

4 Should Welldone wish to initiate the procedure for both tax authorities to discuss and reach an agreement, it is required to present the case to the IRD within three years from the first notification to the company of the PRC transfer pricing assessment. If this is not achieved, the IRD would endeavour to resolve the case by mutual agreement with the PRC tax authority. However, Article 25 does not compel agreement, and the IRD clarifies in DIPN No. 45 that relief will be provided only to the extent that the Commissioner agrees both in principle and in amount with the profit reallocation adjustment made by the other DTA side (i.e. the PRC). (iv) Replacing the PRC branch with a PRC incorporated wholly-owned subsidiary Under this proposal, a wholly-owned subsidiary would be established in the PRC and the subsidiary will operate as a separate legal entity from Welldone. As the subsidiary will replace the existing PRC branch, it is reasonable to assume that the goods will be sold by Welldone to the PRC subsidiary which will then on-sell these goods to customers in the PRC. The profit from the sales of goods made to the subsidiary will be recorded in Welldone s books, in a similar way to the profit earned from the sales made to the PRC customers via the branch under the current structure. The question of whether or not such profit would be sourced in Hong Kong and assessable to Hong Kong profits tax still remains. As explained above, this will depend on where the direct profit-producing activities would be regarded as being located. Moreover, the pricing strategy for the goods sold to the subsidiary may be subject to scrutiny by both the Hong Kong and PRC tax authorities. Since the sales will be regarded as transactions effected between associated entities, the issue of transfer pricing arises. Welldone and the PRC subsidiary are associated on the basis that Welldone participates directly or indirectly in the management, control or capital of the subsidiary. In determining the reasonable price for the supply of the goods, the arm s length principle must be observed, making reference to the related transfer pricing rules which are summarised in DIPN No. 46. Under the arm s length principle, the transactions of independent enterprises should be used as a benchmark to determine the transfer price including the allocation of profit and expense between the associated entities. Therefore, the price charged by Welldone for the goods supplied to the subsidiary should be comparable to that which would have been charged if the supply had been made to an independent buyer. If it is found that the sales price of the goods supplied to the subsidiary is understated so that the assessable income of Welldone is understated, the IRD may seek to bring any shortfall of assessable profits into assessment. Alternatively, the IRD may deem that the PRC subsidiary is carrying on business in Hong Kong in such a manner that Welldone makes a profit which is less than the ordinary level, and they may seek to tax the PRC subsidiary on the profit it makes (s.20). However, as the PRC enterprise income tax rate is higher than the Hong Kong profits tax rate, it would be unusual for a Hong Kong company to understate the sales price of goods supplied to a PRC subsidiary. On the other hand, if the sales price to the PRC subsidiary is overstated such that the cost of goods sold is overstated in the books of the subsidiary, the PRC tax authority could challenge the sales price and make a corresponding transfer pricing adjustment. This is similar to the transfer pricing issue encountered under the current structure, except that the type of double taxation involved becomes economical double taxation instead of juridical. Should this happen, relief is still available under the DTA and the mechanism is similar to that described above. In conclusion, from the perspectives of resolving the offshore claim and transfer pricing issues, replacing the current structure with a wholly-owned subsidiary is unlikely to be an effective course of action. We trust that the above addresses all the significant Hong Kong profits tax issues raised. Should there be any questions, please let us know. End of Report 2 Mrs Johnson (a) Position in respect of her employment with KK Ltd Under the Inland Revenue Ordinance (IRO), salaries tax is charged on income from an employment, office and pension arising in, or derived from, Hong Kong (s.8). Income from employment includes income derived from services rendered in Hong Kong and excludes income derived from services rendered outside Hong Kong (s.8(1a)). In the case of employment income, the court ruled in the Goepfert case that the source of employment income should first depend on the source of the employment, which is where the employment is located. If the employment is located in Hong Kong, the employment income is fully taxable unless the employee renders ALL their services outside Hong Kong (s.8(1a)), or the employee visits Hong Kong for not more than 60 days in the year of assessment in issue (s.8(1b)). However, if the employment is located outside Hong Kong (that is, a non-hong Kong employment), only the income derived from services rendered in Hong Kong, including attributable leave pay, is chargeable to salaries tax. In this case, the amount of assessable income is usually computed based on time-in-time-out, with the exception that no tax will be charged if the employee only visits Hong Kong for not more than 60 days in the year of assessment in issue. Due to the different rules applicable to ascertaining the assessable income, it is critical to first identify the criteria leading to the location of employment. Based on the Goepfert case, the Inland Revenue Department (IRD) takes the position in Departmental Interpretation and Practice Note (DIPN) No. 10 that an employment is a non-hong Kong employment where the following three factors are present: (1) the contract of employment was negotiated, entered into, and is enforceable outside Hong Kong; 17

5 (2) the employer is resident outside Hong Kong; and (3) the employee s remuneration is paid to him outside Hong Kong. If all of the above factors are not outside Hong Kong, the first two factors become more important. However, when the employer is resident in Hong Kong (the second factor), the IRD tends to accept that the employment is a Hong Kong employment. The IRD also reserves the right to look beyond these three factors where in reality the employment is a Hong Kong employment but manipulation exists. Mrs Johnson s employer, KK Ltd, would be regarded as resident in Hong Kong on the basis that it has its central management and control in Hong Kong. Therefore, her employment would be regarded as a Hong Kong employment and she will be chargeable to salaries tax on all of her income from her employment with KK Ltd. The exemption for services rendered outside Hong Kong (under s.8(1a)) is not available to Mrs Johnson because she renders services in Hong Kong, and her presence in Hong Kong will be that of either a non-visitor or likely more than 60 days. No time-apportionment is applicable to a Hong Kong employment. In terms of the remuneration, Mrs Johnson s salary will be fully assessed to salaries tax. The housing reimbursement for her apartment is a kind of accommodation benefit statutorily specified as taxable as long as it represents a reward from employment. The taxable value is not the amount of the reimbursement made to Mrs Johnson, but is calculated by way of a rental value reduced by the amount of rent suffered (i.e. cost incurred) by Mrs Johnson. The rental value is equivalent to 10% of Mrs Johnson s assessable income from the employer (excluding any share option gain, retirement sum or terminal payment) after deducting the allowable expenses and depreciation allowance. The rateable value of the property (according to the Rating Ordinance), if lower, could be used instead. In this case, assuming that there are no eligible deductions, Mrs Johnson s assessable income, including the taxable value of the accommodation benefit, will be: $ Salaries ($150,000 x 12) 1,800,000 Rental value ($1,800,000 x 10%) 180,000 Less: rent suffered ($100,000 x 20% x 12) (240,000) 0 Assessable income from employment 1,800,000 (c) Position in respect of the sub-letting of the apartment Mrs Johnson received income of $50,000 in total from her flatmate for sharing the apartment with her. Despite the income being derived from the leasing of a Hong Kong property, Mrs Johnson will not be subject to property tax in Hong Kong for the reason that property tax is only imposed on the owner of the properties (s.5(1)). In this case, the apartment is leased by Mrs Johnson, and the income is in the nature of sub-letting income. Business is defined to include the letting or sub-letting of property by a corporation, and the sub-letting by any other person of any property or portion of the property held by him/her under a lease or tenancy other than from the Government (s.2). In the circumstances, Mrs Johnson will be regarded as carrying on a business in Hong Kong through the sub-letting of her leased apartment. Profits tax is imposed on a trade, profession or business carried on in Hong Kong in respect of profits arising in or derived from Hong Kong (s.14(1)). So, Mrs Johnson will be subject to profits tax in respect of the income of $50,000 arising from the sub-letting of her apartment. The profits tax rate is 15% on the assessable profits which take into account all relevant expenses and outgoings which are incurred in the production of those assessable profits (s.16). It is therefore possible to deduct related expenses such as rent, management fees and repairs. Given that the income is derived from sub-letting part of the property, any property-related expenses would need to be apportioned on a reasonable and justifiable basis if a tax deduction is to be sought. Documentary evidence is required. Overall, Mrs Johnson would be chargeable to both salaries tax and profits tax for the year of assessment 2015/16. Under the IRO, personal assessment provisions provide an opportunity for a taxpayer to elect to aggregate all income from different sources and be assessed based on the total income before Part V allowances apply. For a taxpayer who is assessed at progressive tax rates after Part V allowances, electing personal assessment would normally result in a tax saving. However, the personal assessment election is only applicable to individuals who are aged 18 or above, and are permanent or temporary residents of Hong Kong (s.41(1)). A permanent resident is defined as an individual who ordinarily resides in Hong Kong, and a temporary resident as an individual who is present in Hong Kong for a period or periods during the year of assessment of more than 180 days, or 300 days in two consecutive years, one of which is the year for which an election is sought (s.41(4)). Mrs Johnson may not be accepted as a permanent resident, given her employment is only on a two-year contract. However, if she can prove that she has resided in Hong Kong for more than 180 days during the year of assessment 2015/16, she can still elect for personal assessment as a temporary resident. Effect of property acquisition on the tax position (1) Low-interest-rate loan Mrs Johnson will pay KK Ltd a monthly loan repayment as well as interest on the employer loan. The interest rate is preferential compared to the market rate, and thus she will benefit from savings in interest payments. There are two issues here: whether the savings in interest become taxable income to Mrs Johnson, and whether Mrs Johnson is eligible for any tax deduction for the interest incurred. The interest cost will be incurred on the employer loan which is used to finance the acquisition of the property. Provided that the property is occupied by Mrs Johnson exclusively as her principal place of residence, and the loan is charged 18

6 over a property in Hong Kong, the interest is eligible for a deduction as home loan interest against Mrs Johnson s assessable income in Hong Kong for salaries tax purposes. The maximum amount of deduction for each year is only $100,000 and the deductions may be granted for a maximum of 15 years of assessment, which need not necessarily be consecutive. If the property is to be acquired jointly or in common between Mrs Johnson and any others, Mrs Johnson will still be eligible for a home loan interest deduction for her proportionate share of the total interest cost. For example, if Mrs Johnson owns 50% of the property, she will be eligible for a deduction of 50% of the total interest cost, and the maximum statutory deduction will be reduced to $50,000 per annum. In respect of the benefit from the interest savings representing the interest differential between the market rate and the rate charged by the employer, the IRD clarified in DIPN No. 16 that such benefits would not be assessable if it is the sole liability of the employer and is not of itself convertible into money. Therefore, it would be advisable that Mrs Johnson s employer finance the loan without any guarantee provided by Mrs Johnson and Mrs Johnson is restricted from re-lending the loan money to others in return for a higher interest income. (2) Conversion of the housing reimbursement to salary to be used for loan repayments Following her acquisition of the apartment, Mrs Johnson will be the owner of the property in which she lives, and thus no longer in receipt of any accommodation benefit from her employer. Going forward, no rental value will be calculated and assessable. If the employer agrees to continue to pay an amount equivalent to the 80% reimbursement of accommodation cost under the current arrangement, i.e. $80,000 per month, this amount would be regarded as additional salary which is fully assessable. The fact that the additional amount would be used to repay the outstanding employer loan is irrelevant for tax purposes. The loan repayment would not be tax deductible, save for the interest portion which could be deducted as home loan interest (as above). 3 (a) Alan, Barbara and Calvin (i) Each purchaser and vendor of immovable property is required to execute an agreement for sale (AFS) within 30 days after the relevant date (s.29b(1) of the Stamp Duty Ordinance (SDO)). The AFS is chargeable with stamp duty (under s.29c(2)) in accordance with the provisions of Head 1(1A) of the First Schedule to the SDO. Because Barbara already owned a residential property in Hong Kong at the time of the acquisition, ad valorem duty (AVD) at Scale 1 will be payable on the entire stated consideration or full value of the property, whichever is the higher, regardless of the respective share of interest of the purchasers in the property acquired. The fact that Barbara is a close relative of Alan who did not own any other residential property in Hong Kong does not make any difference. Therefore, the AVD is payable at 4 5% on $4 million, i.e. $180,000; and in addition, the conveyance on sale is chargeable with a fixed duty of $100 (s.29d(2)(a)). If the AFS is not stamped, the total payable will be the same, the conveyance on sale is chargeable under Head 1(1) at 4 5% on $4 million, i.e. $180,000; and the AFS is chargeable with a fixed duty of $100 (s.29d(2b)(iii)), subject to a penalty for late stamping. Because of the inadequacy of the consideration, the transfer of Calvin s share in the property is regarded as a voluntary disposition inter vivos (s.27(4)). As such, stamp duty is chargeable on the market value of the property transferred (s.27(1)). AVD payable at the Scale 1 rate is $21,000 ($4 2 million/3 at 1 5%). In addition, special stamp duty (SSD) will be imposed, because the transaction relates to a residential property which was acquired after 27 October 2012 and disposed of within 36 months (s.29ca and s.29da). Since Calvin disposes of his share within six months of acquisition, the SSD payable will be $280,000 ($1 4 million at 20%). Buyer s stamp duty (BSD) is not chargeable because although the property is a residential property, all three purchasers are Hong Kong permanent residents (HKPRs) acquiring the residential property on his/her own behalf (i.e. the person is both the legal and beneficial owner). (ii) If Calvin is not a HKPR, upon the purchase of the residential property on 1 February 2016, Scale 1 AVD rates still apply on the basis that one of the purchasers (Barbara) already owned a residential property in Hong Kong at the time of acquisition. The fact that Calvin is not a HKPR would not change the conclusion. On the contrary, had Barbara not owned a residential property in Hong Kong at the time of acquisition, the non-hkpr status of Calvin would have been relevant to cause the Scale 1 rate to apply. In addition, BSD would be payable at the flat rate of 15% on the full value of the property, regardless of the proportion of the non-hkpr s (Calvin s) share of the interest and would therefore be $600,000 ($4 million at 15%). Upon the transfer of Calvin s share in the property to the other two purchasers (Alan and Barbara), the liability to AVD and SSD remains the same even if Calvin is a non-hkpr. However, BSD would not be payable as Calvin is the seller in this transaction, and the purchasers are HKPRs. Ace Ltd, Best Ltd and Champion Ltd (i) The documents in the acquisition of the shares in Best Ltd are the bought and sold notes for the shares and the instrument of transfer. The bought and sold notes are dutiable under Head 2(1) of the First Schedule to the SDO and stamp duty is payable on both notes at the rate of 0 2%, i.e. $18,000 ($9 million at 0 2%). The instrument of transfer is dutiable under Head 2(4) at a fixed duty of $5. The documents for the formation of the subsidiary, Champion Ltd, do not fall within any of the charging heads for stamp duty and are not dutiable. 19

7 (ii) (iii) Stamp duty payable on a two-year lease is 0 5% of the average yearly rent (Head 1(2)(iii)) and at 4 25% of the premium (Head 1(2)(a)). In this case, the rent payable is $50,000 per month plus an unascertainable amount attributable to the future turnover of the business. It is clear that stamp duty can only be charged on amounts which are ascertainable at the time the lease is entered into. At the beginning of the lease, the amount of future turnover is speculative, and it therefore follows that no duty can be levied in respect of the rental payment attributable to the turnover. Therefore, the stamp duty payable on the lease will be $7,250 (($50,000 x 12) at 0 5% + $100,000 at 4 25%). A fixed duty of $5 is payable on any duplicate or counterpart (Head 4). Stamp duty is payable despite the fact that Best Ltd and Champion Ltd are associated (Ace Ltd is the beneficial owner of not less than 90% of the issued share capital of both Best Ltd and Champion Ltd), because the exemption for property transfers between associated bodies corporate (under s.45) is not applicable to leases. It is fundamental that stamp duty is levied only on written documents, and not on transactions. Therefore, no stamp duty would be payable if the lease agreement is not evidenced in writing but only made by an oral agreement. Since the lease does not exceed three years, it does not need to be evidenced in writing and it could be entered into by oral agreement. Where the lease stipulates a certain figure (as a minimum or maximum amount) on account of an unascertainable amount, that figure can be taken into account in ascertaining the stamp duty payable. Thus, the average yearly rent, to which the 0 5% rate would be applied, will be $960,000 ($80,000 x 12); and the stamp duty payable will be $9,050 (($960,000 at 0 5%) + ($100,000 at 4 25%)). 4 Daniel (a) Proposed sale of business assets Daniel will make a profit of $29 million ($88 million $59 million) from selling his business assets to Takeover Ltd (Takeover). In general, any profits arising from the disposal of capital assets, being the designs, shop premises, warehouse, plant and machinery and business goodwill, will not be taxable (s.14). But profits arising from the sale of revenue assets, being the inventory, will be taxable. In this regard, it is fundamental that the agreement between Daniel and Takeover sets out the allocation of the total sales price of $88 million between the different assets being sold, so that the profit (or loss) attributable to each asset can be calculated. In the event that the parties fail to agree to make this allocation themselves, the Inland Revenue Department (IRD) is likely to treat each asset as having been disposed of at its fair market value. In agreeing these values, the following considerations with respect to the individual assets should be taken into account: Designs Capital expenditure on designs is by general principle not tax deductible. However, the cost of purchasing registered designs can be deductible if the specified conditions are fulfilled (s.16ea). The tax deduction is granted over five successive years (or a shorter period when the design is due to expire at the end of its maximum period of protection) on a straight-line basis starting from the year of acquisition. However, where the designs are subsequently sold, the excess of the relevant sale proceeds over the balance of unclaimed acquisition costs (if any) will be treated as a taxable trading receipt. The amount of the taxable receipts cannot exceed the amount of the tax deductions previously allowed. If the relevant sale proceeds are smaller than the balance of the unclaimed acquisition costs, the unclaimed balance can be deducted in the basis period during which the sale occurs. On the other hand, if Daniel developed and registered the designs himself, rather than purchasing existing designs from a third party, no deduction would have been allowed on the basis that the costs were not incurred to purchase the asset. Instead, if the costs had been capitalised as research and development, Daniel might have been able to seek a tax deduction for research and development expenditure (s.16b). If a deduction for the capital expenditure incurred in developing the designs was allowed, then the sale proceeds of the designs would be treated as a trading receipt and taxable, subject to a limit of the total amount of deduction claimed. Assuming that either s.16ea or s.16b applies, it would be in Daniel s interest to allocate a value to those designs equal to his original acquisition price, rather than their current market value. This is because Daniel would otherwise be subject to tax on the excess. Because this price for the designs would have been negotiated with an independent third party, it is questionable whether the Commissioner would have any power to challenge an allocation made at less than fair market value. However, the Commissioner could seek to apply the general anti-avoidance provisions in s.61a to challenge any price below the market value. Shop premises and warehouse The positions with respect to the shop premises and warehouse are similar in that both buildings would have qualified for depreciation allowances, namely, commercial building allowances for the shop premises and industrial building allowances for the warehouse. Since the manufacturing business carried on by Daniel is a qualifying trade, any building (except a retail shop) used in a qualifying trade is a qualifying industrial building (s.40(1)). Where the relevant interest in a commercial or industrial building is sold, a balancing charge or a balancing allowance is to be calculated by comparing the sale proceeds with the residue of expenditure. Any balancing charge is restricted to the total of the allowances claimed. However, depreciation allowances are applied only with respect to the construction cost of the buildings, not to the cost of the underlying land. For the purpose of determining balancing allowances and balancing charges 20

8 on disposal of the buildings, it will be necessary for Daniel not only to seek to agree the values to be allocated to the shop premises and the warehouse, but also for the values to be allocated between the buildings and the land. The former amount would then determine the extent to which Daniel would be subject to any balancing adjustment with respect to those buildings. Depending on the tax written-down values of the buildings, it would be in Daniel s interest to seek to allocate a low value to the buildings. Also, ad valorem stamp duty at Scale 1 rates ranging from 1 5% to 8 5% will be payable on the legal assignments of the shop premises and warehouse. The amount subject to stamp duty will be based on the amount of the consideration which is allocated to the shop premises and warehouse. Thus, to minimise stamp duty, the parties would have an interest in seeking to allocate a low value to the shop premises and warehouse. However, this must be done within reason because, if the Collector of Stamp Revenue were to believe that the parties have artificially deflated the price to be paid for the properties, he would seek to raise the stampable value to the market value of the property by invoking the voluntary disposition inter vivos provisions (s.27 of the Stamp Duty Ordinance) and the Ramsay principles. Conversely, if the parties allocate an excessive amount to the buildings, they will end up paying an unnecessarily high amount of stamp duty. Plant and machinery The plant and machinery will also have been depreciated by Daniel for tax purposes. It is quite possible that the tax written-down value of the plant and machinery is less than its market value. It therefore follows that, if Daniel sells the plant and machinery at market value, he will suffer a balancing charge which would be taxable. Again, the balancing charge will be limited to the amount of any depreciation allowances claimed, and any excess treated as a tax-free capital gain. It would therefore be preferable for Daniel to seek to allocate an amount equal to its existing tax written-down value to the plant and machinery (or, even better, a lower amount, because this would give him a balancing allowance which would be deductible). Within reason, there is scope for Daniel to negotiate an advantageous allocation of the total purchase price to these assets. However, where different assets are sold together for one price, the IRD has the power to allocate a purchase price to each individual asset (s.38a). This is what the IRD would seek to do if the parties fail to agree and make their own allocation, or if they allocate an excessively low amount, to the plant and machinery. Nevertheless, as a practical matter and within reason, there is scope for some tax planning here. Inventory Any profit made by Daniel on the sale of the inventory will be taxable, and any loss will be tax deductible. It is therefore in his interest to sell the inventory at as low a price as possible, even if this is at less than market value. Where a person who ceases to carry on his/her business sells his/her trading stock to another person who carries on or intends to carry on business in Hong Kong (such as in this case), the value of the inventory shall be taken to be the amount realised on the sale (s.15c). Within reason, Daniel and Takeover are free to allocate a value to the inventory which need not necessarily equate with its market value; and Daniel should therefore seek to allocate a lower amount to the inventory. Tutorial note: While the allocation of a lower amount to the inventory will benefit Daniel, it will result in Takeover paying more tax because the amount deductible for cost of goods sold will be reduced. Therefore, Takeover is likely to seek to negotiate as high a price as possible, even greater than Daniel s cost price. So it is quite possible that they will end up allocating the fair market value to the inventory. Trade receivables The trade receivables would appear to have no tax impact, assuming they are sold at their face value, which is the same as their market values in this case. These amounts represent unpaid prices for goods sold, and will have already been taxed when the receivables arose. It might make sense for Daniel to allocate values to the receivables which are greater than their face values, because he would not be taxed on any excess which is a capital gain; but this is exposed to a resisting adjustment by the IRD under s.61a. On the other hand, if Daniel were to allocate a lower amount to the receivables it would not save any tax, as it is unlikely that he would be able to claim a bad debt deduction. Therefore, a transfer at face value appears to be most appropriate. Tutorial note: Takeover will likely request Daniel to ensure that all potential uncollectables are adequately allowed for before the transfer because it will not be entitled to a deduction for any bad debts as these receivables will not have been included in the assessable receipts of Takeover. Goodwill The assets of the business are worth $84 million, but Daniel will receive $88 million. In general, the excess of $4 million would be regarded as business goodwill, which would constitute a non-taxable capital profit generated from the disposal of a long-term business. Waiver of debt If Takeover were to waive the debt, then the amount of $300,000 would be taxable on Daniel if he has previously deducted this amount for tax purposes, e.g. via cost of sales; or, if it arose in the current year, it would not be deductible (s.15(2)). Daniel would be better advised to pay the debt, and to seek an additional $300,000 from Takeover as part of the purchase price for the business. In this case, he would not be subject to tax on that amount if it is allocated to goodwill or to another capital asset where it would constitute an excess amount over cost, which would be treated as a non-taxable capital gain. 21

9 5 Won Ltd (a) (c) Tax compliance obligations As a company carrying on business in Hong Kong and as an employer, Won Ltd (WL) has to comply with the following compliance obligations: Since WL has received income chargeable to tax in Hong Kong (under s.51(2)), it has to notify the Inland Revenue Department (IRD) within four months after the end of the basis period for the relevant year of assessment in which the chargeable income is received, unless it has been required to file a tax return by the IRD. If the first accounts are closed on 31 March 2015, the first relevant year of assessment would be 2014/15. The basis period for this year of assessment is 1 June 2014 to 31 March 2015, and four months from the end of the basis period would be 31 July Therefore, WL should have notified the IRD of its chargeability to tax on or before 31 July 2015, unless a tax return had been issued to it before that date. If the first accounts are closed on 31 May 2015, the first relevant year of assessment would be 2015/16. The basis period for this year of assessment is 1 June 2014 to 31 May 2015, and the due date for WL to notify its chargeability would have been 30 September If WL has been issued with an annual tax return by the IRD, the company is obliged to complete and submit the return within the period stipulated, together with its audited accounts (s.51(1)). Normally, one month is allowed for filing purposes but in practice, an extension would be given upon application depending on the situation. WL also has to maintain proper business records in respect of transactions conducted for a period of at least seven years (s.51c). As WL has employed staff and incurred salary expenses, it is obliged to complete and submit notifications of commencement of employment within three months of commencement, as well as an annual employer s return in respect of each member of staff, giving details of the staff involved and the remuneration paid (ss.52(2) and 52(4)). It is also required to submit notification of any employee who is about to cease to be employed within one month before cessation (s.52(5)); notification of any employee who is about to leave Hong Kong for more than one month other than for a business purpose, one month before the employee s departure (s.52(6)); and to retain money payable to any employee who will cease employment and leave Hong Kong for one month from the date of the notice (s.52(7)). Defects in the notice The notice sent to Won Ltd by the assessor is defective on the following grounds: (1) The notice should be sent in the name of the Commissioner or Deputy Commissioner. An assessor has no power to send this notice in the capacity of an assessor. (2) Only the Commissioner or the Deputy Commissioner has the power to raise an assessment under s.82a. The assessor has wrongly indicated that he has this power by stating I propose to assess additional tax. (3) The notice must inform WL of its right to submit written representations. This was not done. (4) The notice must specify a date by which the representations (as in (3)) must be received. This date must not be sooner than 21 days from the service of the notice. The only date specified in the notice related to queries only and states that these should be received by the assessor within 14 days. (5) The maximum amount of additional tax payable under s.82a is three times the amount of the tax undercharged, or which would have been undercharged, as a result of the non-submission of the return. The assessor states a maximum amount of $330,000 whereas the maximum can only be $247,500 (3 x $82,500). (6) Proceedings under s.82a is an alternative to prosecution. Therefore, once an assessment has been made under s.82a, WL could not, as was suggested by the assessor, be further prosecuted (under either ss.80(2) or 82(1)) on the same facts (see s.82a(7)). Reasonable excuse (i) A person is not liable to be assessed under s.82a if he/she has a reasonable excuse for committing the wrongdoing in respect of which the tax under s.82a is charged on him/her. There is no statutory definition of reasonable excuse and what constitutes a reasonable excuse depends on the circumstances of each case. In D13/85, the Board of Review described the concept of reasonable excuse as follows: We consider that the correct test to be applied in ascertaining reasonable excuse is what one would expect a reasonable person to do in all of the circumstances. A reasonable person is not a perfect person, but an average person using the reasonable skill and care in handling his taxation affairs which one would expect to see from such an average person. Therefore, a person would have to show that he/she acted reasonably and in good faith in doing what he/she did as an average person would have, and that a reasonable person would regard this as an excuse consistent with a reasonable standard of conduct. 22

10 (ii) This proposition can be illustrated by reference to various decisions of the Board of Review as below: In BR80/76, an individual was held to have a reasonable excuse by having an honest and reasonable belief that the transactions entered into were not trading transactions subject to profits tax. BR80/76 is also an authority for the view that a reasonable excuse may exist if a person relied upon professional advice that the income was not taxable, even though it subsequently proved to be taxable (see also D59/87). However, mere reliance on professional advice may not prevent the application of s.82a where that reliance is unreasonable in the circumstances (see BR1/82 and D28/84). In Dodge Knitting Co Ltd v CIR and D2/81, the taxpayer was held to have a reasonable excuse where the taxpayer had no income or losses for the year in which the penalty tax assessment was raised. However, it was held in BR7/79 that it was not a reasonable excuse for understating income in a salaries tax return on the ground that the amount in question had been correctly reported in the employer s return and that therefore the Commissioner had the true information in his possession anyway. Whether the resignation of the company s accountant can be regarded as a reasonable excuse depends on various factors. Usually the return would have been issued on 1 May 2015, which is the month in which the accountant resigned. In order to establish that the accountant s resignation is a reasonable excuse for the failure to submit the return as required, the following should be proved: (1) the resignation caused WL to have no resources to prepare the return; (2) WL, upon notice of the accountant s resignation, had taken all possible measures including recruiting a replacement and/or out-sourcing to obtain resources to prepare the return; and (3) WL failed to obtain the resources to prepare the return before the due date. It is up to WL to prove this to the satisfaction of the Commissioner or his deputies and upon appeal, if any, the Board of Review and the courts if applicable. 23

11 Professional Level Options Module, Paper P6 (HKG) Advanced Taxation (Hong Kong) June 2016 Marking Scheme Available Maximum 1 (i) Chargeability of the profits from sales made in the Hong Kong and PRC markets Conditions of s.14(1) 1 Application in this case 1 Broad guiding principle 0 5 Direct profit-generating activity 0 5 Antecedent and incidental activities are irrelevant 1 Different source tests 1 Agency principle 1 Contract effected test 1 Conditions leading to profits as onshore 1 Conditions leading to profits as offshore 1 Need for further information (ii) Tax assessment for 2014/15 Explain the assess-first-audit-later system 1 Power to raise assessment within six years 1 If fraud or wilful evasion, ten years 0 5 Due date for 2014/15 additional assessment 0 5 Purpose of IRD s enquiry 1 Conditions for valid objection 1 5 Holdover of tax in dispute (iii) Double taxation relief in respect of the PRC transfer pricing adjustment Two types of double taxation 1 Explain economic double taxation 1 Explain juridical double taxation 1 Explain Welldone s case is juridical double taxation 1 Power of the PRC to impose tax (Art 7) 1 IRD obliged under DTA to grant relief (s.50, Art 23) 1 IRD may grant tax credit for PRC tax paid 1 PRC may be convinced incorrect and adjust back 1 Mutual agreement between PRC and HK tax authorities (Art 25) 1 Taxpayer to present the case to the IRD within three years 1 Relief only if IRD agrees in principle and in amount (iv) Replacing the PRC branch with a PRC wholly-owned subsidiary Separate legal entity 0 5 Source of sales profits, same as currently 0 5 Pricing strategy subject to scrutiny 0 5 Associated entities, with reason 1 Arm s length principle 1 Transfer pricing risk in HK 1 PRC subsidiary profits may be deemed HK sourced (s.20) 1 Transfer pricing risk in PRC 1 Double taxation economical 0 5 Conclusion: Double taxation risk and relief similar to currently Appropriate format and presentation 1 Logical development 1 Effectiveness of communication