Professional Level Options Module, Paper P6 (HKG)

Transcription

1 Answers

2 Professional Level Options Module, Paper P6 (HKG) Advanced Taxation (Hong Kong) June 2017 Answers Cases are given in the answers for educational purposes. Unless specifically requested, candidates are not required to quote specific case names to obtain the marks. Only the general principles involved are required. The suggested answers are in the nature of general comment only. They are not offered as advice on any particular matter and should not be taken as such. No reader should rely on the suggested answers as the basis for any decision. The examiners expressly disclaim all liability to any person in respect of any direct, indirect, incidental, consequential or any other damages relating to the use of the suggested answers. 1 Report to Fortune Jewel Ltd To: Mr Ng, CEO of Fortune Jewel Ltd (FJL) From: Tax adviser Date: 8 June 2017 Subject: Business re-engineering We refer to our discussion with you on the proposed re-engineering of FJL s retailing business and the related tax issues arising therefrom. As requested, we provide below our comments on the respective issues. (a) Termination of leases application of rental deposits to cover rental payment FJL intends to terminate the leases of three stores by issuing a three-month termination notice to the landlords as per the lease terms. The lease rentals during the three-month notice period will not be paid but FJL will request the landlords to apply the rental deposits to cover the lease rentals. On the assumption that three months rental was paid as a deposit at the time of signing the leases, there should be no excess or deficiency in the rental deposit covering the rental payments. The following comments assume that the landlords will agree to applying the respective deposits held by them against the remaining three months rentals payable by FJL. From an accounting perspective, it is expected that FJL will write off (i.e. credit) the rental deposit from accounts receivable to (i.e. debit) rental payments as operating costs. From a tax perspective, the implication for FJL is whether in these circumstances the rental payment is tax deductible. Under s.16(1) of the Inland Revenue Ordinance (IRO), an expense or outgoing must be incurred during the basis period for the year of assessment in the production of profits chargeable to profits tax for any period, unless the expense or outgoing is disallowed under s.17 by reason of, inter alia, being capital in nature. In FJL s case, there is no question that FJL is liable and thereby incurs the liability to pay the rental payments for the three months when these payments are due pursuant to the lease contracts, i.e. within the year ended 31 March The issue is whether the rental payments for the three months will be incurred when the payments will be effected by the landlords invoking their rights under the lease agreements to offset such rental payments due in that year by the rental deposits paid before the basis (i.e. accounting) period. In the Secan decision, the Court of Final Appeal held that interest expenses were to be deducted for tax purposes not when they were paid, but when they were amortised in the claimant s profit and loss account if such amortisation was not inconsistent with the IRO. Although the Secan case relates to interest expenses, the current position of the Inland Revenue Department (IRD) in applying the deduction principle is also relevant to FJL s position in respect of the rental deposits. In Departmental Interpretation and Practice Note (DIPN) No. 40, the IRD applied the Secan case to prepayments and opined that prepayments are deductible only when they are charged to the profit and loss account (or income statement) in accordance with generally accepted accounting principles, provided that such charge is not inconsistent with the IRO. Hence, despite the rental deposit being paid in previous years, it is not charged (i.e. debited) to the profit and loss account (or income statement) for the reason that it is refundable by the landlord, and thus is an asset instead of a liability to FJL. However, upon termination of the leases and consents by the landlords to apply the rental deposits to settle the rental payments, the rental deposits will be written off to the profit and loss account (or income statement) as expenses. As a result, FJL should be entitled to have the three-month rental payments (in amounts equal to the rental deposits) deductible against its assessable profits for the year ended 31 March (b) (i) Sale of retail store owned by FJL Profit from sale According to the IRO, profits arising from the sale of capital assets are excluded from assessment (s.14). Whether or not an asset is a capital asset is a question of fact rather than a matter of law. The decision has to be made by reference to the factual circumstances, including FJL s intention on acquiring the asset in issue and when holding it. In the case of FJL, the store has been held by FJL since 2010 for use in its retail operations which has been its principal line of business since the store was acquired. In the absence of other information indicating that FJL had the intention upon acquiring and during the ownership of the store of reselling it for a profit, the building would be regarded as a capital asset. It follows that any profit from its sale is not chargeable to profits tax. Depreciation adjustments In the year of assessment during which the building is sold, a balancing adjustment, either a balancing charge or balancing allowance, as the case may be, has to be made on FJL. FJL s assessable profits will be increased by a balancing charge (i.e. the excess of the sale price over the residue of expenditure, up to the aggregate of allowances granted before); or reduced by a balancing allowance (i.e. the excess of the residue of expenditure over the sale price). 13

3 (ii) The residue of expenditure means the capital expenditure as reduced by the allowances granted. This adjustment applies to any building which qualifies for industrial building allowance (IBA) or commercial building allowance (CBA). In FJL s case, in order to calculate the balancing adjustment, it is necessary to first ascertain the total allowances claimed in all previous years since acquisition. Broadly speaking, any building or structure other than an industrial building or structure is defined as a commercial building (s.40(1)). In FJL s case, the building (store) has been occupied and used as a retail store, which does not fall within the qualifying uses for industrial building allowance purposes. As a result, the building qualifies as a commercial building for depreciation allowance purposes. Given that the building was bought from the property developer, the rate of annual CBA should be 4%, based on the qualifying expenditure determined by the capital expenditure incurred on construction of the building and structure, excluding the land value. It is given that annual tax depreciation has been claimed on $12 million which is the qualifying expenditure for tax purposes. Assuming that the building was immediately put into use in the year of acquisition, i.e. in 2010, annual CBA at 4% on $12 million should have been claimed for eight years starting from the year of assessment 2009/10 (acquisition in March 2010) up to the year before its disposal of 2016/17. Therefore, the balancing adjustment to FJL is estimated as follows: $ Qualifying expenditure 12,000,000 Annual allowance: $12,000,000 x 4% = $480,000 Total annual allowance from 2009/10 to 2016/17 ($480,000 x 8) (3,840,000) Residue before sale 8,160,000 Year of assessment 2017/18 (year of disposal): $ Residue before sale 8,160,000 Sale price (building portion $30,000,000 x 80%) (24,000,000) Excess of sale over residue 15,840,000 Balancing charge limited to total allowance claimed before 3,840,000 Annual deprecation allowance available to the purchaser You are also interested in knowing the purchaser s tax depreciation allowance position following their acquisition of the store building. Assuming that the building continues to qualify as a commercial building to the purchaser, annual CBA will be allowed. However, the annual allowance will be at a rate different from 4%, given that the store building is not first used by the purchaser. The estimated annual CBA to the purchaser is as follows: Year of assessment 2017/18 (assumed used by purchaser): $ Residue before sale 8,160,000 Balancing charge taxable on seller (FJL) 3,840,000 Residue after sale, qualifying expenditure for CBA to buyer 12,000,000 Annual allowance each year from 2017/18 onwards ($12,000,000 x 1/18)** 666,667 ** Year of assessment in the basis period for which the sale takes place 2017/18 25th year after 2009/10 (year of first use) 2034/35 Number of years from 2017/18 to 2034/35 18 years Final year of allowance to the purchaser 2034/35 ($666,661) (c) (i) Redundancy payment and additional gratuity implications for FJL The general rule for the deductibility of expenses requires that the expense and outgoing must be incurred during the basis period for the year of assessment in the production of profits chargeable to profits tax (s.16(1)). An expense which is capital in nature is disallowed (s.17(1)(c)). However, the IRO does not define a capital expense, and thus the rules generated from common law would have to be observed. In the case of redundancy payments made in accordance with the statutory requirement, it has been established in CIR v Cosmotron Manufacturing Company Limited that, despite the payment being made at the time of cessation of a business, the payments represented a discharge of a statutory obligation incurred in the running of the business prior to its cessation. More importantly, since it is statutorily required, the liability to pay will have accrued as a cost of employing staff from the time the staff are employed, even though this liability does not crystallise until actual payment is due. On this reasoning, the redundancy payment made under the statutory requirement will be tax deductible to FJL. As for the additional gratuity, the extent to which it is deductible depends on the nature and purpose of its payment. If it represents a reward for past services like a bonus, or a token of appreciation for the staff s loyalty, it would normally 14

4 (ii) be treated as a normal staff cost incurred in the course of operation, and thus tax deductible. It is recommended that FJL maintains sufficient evidence to prove the true purpose of making the gratuity, and justifies it by way of calculation and documentation. Redundancy payment and additional gratuity implications for leaving staff From the perspective of the leaving staff, the taxability of the redundancy payment and gratuity depends on whether it is considered as income from employment (s.8(1)(a)) which includes a reward for services, or as compensation for the deprivation of rights. The former would be taxable under salaries tax, and the latter would not be taxable. A redundancy payment is an income from employment for past services. However, if the redundancy payment is effectively a severance payment calculated and paid according to the Employment Ordinance in Hong Kong, it is not taxable to the leaving staff. However, any excess of the payment over the statutory amount will be taxable. As for the gratuity, if it is the intention of FJL to make the payment in appreciation of the past services rendered by the leaving staff, it is clearly a reward for services and taxable to the staff under salaries tax. However, if there is sufficient documentary proof to justify that the payment is to compensate the staff for the loss of office and such compensation is not provided for in the employment contract, it is possible to argue that the payment is not taxable. (d) (i) Additional funding through an interest bearing loan from FJL s shareholder, Precious Stone Ltd (PSL) If PSL injects additional funding into FJL in the form of an interest bearing loan, then an interest expense will be paid by FJL to its shareholder. The tax deductibility of the interest expense incurred on the loan will depend on: whether the loan interest is incurred in the production of assessable profits (s.16(1)); and whether the loan money is used for the production of assessable profits (s.16(1)(a)); whether the borrowing, being a loan from a person other than a financial institution, generates interest income which is chargeable to profits tax in Hong Kong in the hands of that person (s.16(2)(c)); or the loan is used to finance acquisition of trading stock or plant and machinery and the lender is not an associate of the borrower (s.16(2)(e)); and if all of the above are satisfied, whether the deduction amount will be restricted under the secured loan test (s.16(2a)) or interest flow back test (s.16(2b)). In the case of FJL, the first condition is likely to be satisfied as the additional funding from the loan is to be applied in FJL s operations, which generate income subject to tax in Hong Kong. In the case of the second condition, PSL will be chargeable to profits tax in Hong Kong if it puts the loan money into the possession or control of FJL in Hong Kong, or the loan to FJL is made in the course of a money lending business carried on by PSL in Hong Kong and a substantial part of the activities leading to the loan to FJL are carried out in Hong Kong. However, if PSL puts the loan money into FJL s bank account outside Hong Kong (as is proposed) and otherwise will not carry on business in Hong Kong, the second condition under s.16(2)(c) will not be satisfied. Whether PSL is in Austria or any jurisdiction other than Hong Kong is irrelevant. The alternative condition for an interest deduction under s.16(2)(e) will also not be satisfied, because the lender (PSL) is FJL s shareholder, so will be considered as an associate, even though the loan may be used to acquire machinery or plant or trading stock. As a result, it is likely that FJL will not be allowed a tax deduction on the loan interest paid. As for the interest income received by PSL in Austria, it is likely not to be taxable in Hong Kong for the reason that it does not carry on a business in Hong Kong and the interest is not sourced in Hong Kong. However, if PJL is actually carrying on a money lending business in Austria, the situation may be different. We will need more information to assess this issue further. (ii) Additional funding through the sale and license back of FJL s brand name This action involves two steps: (1) sale and (2) license back. Under step 1, FJL is expected to make a gain from the disposal. The tax implication to FJL is whether or not the gain is taxable under profits tax. Profits from a business, trade or profession carried on in Hong Kong are chargeable to profits tax as long as the profits are derived from a source in Hong Kong and the profits are not capital in nature (s.14(1)). In the case of FJL, as the brand name has been owned and used by FJL for its operations for more than 20 years, it can be argued that the brand name is a capital asset to FJL. Therefore, the profit arising from its sale will be exempt from profits tax under s.14. Under step 2, following the sale of the brand name to PSL, FJL will license it back pursuant to a licence agreement under which FJL will pay a licence fee to the lessor (PSL). To FJL, the licence fee payment is likely to be tax deductible provided that the brand name is used in the production of assessable profits. As the licence fee is received by PSL, an overseas lessor who is not carrying on a business in Hong Kong, the normal profits tax charge under s.14 does not apply. However, the licence fee will still be deemed to be a receipt arising in or derived from Hong Kong from a trade, profession or business carried on in Hong Kong if it is received for the use of, or the right to use, the brand name in Hong Kong (s.15(1)(b)). In normal circumstances, the lessor will be chargeable to profits tax based on 30% of the fee received (s.21a(1)(b)), at the corporation tax rate of 16 5%. However, if the brand name has previously been owned by any person carrying on a business in Hong Kong, and the fee is received by an 15

5 associate of that person, the deemed rate of 30% does not apply and the full amount of the licence fee will be taxable at 16 5%, without deduction for any expenses (s.21a(1)(a)). In this case, given that the lessor, PSL, is an associate of FJL, and the brand name was previously owned and used by FJL before its transfer to PSL, the Hong Kong profits tax payable by PSL will be 16 5% of the gross fee it receives from FJL. This tax liability will be collected through a withholding mechanism, which obliges FJL, as the payer of the fee, to withhold the calculated tax amount from the payment made, and only remit the net amount to the lessor. FJL should then file a Hong Kong tax return on behalf of PSL, as lessor, reporting the amount of the licence fee paid and the amount of tax payable. Upon receipt of the tax assessment, FJL will then forward the amount withheld to the IRD on behalf of PSL. We trust that the above addresses all the Hong Kong profits tax implications arising from the proposed transactions. Should there be any questions, please let us know. End of report 2 Jack Young (a) Hong Kong salaries tax If Jack has an employment located in Hong Kong, all the income from that employment for a year of assessment is liable to salaries tax unless: (1) no services are rendered in Hong Kong during the basis period of the year of assessment; or (2) services are rendered in Hong Kong during the basis period of the year of assessment but Jack s visits to Hong Kong during the basis period for the year of assessment do not exceed 60 days; or Tutorial note: If Jack s visits to Hong Kong during a year of assessment exceed 60 days and during any of his visits, even just on one day, he renders any services in Hong Kong, this exemption will not apply: Jack So s case. (3) tax similar to salaries tax is paid outside Hong Kong on any income referable to services performed outside Hong Kong in that taxing jurisdiction. If, on the other hand, Jack has an employment located outside Hong Kong and his visits to Hong Kong exceed 60 days, only the income derived from the services rendered in Hong Kong, including the leave pay attributable to such services, is subject to salaries tax. This is usually determined on a time-apportionment basis, i.e. Jack s employment income will be apportioned according to the number of days that he is present in Hong Kong during the basis period for the year of assessment. On the basis of the Goefert s case, the location of an employment is generally determined by the Inland Revenue Department (IRD) as outside Hong Kong where the following three factors are present: (1) the contract of employment was negotiated, entered into and is enforceable outside Hong Kong; (2) the employer is resident, i.e. managed and controlled, outside Hong Kong; and (3) the employee s remuneration is paid outside Hong Kong. In Jack s case, factor 3 could easily be satisfied. Factor 1 would seem to be less easily satisfied because PC Gambling (HK) Ltd (PCG-HK) is a local company carrying on business in Hong Kong. Thus, Jack s contract of employment would be enforceable in Hong Kong. However, it would be helpful if Jack was able to prove that the discussions relating to, and finalisation of, the terms of his employment with PCG-HK took place with his father outside Hong Kong. Although factors 1 and 2 are not singly determinative of either a Hong Kong or a non-hong Kong employment, factor 2 will (and in practice generally does) prove critical. Even though PCG-HK is incorporated in Hong Kong, factor 2 could nevertheless be satisfied provided the company s board of directors, when meeting to determine the conduct of the business of PCG-HK, performs its functions outside Hong Kong. If the above factors (particularly factor 2) can be satisfied, and this is well documented as evidence, it might be argued that Jack s employment is located outside Hong Kong. In which case (as indicated above), only his income referable to services rendered in Hong Kong, usually determined on a days in/days out basis, will be charged to salaries tax. (b) (i) Fringe benefits planning Within limits, fringe benefit planning is commonly done by many employers in Hong Kong, and is generally accepted by the Inland Revenue Department (IRD). However, to be effective, there are various technical requirements which must be complied with, and these inevitably give rise to administrative complexities to the employer. The IRD can be expected to scrutinise fringe benefits planning arrangements carefully to ensure that these technical requirements are being complied with. If the necessary procedures are not followed, the authorities will likely treat the benefits as being taxable at their full value. Applying the relevant statutory provisions contained in the Inland Revenue Ordinance (IRO) and the relevant practices adopted by the IRD to Jack s major expenditures, Jack s remuneration package could be structured as follows: (1) Accommodation Where PCG-HK provides accommodation to Jack, or reimburses the rent paid by him to his landlord, or alternatively pays the rent to his landlord directly, then the amount so paid can be excluded from Jack s taxable 16

6 (ii) income. The rental payment can include not only rent, but also management fees and rates with respect to the premises which Jack is obliged to pay under his lease. Instead, Jack would be treated as having received a taxable benefit equal to the rental value of the premises concerned, and this is normally calculated as 10% of his other taxable emoluments (excluding certain payments such as share option gains and any lump sum payment or gratuity paid or granted on retirement or termination of employment). However, the IRD will stringently monitor the situation to ensure that PCG-HK s obligation to make such rental payments or reimbursements is clearly set out in Jack s contract of employment, and if Jack is reimbursed wholly or partly with the amount of rent he paid, that Jack does in fact incur the rental expenses so provided for. If he is not required to use such payments to pay rent, then the whole of the payment will be taxable as an ordinary salary payment. Other benefits can be paid for by PCG-HK and provided to Jack on a tax-free basis, provided that in doing so PCG-HK does not discharge any legal obligation which Jack has to make such payment, and provided that he cannot convert such benefit into cash. (2) Car and private transport PCG-HK can make the use of a car available to Jack. Provided that he is not personally liable to make any lease or purchase payments to the supplier of the car, this benefit will be tax free. Again, Jack should not have the right to require cash to be paid to him instead. Rather, Jack s employment contract must specify that he is entitled to receive the use of a company car. Alternatively, the contract of employment could be silent on this point, and PCG-HK could simply make the car available to Jack to use. (3) Utilities It would be possible for PCG-HK to pay the utilities bills with respect to Jack s premises, without Jack being taxed thereon. This would cover payments for telephone, gas, water and electricity. However, as noted above, it is necessary that Jack must not have the legal obligation to make these payments to the utility companies concerned. Therefore, it is essential that PCG-HK enters into the contracts with the utility companies for the supply of the various services, i.e. PCG-HK is legally liable to pay these amounts. Furthermore, Jack must not have the option to be able to take cash in lieu of having his utility bills paid by PCG-HK. If he is entitled to simply take cash from PCG-HK directly, then the amount which he could have received from PCG-HK would be taxed on him. It is therefore essential that the employment contract specifies that PCG-HK will make such payments and Jack will not be entitled to payment in cash. (4) Personal expenses It is generally not possible to make any tax planning arrangements for personal expenditure. If PCG-HK reimburses Jack s personal expenditure, the reimbursement is a cash allowance for him. If PCG-HK gives Jack a credit card on which to charge personal purchases, and PCG-HK pays the credit card company, the amount so paid is also taxable on him. The reason for this is that, in ordinary usage, the holder of the card (i.e. the employee) has a liability to pay for the goods or services received which is effectively discharged by the employer when the card is used, resulting in a chargeable benefit to the employee. This result accords with the IRD s practice which states that credit card arrangements will not be accepted by the IRD, and the benefit will be taxed on the employee, when they are used for the private purposes of the employee. (5) Medical expenses Medical insurance is a common fringe benefit (and sometimes dental insurance also). PCG-HK could maintain an insurance policy to cover Jack for his medical needs. Payments made by the insurance company to Jack will be tax free. Alternatively, if PCG-HK wishes to make such payments directly without maintaining insurance, PCG-HK could enter into an arrangement with specified doctors that, should Jack consult with such doctor, the doctor agrees that he/she will not look to Jack for the payment of fees, but will only charge PCG-HK. Through this technique, Jack will avoid entering into a legal obligation to pay the doctor s fee, and the amount paid by PCG-HK to the doctor will be tax free. Salaries tax treatment of the share option The share option is taxable as it is received in compensation for the employment services provided by Jack to PCG-HK. An option benefit is taxed on the gain realised through the exercise, assignment, or release of the option (s.9(1)(d)). For this purpose, the option right is taxed if it is granted at a time when Jack is holding a Hong Kong employment or as a result of a Hong Kong employment. It is not relevant whether or not Jack is still employed by PCG-HK at the time the option is exercised, released or assigned. The taxable gain is the difference between the sale proceeds (i.e. market price minus selling costs) which would have been derived from a sale of the shares at the time of exercise, or the consideration received for the assignment or release, and the cost paid for the option and the shares. Any gain arising from the subsequent sale of the shares is considered as a return from investment rather than employment, and thus is disregarded for Hong Kong tax purposes. If Jack plans to exercise the share option after he returns to the US, the option will still be taxable, although the time for assessing the gain will depend on the timing of the exercise of the option. Section 11D(b)(ii) which deems any taxable income paid by an employer after the cessation of employment to accrue on the last day of employment does not apply 17

7 in the case of a share option gain, because the gain is not a payment made by the employer. Therefore, if Jack makes a gain from exercising the option in the year starting 1 April 2019, the gain will be assessed under salaries tax for the year of assessment 2019/20. However, Jack may elect to have his tax liability ascertained based on a notional exercise of the option on any day within seven days before the day when the return for the final assessment for 2018/19 is submitted. If the return is submitted after his departure, such election shall be made within three months from the date of his departure, which will be taken as the date of the notional exercise for the purpose of calculating the gain. On the other hand, if the share price is not expected to rise significantly, Jack should not make a notional exercise election, and should exercise the option after 1 April 2019, so that any gain from the exercise will fall within the year of assessment 2019/20, as a full year of statutory personal allowance will be granted to reduce his assessable income before tax is charged. 3 Mr and Mrs Li (a) Residential property options (i) Option 1: lease to an outside party at a market rent Property tax Under s.5(1) of the Inland Revenue Ordinance (IRO), property tax is levied on any owner of land or buildings or land and buildings situated in Hong Kong, at the standard rate (15%) on the net assessable value of the property. Net assessable value includes any consideration payable in money or money s worth in respect of the right to use the land and/or buildings, as reduced by (i) government rates paid by the owner if it has been so agreed between the owner and the tenant; and (ii) a statutory allowance of 20% of the assessable value after deducting the rates paid, if applicable (s.5b). The statutory allowance is deemed to cover all related expenses incurred by the owner on the property. Therefore, all other actual expenses including management fees, rates and loan interest are not deductible for property tax purposes even though they are incurred by the owner. Mr and Mrs Li will be subject to property tax in respect of the rental income received from the letting of the residential property. This is the position regardless of whether or not they remain resident in Hong Kong. Assuming that the monthly market rent of $20,000 is receivable for 12 months, the estimated annual property tax payable for a year of assessment (assuming the same rates as in 2016/17) is as follows: $ Assessable value (20,000 x 12) 240,000 Less: 20% statutory deduction (48,000) Net assessable value 192,000 Property tax at 15% 28,800 For property tax purposes, there are no provisions to allow a tax deduction for mortgage loan interest paid, and no personal allowance would be deducted. However, if the couple are eligible to elect for personal assessment, the mortgage loan interest could be deductible, as well as the personal allowance. To be eligible for a personal assessment election, the individual taxpayer (or his or her spouse) must be either a permanent or temporary resident in Hong Kong. Permanent resident refers to an individual who ordinarily resides in Hong Kong. Based on R v Barnet London Borough Council, a person is resident in a place where a person lives and conducts his daily life in circumstances which lead to the conclusion that he is living there as an ordinary member of the community would live for all the purposes of his daily life. A temporary resident refers to an individual who is present in Hong Kong for a period or periods during the year of assessment amounting to more than 180 days or for more than 300 days over two consecutive years, one of which is the year for which an election is sought. In the case of Mr and Mrs Li, they would likely not be regarded as permanent residents after they emigrate to Canada, but may still qualify as temporary residents if they satisfy the number of days present in Hong Kong. The loan interest deduction under personal assessment will be restricted to the extent of the rental income earned from that property, i.e. based on the above calculation $192,000. Home loan interest deduction The couple have been claiming a home loan interest deduction against their employment income based on the amount of mortgage loan interest paid during the year, subject to a maximum of $100,000 per year. This deduction is available for a total of 15 years, so as they have only claimed it for ten years, they are potentially still eligible for another five years. However, the home loan interest deduction requires that the property must be occupied by the couple as their primary principal residence in Hong Kong. Following their emigration, Mr and Mrs Li will cease using the property as their residence and so will not be allowed the deduction. This remains the case regardless of whether they continue to pay the mortgage loan interest after they move out of the property. Stamp duty In terms of stamp duty for an agreement for the lease of immovable property in Hong Kong, Head 1(2) of the Stamp Duty Ordinance requires that stamp duty on the average yearly rent is payable at 0 25% for a lease term which does not exceed one year; 0 5% for a lease term between one and three years; and 1% for a lease term exceeding three years. Stamp duty is chargeable on the legal instrument and thus is payable as long as a lease agreement is effected. No stamp 18

8 (ii) (iii) duty arises where no written lease is entered into, however, this is unlikely to be advisable in the case of a lease to an outside party. Tutorial note: Any lease for more than three years is statutorily required to be reduced into writing. Option 2: lease to Mrs Li s uncle at less than market rent Property tax Property tax under s.5 is charged on the consideration payable in money or money s worth. If rent is charged at below the market rate, only the total rent receivable is taxable provided that no other consideration in money s worth is payable. Moreover, if no rent is charged or receivable, no property tax is imposed, whether the lease is made with an outside party or a family member, though in the latter case the Inland Revenue Department might strive to invoke anti-avoidance principles in appropriate cases. Stamp duty As stated in relation to Option 1, stamp duty is not payable if there is no written lease, which could be the case where the property is leased to a family member, such as in this case. Option 3: occupied by Mr and Mrs Li s son Property tax In the event that the property is occupied by the couple s son rent free, but the son is only required to repay the mortgage loan on behalf of the couple, strictly speaking, Mr and Mrs Li would be chargeable to property tax for the amounts of these mortgage repayments made by their son. The mortgage payments would be money s worth payable for the benefit of the owner in respect of the right of use of the property as stipulated in s.5b(2). Home loan interest deduction The son will not be eligible for any deduction for the mortgage loan interest paid as he is not the owner of the property. Therefore, no home loan interest deduction will be granted to either the son, or to the couple. (b) (i) Statutory reporting obligations Under the IRO, any person who ceases to own a source of income chargeable to tax in Hong Kong is obliged to inform the Commissioner of Inland Revenue (CIR) within one month of such cessation (s.51(6)). This applies to Mr and Mrs Li, such that they should have filed the notice of cessation of employment within one month of their cessation. Moreover, any person who is chargeable to tax in Hong Kong and who is about to leave Hong Kong for a period which will exceed one month (except for a vacation or business purpose) must inform the CIR in writing of his expected date of departure and return, and this notice should be filed at least one month before the departure (s. 51(7)). In the case of Mr and Mrs Li, they are leaving for Canada as emigrants and thus are expected to leave Hong Kong for more than one month. They are therefore required to file the notice of such departure to the CIR. Tutorial note: The notice of departure enables the IRD to take the necessary actions to clear a taxpayer s Hong Kong tax liabilities before they leave Hong Kong. (ii) Recovery actions by the CIR If Mr and Mrs Li fail to comply with the reporting obligations without reasonable excuse, they will be regarded as having committed an offence under s.80(1), and subject to a fine at level 3 ($10,000) or at a penalty amount compounded by the CIR. In the event that there are outstanding Hong Kong tax liabilities after Mr and Mrs Li have left Hong Kong, the IRD is empowered by the IRO to take necessary actions to recover the tax due, including surcharges, penalties and costs involved. These actions include: (1) A civil debt action in the District Court. (2) Collection from any third party who owes or is about to pay money to the defaulter; holds money for or on account of the defaulter; holds money on account of some other person for payment to the defaulter; or has authority from some other person to pay money to the defaulter. (3) Issuing a departure prevention direction to prevent the defaulter from leaving Hong Kong. For action (1), the CIR will sign a certificate giving the address of the defaulter and the particulars of the outstanding tax, and apply for a court judgement. Once judgement is given, collection actions requiring a court judgement will proceed. For action (2), the CIR will issue a notice to the third party, with a copy to the defaulter, requiring them to pay over to the IRD a sum held in his account or a sum sufficient to settle the tax due. In the case of Mr and Mrs Li, the third party could be the bank or their son in Hong Kong who holds money on the couple s account (such as any bank account balance or the loan repayment due and payable by the son). For action (3), the direction once issued will remain in force until the tax is paid. Therefore, it will remain valid whenever Mr and Mrs Li return to Hong Kong. 19

9 4 (a) The Association of Food Lovers Ltd (i) Liability to tax in 2016 The Association of Food Lovers Ltd (AFL) is a club, and its tax position is therefore governed by s.24(1) of the Inland Revenue Ordinance (IRO). The general position is that a club effectively comprises its members who in substance deal with themselves. In common law, this would not give rise to a profit which is recognisable for tax purposes, on the basis of the so-called mutuality principle. On the other hand, receipts by the club from non-members would normally be taxable where these receipts are generated from the activities of the club which amount to a business or trade or profession. Section 24(1) is designed to avoid this anomaly. It provides that where the club receives at least 50% of its gross receipts on revenue account from its members, then the club is deemed not to be carrying on a business, in which case it cannot be taxed on its profits. Conversely, where less than 50% of the club s gross receipts are received from members, then it is taxable on all of its profits. This test is to be done for each year and thus a club may be liable to profits tax in one year but not in another year. The facts indicate that AFL makes profits from buying high quality, organic food items and reselling them to members as well as to their friends (non-members). Also, the restaurant which it operates is open to both members and their guests. It needs to be ascertained what percentage of the club s gross revenues came from members versus non-members in the relevant year. Without this information, no definitive conclusion can be drawn. If AFL is unable to provide this information, then it follows that it will not be able to discharge its burden of proving that it is exempt under s.24(1), if the Inland Revenue Department (IRD) were to assess it to profits tax. In determining gross receipts for the purposes of the application of s.24(1), the up-front fees received from new members are also taken into account. Therefore, if not less than half of the gross receipts on revenue account, including the up-front fees, as well as the monthly fees, are from its members, the club will be deemed not to be carrying on business and, therefore, its profits will not be chargeable to profits tax. Otherwise, AFL will have to pay tax on its profits. It should also be noted that s.24(1) applies only in respect of members who are entitled to vote at a general meeting of the club. It therefore needs to be ascertained whether the members of AFL do in fact have such voting rights. (ii) Steps to avoid/minimise liability To avoid issues of taxability in the future, and to ensure that AFL will be tax exempt on profits which it makes, the club could institute procedures to ensure that it obtains money only from its members. For example, it could institute a system whereby the members friends and guests are entitled to use the club s facilities, but all payments are charged to members accounts or paid directly by members. Alternatively, non-members could purchase vouchers which would enable AFL to keep track of how much money is being spent by non-members (by comparing tenders of vouchers versus cash); and to ensure that receipts from non-members will not exceed 50% of the total receipts on revenue account. (b) Ace Insurance Ace Insurance is obviously engaged in non-life insurance business. Although it is incorporated outside Hong Kong, the provisions under s.23a of the IRO would apply to assess its profits to profits tax if: (1) the premiums are earned in respect of insurance contracts made in Hong Kong; or (2) the premiums are earned on policies the proposals for which were made to a corporation in Hong Kong. If all or part of Ace Insurance s premiums fall within either of these conditions, that part of the premiums would be liable to profits tax; and the assessable profits will be computed according to the following formula: Gross premiums from non-life insurance business in Hong Kong Add: Any interest or other income arising in or derived from Hong Kong Less: Returned premiums Corresponding reinsurance premiums Any increase in the provision for unexpired risks per accounts Actual losses less recoveries Agency expenses Head office administration expenses relating to the Hong Kong business Depreciation allowance/balancing adjustment relating to the Hong Kong business Despite the above, s.23a(1) allows the Commissioner to exercise his discretion to adopt any other basis of calculation which he considers to be more equitable in ascertaining the assessable profits of a non-resident non-life insurance company. A non-resident insurance company with limited business transacted in Hong Kong may be permitted to ascertain its assessable profits by reference to the proportion of the total profits and income of the company corresponding to the proportion which its premiums from insurance business in Hong Kong bear to its total premiums or on any other basis which appears to the Commissioner to be equitable (s.23a(1) proviso). The insurance premium payable by Ace-Hong Kong to Ace Insurance would be tax deductible for profits tax purposes, subject to the general principles under s.16(1), i.e. that the expense was incurred in the production of the assessable profits of Ace-Hong Kong. 20

10 The following criteria must also be satisfied: (1) The transaction between Ace Insurance and Ace-Hong Kong is on an arm s length basis, i.e. arranged as if both parties are unrelated third parties, including the assessment of risks and determination of premiums. (2) The transaction is commercially justified, i.e. not entered into for the sole or dominant purpose of avoiding tax. (3) The insurance policy written by Ace Insurance is for the benefit of Ace-Hong Kong in the production of Ace-Hong Kong s assessable profits. (4) The amount of premium charged is substantiated with calculations. (5) The basis of charge is commensurate with the benefits accrued to Ace-Hong Kong and makes no reference to the profitability of Ace-Hong Kong. (6) The amount of premium charged is realistic, reasonable and not excessive. (7) Documentation is properly put in place, including proposals and policies, relevant board minutes or resolutions, invoices, receipts, payment records and working papers to substantiate the calculations. (8) The transaction is not artificial and/or fictitious. If the IRD has reason to believe that Ace Insurance was set up solely or dominantly for avoiding Hong Kong tax, the arrangement may be disregarded and any tax deduction would be denied under s.61a. Further, the IRD may also assess Ace-Hong Kong as agent of Ace Insurance under s.20, if Ace-Hong Kong (a resident person) carries on business with Ace Insurance (a closely connected non-resident person) in such a way that it produces to Ace-Hong Kong either no profits or less than the ordinary profits which might be expected to arise or be derived from Hong Kong. 5 HK Co Ltd (HK-Co) (a) (b) (c) Depreciation on computer systems Capital expenditure incurred on the acquisition of fixed assets would normally not be allowed as an expense for tax purposes, but would qualify for a depreciation allowance if it represents qualifying expenditure for machinery and plant, industrial buildings or commercial buildings. The Inland Revenue Ordinance (IRO) contains specific provisions governing the rates and methods of calculation of the depreciation allowance. Computer systems qualify as plant and machinery subject to an initial allowance at 60% of the capital expenditure incurred in the year of purchase, and an annual allowance of 30% of the reducing balance brought forward in each year of use. Some capital expenditures qualify for an outright deduction, such as expenditure for the provision of a prescribed fixed asset under s.16g, as long as the relevant asset is used in the production of assessable profits. Prescribed fixed asset is specifically defined, and includes computer hardware (other than hardware as an integral part of any machinery and plant), software and systems but does not include assets under a lease or hire purchase. In the case of HK-Co, assuming that the computer systems were not acquired under a lease or hire purchase, the total cost of $100,000 should qualify as expenditure on a prescribed fixed asset and be eligible for a 100% outright tax deduction in the year of purchase. No tax depreciation allowance can be claimed. The accounting depreciation of $30,000 will be added back in the tax computation. Incorporation and business registration fees A tax deduction is denied for expenditure which is of a capital nature (s.17(1)(c)). In determining the nature of an expenditure item, case law has developed various tests to identify the nature of expenditure, including but not limited to, the once-and-for-all test, enduring benefit test, fixed capital v circulating capital test, etc. Caution is required in applying the different tests and each case has to be examined on its own facts. In the case of an incorporation fee, the item was obviously incurred once and for all and is not of a recurring nature. Moreover, by incurring the fee, it brings into existence the company which by itself constitutes an advantage for the enduring benefit of the business. An incorporation fee is also incurred to establish the capital structure of the taxpayer s business, rather than to preserve its capital. As a result, the incorporation fee of $50,000 is a capital expenditure and so not tax deductible. The business registration fee of $2,250 is deductible under s.16(1). It is a recurrent expenditure, hence not a capital expenditure. It is payable annually in compliance with the legal requirement (Business Registration Ordinance) for carrying on business. Hence it is incurred in the course of carrying on the business which, based on the facts stated in the question, is presumably run for profits. Therefore, no adjustment is required in the tax computation. Mandatory provident fund (MPF) contributions, including an initial lump sum Regular contributions to MPF, whether actually paid or accrued as an accounting provision, would be regarded as part of employee costs which would be tax deductible if the employee costs are incurred in the production of assessable profits (s.16(1)). However, the deduction is subject to a maximum limit of 15% of each employee s remuneration (s.17(1)(h) or s.17(1)(i)). Initial or special contributions other than regular which are actually paid are only allowed over a period of five years in equal annual instalments, commencing from the year the contributions are made (s.16a). Accruals for such non-regular contributions are not allowed for tax deduction. 21

11 In the case of HK-Co, the initial lump sum contribution of $20,000 to set up the fund is eligible for a deduction of 20% each year for up to five years, provided that it has already been paid. Therefore, in 2016 (the first year) 80% of the amount paid, i.e. $16,000, will need to be added back in the tax computation. Regarding the balance of $30,000, assuming it is the first of several regular contributions, it will be deductible to the extent of 15% of any employee s remuneration. Any excess over 15% will not be deductible and will need to be added back in the tax computation. (d) (e) (f) Compensation for restrictive covenant paid to a resigning member of staff The deductibility of the compensation payment made to a leaving employee depends on whether the outgoing is capital in nature or not. If it is considered capital in nature, based on the tests in case law (as referred to above in (b)), the outgoing is not deductible (s.17(1(c)). The enduring benefit test is taken from the perspective of the nature of the benefit created by the expenditure. Expenditure giving rise to a benefit which is enduring in nature and lasting longer than normal revenue expenditure is likely to be considered as capital in nature. In the case of HK-Co, the compensation payment is made for the purpose of securing a covenant from the leaving employee not to compete for a long time-span of five years after he left, therefore, the benefit is likely to be considered as long lasting and enduring. As capital expenditure, the payment of $100,000 is not deductible for profits tax purposes and needs to be added back in the tax computation. Incentive to employee to remain in employment Any expense or outgoing to the extent incurred in the production of assessable profits may be deductible provided that it is not restricted by way of being capital, domestic or private in nature (s.16(1)). The purpose of the incentive payment was to retain the employee in the workforce. Assuming that the income generated by the workforce is subject to tax in Hong Kong, the cost incurred to maintain the workforce would be an expense incurred in the production of assessable profit. The fact that the incentive is paid once does not alter the deductibility of the expenditure. Therefore, in the case of HK-Co, the $80,000 is tax deductible and so no adjustment is required in the tax computation. Interest expense on bank mortgage loan for staff quarters The deductibility of an interest expense is governed by s.16(1)(a) and s.16(2), subject to the restrictions under s.16(2a) and s.16(2b), in addition to the general rule that an expense or outgoing is deductible to the extent that it is incurred in the production of assessable profits (s.16(1)). Specific to interest expense, interest on money borrowed for the purpose of producing assessable profits, together with other related expenditure, is deductible provided that any condition under s.16(2) is satisfied (s.16(1)(a)). Whether interest is incurred for the purpose of producing assessable profits is usually dependent upon how the loan proceeds are applied, and in the case where the proceeds are used to acquire an asset, whether or not the asset is used to produce assessable profits. The fact that the loan money was applied to acquire a capital asset does not render the loan interest to be a capital expense unless the capital asset so acquired is not immediately used for producing assessable profits. In the case of HK-Co, the mortgage loan was obtained to acquire the residential property occupied by staff for accommodation purposes. The provision of accommodation to staff is considered as a kind of employee benefit which, together with other staff costs, contribute to the operation of the business for the production of assessable profits. As a result, the interest of $190,000 on the mortgage loan satisfies both s.16(1) and s.16(2)(a). As regards the condition under s.16(2), the payment of interest to a bank already satisfies s.16(2)(d). Since the bank loan was mortgaged over the property acquired and presumably there is no arrangement whereby the interest expense would flow back to HK-Co as non-taxable interest income, neither restriction under s.16(2a) nor s.16(2b) applies. As a conclusion, the bank mortgage loan interest is tax deductible for profits tax and no adjustment in the tax computation is required. 22