THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND ADMINISTRATORS

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1 THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND ADMINISTRATORS International Qualifying Scheme Examination HONG KONG TAXATION PILOT PAPER Time allowed 3 hours Section A Compulsory questions Section B 5 long questions (attempt any 3) DO NOT OPEN THIS PAPER UNTIL INSTRUCTED TO DO SO BY THE INVIGILATOR Important Note: Candidates are allowed 15 minutes reading time to read through the question paper before the commencement of the examination between 2:15pm-2:30pm. During the reading time, all candidates must be silent and must not write or mark anything on their question papers or answer books. Candidates must close all their reference books, notes or other unauthorised materials and put these under their chairs. If any candidates write or make any marks during the reading time, or if they speak or in any other way communicate with anyone either in or outside the examination hall during this period or read any unauthorised materials, they will be disqualified from continuing this examination paper. Once candidates have opened the question paper, they are not allowed to leave the examination hall until 3:00pm. Page 1 of 16

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3 SUBJECT NO 16M HONG KONG TAXATION PILOT PAPER The examination paper is divided into TWO Sections. Section A is compulsory and carries 40 marks. Candidates should attempt THREE questions from Section B, all of which carry 20 marks each. You should allow yourself approximately 70 minutes in total to answer the questions in Section A, and 35 minutes for each of the questions attempted in Section B. Unless otherwise stated, $ denotes Hong Kong dollars. Saturday afternoon 13 December 2008 Time allowed: 3 hours SECTION A (Compulsory answer ALL parts of this question) Question 1 Mr. Davidson, a US resident, has approached you, a tax consultant, for your advice in respect of his Hong Kong tax affairs. In a meeting on 18 May 2008 with Mr. Davidson, you obtained the following information from him: 1. Mr. Davidson was employed by PanHealth (US) Limited, a large multinational company based in the United States. PanHealth has expanded its business in the Asia Pacific region through various subsidiary companies. GoodHealth (HK) Limited is PanHealth s wholly-owned subsidiary, set up for its business operations in Hong Kong. According to the employment contract entered into with PanHealth in the United States, Mr. Davidson s job duties are exclusively to oversee and supervise the operations of various subsidiary companies in the Asia Pacific region. For convenience, he was attached to GoodHealth in Hong Kong and performed most of his work in Hong Kong. 2. Mr. Davidson arrived in Hong Kong on 1 April 2006 to carry out his employment duties. GoodHealth acted as the sponsor of his Hong Kong work visa. During the year ended 31 March 2007, he spent 195 days, including 15 days of his vacation, in Hong Kong and 170 days in various countries in the region. His work was for the benefit of all PanHealth s subsidiary companies in the Asia Pacific region and he reported on his duties to PanHealth on regular intervals. 3. Mr. Davidson s annual salary for the year of assessment 2006/07 was $1.5 million equivalent and was paid directly into his bank account by PanHealth in the United States. During the year 2006/07, PanHealth charged 20% of Mr. Page 3 of 16

4 Davidson s salary cost to GoodHealth as a management fee. While Mr. Davidson stayed in Hong Kong, he lived in a flat provided by GoodHealth. A sum of $12,000 equivalent was paid by Mr. Davidson to GoodHealth during the year 2006/07 for his housing. 4. In September 2006, there was a management reorganisation at GoodHealth. Mr. Davidson was appointed as a director of GoodHealth with effect from 1 October During 2006/07, he attended all board meetings in Hong Kong and received a directors fee of $60,000 equivalent. 5. Mr. Davidson has some investments in Hong Kong as follows: (a) He purchased 5,000 shares in a public company listed on the Hong Kong stock market for $100,000 in January During 2006/07, he received a dividend of $10,500 from these Hong Kong shares. In December 2007, he gave all these Hong Kong shares to his wife, Mary Davidson, as a Christmas gift. The market value of the shares at the date of gift was $25 per share. (b) He acquired a flat in Hong Kong for $7 million in May The purchase was financed partly by an advance of $2 million from his friend in the United States and partly by a mortgage loan of $4 million from Hang Seng Bank. On 1 June 2006, Mr. Davidson, through a property agent, entered into a two-year lease with Mr. Wong on the following terms: (i) Lease period of two years from 1 June (ii) Monthly rent of $30,000, payable on the first day of each month starting from June (iii) Rent deposit of $60,000 payable at the start of the lease. (iv) Premium of $80,000 payable at the start of the lease. (v) Landlord responsible for paying rates of $2,800 per quarter. (vi) Tenant responsible for paying monthly management fees of $1,800. During 2006/07, Mr. Davidson paid interest of $51,000 to his friend in the United States and mortgage loan interest of $142,000 to Hang Seng Bank in respect of his flat. 6. Mr. Davidson supported his family in the United States. During 2006/07, his wife did not work and lived in the United States with their two children, Joey and Robert, and Mr. Davidson s father. Robert, aged 13, was a high school student and Joey, aged 20, was a full-time college student. Mr. Davidson s father, aged 72, was a retired businessman. 7. During 14 April 2008 to 16 May 2008, Mr. Davidson was away from Hong Kong on overseas business trips. When he came back to Hong Kong, he discovered that the Hong Kong Inland Revenue Department (IRD) had sent him an estimated Hong Kong salaries tax notice of assessment for the year 2006/07 issued on 15 April 2008, which assessed his full salaries of $1.5 million and directors fee of $60,000 for the year of assessment 2006/07. The salaries tax liability of $249,600 was computed at the standard rate of 16%. Mr. Davidson remembered that this was the second piece of correspondence he had received from the IRD. The first one was an individual tax return for the year 2006/07 in June The tax return was put aside by him as he considered that, as a US resident, he should be chargeable to US taxes rather than to Hong Kong taxes. Page 4 of 16

5 Required: (a) Briefly explain to Mr. Davidson the significance of the residence concept in the context of Hong Kong revenue law and the obligations that he has to observe if he is a chargeable person under Hong Kong revenue law (9 marks) (b) Calculate Mr. Davidson s 2006/07 Hong Kong salaries tax and Hong Kong property tax liabilities, if any (ignore the one-off waiver of salaries tax in 2006/07). (14 marks) (c) Advise Mr. Davidson of his course of action in relation to the 2006/07 estimated salaries tax assessment received by him and the Hong Kong tax treatment on the interest expenses paid by him in item 5(b) above during the year of assessment 2006/07. (9 marks) (d) Advise Mr. Davidson whether, and if so to what extent, the documents executed for the transactions in item 5 above attract Hong Kong stamp duty. (8 marks) (Total: 40 marks) Page 5 of 16

6 SECTION B (Answer THREE questions from this section) Question 2 Peter Tong is the senior marketing manager of a Hong Kong company. During the year ended 31 March 2008, he received the following income/benefits from his employer and incurred the following expenses. $ Income: (1) Salary and bonus ($700,000 and $70,000 respectively) 770,000 (2) Outstanding sales award (two non-transferable air tickets for a vacation trip to Australia. The company paid $14,000 directly to the airline for the tickets) (3) Reimbursement of rent for housing provided by his employer 240,000 (4) Reimbursement of wages to his maid (the employment contract was signed between Mr. Tong and his maid) 40,000 (5) A company car provided (the cost of the car to the employer was $100,000) Expenses: (6) Contribution of 5% of his salary to the housing provided by the employer (not covered by the reimbursement of $240,000 mentioned above) 36,000 (7) Contribution to the company s mandatory provident fund 40,000 (8) Tuition fees paid in respect of a management strategic course offered by the Hong Kong Polytechnic University 50,000 (9) Car running expenses (55% of the car s is estimated to be for business purposes) 42,000 (10) Membership fees paid to a social club (Mr. Tong often entertained the company s clients in the club house) 20,000 On 18 January 2008, Mr. Tong, pursuant to his company s staff share option scheme, acquired 10,000 shares in an associated company of the employer at a price of $20 per share (market value of the share on the same day was $24). On 17 March 2008, Mr. Tong received a dividend of $10,000 from these shares. During the year of assessment 2007/08, he donated $50,000 to the Hong Kong Community Chest. Mr. Tong is a married man and Mrs. Tong is a housewife. Their first baby was born in November Mr. Tong also maintains his sister who is 25 years old and who cannot work because of a physical incapacity. The sister lives with Mr. Tong and receives the Government Disability Allowance. Mr. Tong is now considering an offer from his employer for his existing housing benefit to be replaced by a monthly home finance allowance ($22,000). Mr. Tong can use the allowance to buy a flat in Kowloon. The flat will be financed by a bank mortgage loan of which Mr. Tong has to pay mortgage loan interest. Page 6 of 16

7 Required: Advise Mr. Tong in respect of the following: (a) his Hong Kong salaries tax liability for the year of assessment 2007/08 (ignore provisional tax and the proposed one-off waiver of salaries tax of 2007/08). Briefly explain the tax treatments that you have accorded to items (2), (4), (5), (8) and (10) in the question; and (b) the Hong Kong salaries tax implications of the potential change in his housing benefit. (Total: 20 marks) Page 7 of 16

8 Question 3 Tai Wong Limited has been trading electronic products in Hong Kong since The company normally prepares its accounts to 31 December. The profit and loss account for the year ended 31 December 2007 showed a net profit before taxation adjustments of $7.8 million. The company s chief accountant has supplied you with the following information for the year ended 31 December 2007 and asked for your advice about the effect it might have on the company s assessable profits: 1. Commission income Tai Wong Limited was appointed by a Taiwan manufacturer as its sole agent for the distribution of its electronic products in the China market. The agency agreement was signed in Taiwan. Tai Wong Limited appointed sub-agents in China to conclude sales contracts with Chinese customers directly under instructions from the Taiwan manufacturer. The goods were directly delivered to the Chinese customers by the Taiwan manufacturer and settlement of accounts was made between the sub-agents and the Taiwan manufacturer. Tai Wong Limited received a sales commission of $520,000 from the Taiwan manufacturer during the year. 2. Interest income $ Interest from debentures issued and listed in Luxemburg 50,000 Interest on HK$ deposits with Wing Lung Bank, securing overdraft facilities with the bank 65,000 Interest paid by a European customer for an overdue trade debt 30, Interest expenses Interest on bank overdraft (see item 2 above) for business operations 46,000 Hire purchase interest (see item 7 below) 5, Legal and professional expenses Legal fees in respect of dismissal of a senior staff member 12,000 Registration of trademark 15,000 Cost of appeal against rates 5, Repair and replacement expenses Acquisition of loose tools (65% was replacement cost) 4,780 Renovation of the business premises 250, Provisions and losses Exchange losses from a seven-day call deposit with a bank in Singapore, the money came from collection of trade debts there 20,100 Provision for slow moving and obsolete stock 86,000 Page 8 of 16

9 7. Hire-purchase computers (30%) During the year, computers at a total cost of $240,000 were bought on hire-purchase term as follows: Down payment 40, monthly installments of $21,000 each payable from 1 August Other expenses Annual subscription to trade association 12,000 Annual contributions to staff MPF 360, Miscellaneous items Scientific research expenditure 200,000 Compensation received for cancellation of a contract 80,000 Required: Explain the following to the chief accountant: (a) The tax effect of EACH item from item 1 to item 8 on Tai Wong Limited s assessable profits for the year of assessment 2007/08; and (b) What additional information is required about the two items shown in item 9 in order to determine their effects on Tai Wong Limited s assessable profits for the year of assessment 2007/08. (Do not perform the profits tax computation.) (Total: 20 marks) Page 9 of 16

10 Question 4 (a) On 18 October 2007, Sunny Limited transferred its commercial unit in Wan Chai to Windy Limited for a consideration of $14 million. The market value of the property was $16 million on 18 October To finance the purchase, Glory Limited and Rainy Limited provide advances of $8 million and $6 million respectively to Windy Limited. Windy Limited is a wholly-owned subsidiary of Glory Limited. Glory Limited also holds 85% of the issued share capital of Rainy Limited which holds 60% of the issued share capital of Sunny Limited. The remaining 40% share capital of Sunny Limited is owned by Windy Limited Required: Explain whether any stamp duty is payable on the above transaction and, if so, calculate the amount of stamp duty. (7 marks) (b) Qtech Limited is a Hong Kong company which has been carrying on business as an electronic toy manufacturer in Hong Kong since It closes its accounts annually on 31 December. The management of Qtech Limited is now considering two proposals in relation to its business. Proposal 1 Two of its production lines will be shifted to mainland China. Qtech Limited will enter into a co-operative (or processing) agreement with an entity in China. Under the agreement, Qtech Limited will provide technical know-how, management, production skills and skilled labour for the production. The Chinese entity will provide labour, factory premises and materials for which it receives a processing fee from Qtech Limited. The finished goods will be sold by Qtech Limited. Proposal 2 Qtech Limited will sell its patent for a special electronic toy to an overseas associated company at a price of $4 million. The patent was purchased by the company in 1998 at a cost of $3.5 million. The patent cost has been allowed for profits tax purposes previously. The overseas associated company will then grant Qtech Limited the right to use the same patent in Hong Kong for a royalty of $400,000 per annum. Required: Advise the management of Qtech Limited on the Hong Kong profits tax implications of the two proposals described above. (13 marks) (Total: 20 marks) Page 10 of 16

11 Question 5 Eversuper Limited is a long-established home appliances manufacturer in Hong Kong. Its goods are primarily manufactured in Hong Kong and sold to customers in North America. The management of Eversuper is now considering acquisition of a special know-how right for $6 million from a German company for use in its manufacturing business. Eversuper and the German company are two unconnected companies. Four alternatives fund-raising proposals are being considered to finance the acquisition. (i) Special machines would be sold to Evergain Limited, an associate company of Eversuper in Hong Kong, for $6 million. These machines are used in Eversuper s manufacturing process in Hong Kong. A lease agreement would be entered in Hong Kong to lease back these machines at a monthly rent of $300,000 so that Eversuper Limited can continue to use these machines. (ii) A loan of $4 million would be borrowed from Eversuper s associated company in the US at the market interest rate. The loan would be transferred into the bank account of Eversuper in Hong Kong. The other $2 million would be borrowed from the local associated company, Evergain Limited. (iii) $4 million would be deposited by Eversuper s associated company in the US to a local bank in Hong Kong. A loan of $6 million would be arranged from the local bank to Eversuper. The terms of the first loan would state that the payment of interest as well as the principal by the bank to the associated company would be subject to the payment of interest and principal made by Eversuper to the bank. (iv) Eversuper would assign its right to receive rental income from its properties in Hong Kong for the coming two years to a local bank for $6 million. The total rental income over the two years would amount to $7.8 million. Required: Advise the management of Eversuper Limited in respect of the Hong Kong profits tax implications on the acquisition of the know-how right and each of the four financial alternatives. (Total: 20 marks) Page 11 of 16

12 Question 6 (a) KKB Limited has been engaged in a fashion manufacturing and trading business in Hong Kong for many years. The company s management is now considering expanding its trading business into the North America market. One of the directors of KKB, David Poon, has submitted a proposal to the management of KKB to acquire the shares in a private company, Panmex Limited, which carries on a fashion trading business in Hong Kong. Panmex has established a good trading network in North American market. However, Panmex is now facing liquidity problems. It has suffered $10 million tax losses in the last few years due to management problems. Mr. Poon proposes that, after acquiring the Panmex shares, KKB can restructure Panmex s management and inject working capital via an interest free loan to resolve its insolvency problem. KKB can then expand its trading business into the North American market through Panmex. Required: Advise the management of KKB Limited of the Hong Kong tax implications of the above proposal. (10 marks) (b) Topsky Limited has a manufacturing business in Hong Kong. In October 2004, the company contracted for an industrial building to be built in Tsuen Wan at a construction cost of $10 million. $6 million was paid on signing the contract and the balance was paid in November 2005 upon the completion of the building. Topsky moved its manufacturing operations into the new building in January In March 2007, the building was sold to Bigg Limited for $14 million, excluding the land cost. Bigg immediately used the building to carry out scientific research. Topsky closes its accounts on 31 December annually, while Bigg uses 31 March as its accounting year end date. Required: Calculate the depreciation allowances (including the balancing adjustment, if any) for Topsky Limited and Bigg Limited for all relevant years of assessment up to and including the year of assessment 2007/08. (10 marks) (Total: 20 marks) Page 12 of 16

13 Tax Rates and Allowances 2007/ /07 Personal Allowances: $ $ Basic allowance 100, ,000 Married person s allowance 200, ,000 Child allowance - first to ninth child, each 50,000 40,000 - year of birth each child, additional 50, Dependent brother or sister allowance 30,000 30,000 Dependent parent/grandparent allowance (aged 60 or above) - basic 30,000 30,000 - additional 30,000 30,000 Dependent parent/grandparent allowance (aged 55 to 59) - basic 15,000 15,000 - additional 15,000 15,000 Disabled dependent allowance 60,000 60,000 Single parent allowance 100, ,000 Tax rates: Progressive rates: 2007/ /07 First $35,000 2% First $30,000 2% Next $35,000 7% Next $30,000 7% Next $35,000 12% Next $30,000 13% Remainder 17% Remainder 19% Standard rate: 16% 16% Profits tax rate for Corporations: 17.5% 17.5% Depreciation Allowances (2004/05 onwards): Plant and Machinery: Initial Allowance 60% Annual Allowance 10%, 20% or 30% (as specified in question) Industrial Building: Initial Allowance 20% Annual Allowance 4% Commercial Building: 4% Page 13 of 16

14 Stamp Duty Rates (2004/05 onwards): Head 1(1) and Head 1(1A) Consideration (round up to nearest $1) Up to $1,000,000 $100 Rate $1,000,001 - $1,080,000 $ % of excess over $1,000,000 * (effective from 28 Feb. 2007, reduced to a fixed sum of $100) $1,080,000 - $2,000, % (effective from 28 Feb. 2007, reduced to a fixed sum of $100) $2,000,001 - $2,176,470 $15,000 (i.e. 2,000,000 x 0.75%) + 10% of excess over $2,000,000 * $2,176,471 - $3,000, % $3,000,001 3,290,320 $45,000 (i.e. 3,000,000 x 1.5%) + 10% of excess over $3,000,000 * $3,290,321 - $4,000, % $4,000,001 - $4,428,570 $90,000 (i.e. 4,000,000 x 2.25%) + 10% of excess over $4,000,000 * $4,428,571 $6,000,000 3% $6,000,001 - $6,720,000 $180,000 (i.e. 6,000,000 x 3%) + 10% of excess over $6,000,000 * Over $6,720, % Head 1(2) Premium: Same as under Head 1(1) Lease with rent only: Term of Lease Not defined or uncertain Not exceeding 1 year Between 1 to 3 years Exceeding 3 years 0.25% of annual rent 0.25% of total rent 0.5% of annual rent 1% of annual rent Head 2(1): 0.1% of the consideration on every note Head 2(2) $5 Head 2(3) $ % of value Head 2(4) $5 Head 3(1) 3% of market value Head 3(2) $5 End of Examination Paper Page 14 of 16

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