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 DECEMBER 2010 Suggested Answers The suggested answers are published for the purpose of assisting students in their understanding of the possible principles, analysis or arguments that may be identified in each question 1

2 SECTION A 1. (a) Explain the taxation position of employment income in each of the following scenarios: (i) Hong Kong employment; services were partly performed in Hong Kong and partly outside Hong Kong. (ii) Hong Kong employment; all services were performed outside Hong Kong. (iii) Non-Hong Kong employment; services were wholly performed in Hong Kong. (iv) Non-Hong Kong employment; services were partly performed in Hong Kong and partly outside Hong Kong. (a) Taxation position: (i) Fully assessable if taxpayer spent more than 60 days in Hong Kong; fully exempt if taxpayer spent no more than 60 days in Hong Kong. (ii) Fully exempt; taxpayer is eligible for no services rendered exemption. (iii) Fully assessable; taxpayer rendered all services in Hong Kong even though time apportionment is applicable. (iv) Time apportionment basis if taxpayer spent more than 60 days in Hong Kong; fully exempt if taxpayer spent no more than 60 days in Hong Kong. 1 (b) Ben lives in a serviced apartment and is moving to a new job in which he will be entitled to housing assistance. His new employer provides two options for Ben to choose from: Option 1: The employer will sign the tenancy agreement with the landlord as the new tenant Option 2: The employer will pay cash to Ben for him to pay the rent directly. Evaluate the tax implications of the two options. (b) Evaluate the two options: Option 1: quarters are considered to be provided by the employer and the taxable benefit will be 10% of Ben s income from his new employer. Option 2: the rent paid to Ben is considered to be a cash allowance and will be fully taxable. Whether option 1 or option 2 is more tax efficient depends on Ben s income and the amount of the rent. If 10% of Ben s other income is higher than his rent, Option 2 is more tax efficient. (Rateable value is not applicable to a service apartment.) 2

3 1 (c) Explain whether the property income of a corporation is subject to property tax or profits tax or both. (c) Taxation of property income of a corporation: Letting of a property by a corporation is deemed to be a business (section 2(1) of the Inland Revenue Ordinance (IRO)); therefore the corporation is subject to profits tax. If the corporation is the owner of the property, property tax is also chargeable. However, section 5(2)(a) allows a corporation to apply for exemption from property tax on the ground that the property income will be assessable under profits tax. Alternatively, section 25 allows the corporation to set off the property tax it pays against its profits tax liability. 1 (d) Briefly describe the terms contract processing and import processing, and state their respective profits tax treatment. (d) Contract processing and import processing: If a Hong Kong manufacturer operates its own factory or signs a processing/assembling agreement with a party in Mainland China and produces goods in Mainland China, this is called contract processing. The IRD considers that 50% of the manufacturing profits from contract processing have a Hong Kong source and 50% have a non-hong Kong source. If a Hong Kong manufacturer pays subcontracting fees to parties in Mainland China for the manufacture of goods on behalf of the Hong Kong manufacturer, this is called import processing. The profit from import processing is considered to be trading profit and the source is determined according to the contract effected test. 3

4 1 (e) Describe the conditions for deductions of bad and doubtful debts under profits tax. (e) Conditions for deduction of bad and doubtful debts: The debt must have originally been included as a trading receipt. The debt is proved to the satisfaction of the assessor to have become bad. Normally, this means that positive action has been taken to collect payment and that this has proved unsuccessful. A deduction can only be claimed for a specific provision. 1 (f) Happy Partnership has two partners: Mr. A and Mr. B. They share profits/losses equally. For the year ended 31 March 2010, the partnership had a gross profit of $200,000 before the deduction of expenses. The partnership distributed salaries of $10,000 to Mr. A and $20,000 to Mr. B, and interest on capital of $16,000 to Mr. A and $8,000 to Mr. B. The partnership incurred some expenses of $40,000, all of which are allowable. Prepare an allocation of profits for the partnership. (f) Allocation of partnership profits: Mr. A Mr. B Total Salary 10,000 20,000 30,000 Interest 16,000 8,000 24,000 26,000 28,000 54,000 Residual (1:1) 53,000 53, ,000 Net assessable profits 79,000 81, ,000 4

5 1 (g) Explain the profits tax position of a club and a trade association. (g) Club and trade association: To decide whether a club is chargeable under profits tax, the test is whether or not less than half of its gross receipts on revenue account (including entrance fees and subscriptions) are from members. If more than half of the gross receipts are from members, the club is deemed not to carry on a business and is therefore not chargeable to profits tax. To decide whether a trade association is chargeable under profits tax, the test is whether more than half of the receipts by way of subscriptions are from persons who would claim a deduction of such payments under section 16. If more than half of the receipts by way of subscriptions are from such persons, the trade association is deemed to carry on a business and is therefore chargeable to profits tax. 1 (h) List FOUR conditions for a valid objection against an assessment issued by the Inland Revenue Department. (h) The notice of objection must be in writing and addressed to the Commissioner of Inland Revenue. The notice of objection must state precisely the grounds of objection. The notice of objection must be received by the CIR within one month of the date of the notice of assessment unless the CIR grants an extension. If the assessment is an estimated assessment made in the absence of a return, a properly completed return is required to validate the objection. 5

6 1 (i) Explain how a Hong Kong company may use a non-resident company to minimise its Hong Kong tax liability, and explain how the IRD may combat such an arrangement using section 20 of the Inland Revenue Ordinance. (i) A Hong Kong company may set up closely connected non-resident companies in overseas tax haven countries. The Hong Kong company then sells goods to the non-resident company by inflating the cost of purchase or reducing the sales proceeds to minimise its Hong Kong tax liability. Section 20 applies if a non-resident carries on business with a resident with whom he or she is closely connected and as a result the resident has no or less than ordinary profits which arise in or are derived from Hong Kong. Under section 20, the business done by the non-resident is deemed to be carried on in Hong Kong and is therefore subject to Hong Kong profits tax. 1 (j) Under the Stamp Duty Ordinance, an unstamped instrument is generally not admissible as evidence in court. List FOUR exceptions to this. (j) Exceptions to the admissible-in-court rule for unstamped instruments: Criminal proceedings. Civil proceedings instituted by the Collector of Stamp Duty to recover outstanding stamp duty. Civil proceedings before a court if the court so orders upon the personal undertaking of a solicitor to cause such an instrument to be stamped. Civil proceedings before a court if the Collector or the court has already allowed the payment of stamp duty to be postponed. 6

7 SECTION B 2. (a) An overseas merchant, who has no business presence in Hong Kong, wishes to sell some goods to Hong Kong customers. The merchant is considering four options: Option 1: selling to a Hong Kong wholesaler Option 2: selling to a Hong Kong subsidiary set up for this purpose Option 3: selling directly to Hong Kong customers through a branch Option 4: selling directly to Hong Kong customers through a consignment agent REQUIRED: Discuss the Hong Kong profits tax implications for the overseas merchant of each of the four options. In your discussion, you should address who is chargeable to profits tax (if any), and how the related assessable profit is ascertained. 2. (a) Option 1 The overseas merchant is not liable to profits tax because he is only trading with Hong Kong. Option 2 The overseas merchant is not liable to profits tax because he is only trading with Hong Kong. However, the Hong Kong subsidiary will be taxable under section 14 because he is carrying on a trade or business in Hong Kong. The assessable profit of the Hong Kong subsidiary will be determined in accordance with the general rule in the IRO. Option 3 The overseas merchant is liable to profits tax because he is trading in Hong Kong through a permanent establishment. The assessable profit shall be ascertained in accordance with IRR 5. If branch accounts are kept which show the true profits arising in Hong Kong, these are adopted and adjusted in accordance with all the rules in computing the assessable profit. If branch accounts are not kept, assessable profit in Hong Kong = adjusted worldwide profit x Hong Kong turnover / worldwide turnover. In addition, the assessor is empowered to fix the assessable profit at a fair percentage of Hong Kong turnover. Option 4 The overseas merchant is taxable as trading in Hong Kong through an agent. The agent has to file quarterly returns and pay up to 1% of gross proceeds to the IRD. If the agent amounts to a permanent establishment, the profits shall be ascertained in 7

8 accordance with IRR5. 2 (b) Ben operated a profitable shoe retailing business. He purchased the whole of the share capital of B Ltd, which carried out a garment retailing business. B Ltd has sustained heavy losses and has a huge tax loss carried forward. After acquiring B Ltd, Ben transferred the shoe retailing business to the company in consideration for new shares issued by B Ltd. Explain whether B Ltd may utilise its huge tax loss carried forward to offset against its future profits arising from the shoe retailing business. 2. (b) In general, losses can be carried forward indefinitely to set off against future profits under section 19C. However, this is subject to section 61B. Section 61B applies when: there is a loss brought forward for a corporation; then there is a change in shareholding in the corporation; as a consequence of the change in shareholding, profits have been received by or accrued to the corporation; and the CIR is satisfied that the sole or dominant purpose of the change in shareholding was utilisation of this loss to avoid or reduce the tax liability of that corporation or any other person. The consequence of applying section 61B is that the CIR can refuse to allow set-off of the loss brought forward against any such profits. If there is commercial justification for the acquisition of a loss company, section 61B may not be invoked. For example, if Ben is also a garment retailer and the motive for his acquiring B Ltd is to expand his retail outlets, then section 61B may not be applicable. 8

9 3. Mr. Chan was the company secretary of City Limited, a listed company in Hong Kong. During the year ended 31 March 2010, Mr. Chan had a Hong Kong employment and had the following income and expenditure: (i) Monthly basic salary of $50,000. (ii) Encashment of annual leave of $50,000. (iii) Each month, Mr. Chan paid rent for his apartment of $34,000 to his landlord and received a refund of rent of $30,000 from his employer. (iv) Mr. Chan s employer also paid for the apartment s utilities bills (registered in Mr. Chan s own name) totalling $10,000 (for the entire year); these payments were made to the utilities companies directly. (v) On 1 April 2009, City Limited granted Mr. Chan a conditional right to acquire 10,000 shares in the company at $100 per share. The options vested on 1 October 2009 and must be exercised on or before 30 September Mr. Chan sold 2,500 options on 31 December 2009 at $20 per option and exercised 2,500 options (for 2,500 shares) on 31 January These 2,500 shares were sold on 31 March 2010 at the prevailing market price. The market price of City Limited s shares are shown below: Date Market price ($ per share) 1 April October September December January March (vi) Mr. Chan donated $330,000 to an approved charity. (vii) Mr. Chan took the ACCA examination and paid $4,000 examination fees. Mr. Chan studied for the exams on his own and did not register for any 9

10 prescribed course. (viii) Mr. Chan paid $2,400 to the ACCA for his student membership and $2,000 to HKICS for his full membership. (ix) Mr. Chan is single, and has no dependents. REQUIRED: (a) Prepare Mr. Chan s salaries tax computation for the year of assessment 2009/10. (b) Explain the tax treatments that you have applied to items (iv), (v), (vii) and (viii) above. (c) Assume that Mr. Chan left his employment on 31 March 2010 and emigrated to Canada on 8 April Advise Mr. Chan of the time when the outstanding stock options that were granted on 1 April 2009 are assessable to salaries tax. (Note: Ignore the MPF, provisional tax and any rebate announced in the 2010/11 Budget in your answers.) 10

11 3. (a) Mr. Chan Salaries tax computation Year of assessment 2009/10 $ Salary ($50,000 x 12) 600,000 Annual leave encashment 50,000 Utilities 10, ,000 Less: Professional subscription (2,000) 658,000 Add: Rental value ($658,000 x 10%) 65,800 Less: Rent suffered ($34,000 - $30,000) x 12 (48,000) 17, ,800 Add: Gain on sale of share option ($20 x 2,500) 50,000 Gain on exercise of share option ($150 - $100) x 2, ,000 Assessable income 850,800 Less: Self-education expenses (4,000) Charitable donations (Limited to 35% x 850,800) (297,780) Net assessable income 549,020 Basic personal allowance (108,000) Net chargeable income 441,020 Tax at standard 82,353 Tax at progressive rates 62,973 Tax payable 62,973 (b) (iv) An amount paid by an employer in the form of discharge of the employee s monetary or pecuniary liability by the employer is not exempt from salaries tax (i.e. it is assessable). (v) The liability to salaries tax arises when the share option is sold or exercised, not at the time of the grant of the option or the sale of the shares. 11

12 (vii) With effect from 25 June 2004, qualifying self-education expenses are extended to include stand-alone professional examination fees for the purpose of gaining or maintaining qualifications for use in employment. (viii) Only full membership fee subscriptions to professional associations are deductible as a concession under salaries tax; student membership fees are not deductible. (c) Since Mr. Chan had a Hong Kong employment when the stock options were granted, the share option benefit is assessable in full during the year of assignment or exercise, even after he has left Hong Kong. However, the IRD, as a concession, can allow Mr. Chan to elect for the notional exercise of the stock options. Under this election, Mr. Chan would be assumed to have exercised the options on a day with seven days before the date of his departure of 8 April As a result, the notional gain would be assessable in the year of assessment 2010/11. 12

13 4. Des Voeux Limited was incorporated in Hong Kong in It carries on a business as a manufacturer of electronic components in Hong Kong. For the year ended 31 December 2009, it had a tax loss of $100,000. For the year ended 31 December 2010, its profit and loss account is as follows: Notes $ $ Income Turnover 9,000,000 Less: Cost of goods sold (5,400,000) Gross profit 3,600,000 Other income (i) 70,000 3,670,000 Expenses Administrative expenses 50,000 Depreciation 120,000 Employee wages 750,000 Legal and professional fees (ii) 30,000 Repairs and maintenance (iii) 95,000 Other expenses (iv) 150,000 (1,195,000) Net profit for the year 2,475,000 Des Voeux Limited also provides you with the following additional information: (i) Other income: $ Bank interest income derived in Hong Kong 40,000 Dividends received from Hong Kong companies 30,000 70,000 (ii) Legal and professional fees: $ Legal fee for arranging banking facilities from banks in Hong 7,000 Kong Legal fee for arranging the initial lease of business premises 8,000 Taxation fee for tax return preparation and submission 15,000 30,000 (iii) Repair and maintenance: $ Repairs of machinery 20,000 Loose tools (for replacement) 75,000 95,000 (iv) Included in other expenses is the loss ($70,000) on sale of shares listed on the Hong Kong Stock Exchange held for long-term investment purposes. 13

14 Additional information: As at 1 January 2010, the tax written down values of the plant and machinery used in the business to produce assessable profits were as follows: 10% pool: $50,000 20% pool: $220,000 30% pool: $310,000 During the year ended 31 December 2010, the company purchased office furniture (20% pool) for $100,000 and sold a motor vehicle (30% pool) for $30,000 (original cost $100,000). Between January 2010 and October 2010, the company constructed a building costing $880,000. The construction was completed during the year and the building has been used solely for manufacturing purposes since November REQUIRED: (a) Prepare Des Voeux Limited s profits tax computation for the year of assessment 2009/10. (Ignore provisional tax.) (b) Explain the tax treatment that you have applied to items (i), (ii), (iii), and (iv). 14

15 4. (a) Des Voeux Limited Profits tax computation Year of assessment 2009/10 $ $ Net profit per accounts 2,475,000 Add: Depreciation 120,000 Loss on sale of shares 70,000 Legal fee for initial lease of premises 8, ,000 2,673,000 Less: Bank interest income 40,000 Dividend income 30,000 Depreciation allowance (Note 1) 201,000 Industrial building allowance (Note 2) 211,200 (482,200) 2,190,800 Less: Loss brought forward (100,000) Assessable profits 16.5% Profits tax payable for 2009/10 344,982 Note 1: Depreciation allowance 10% Pool 20% Pool 30% Pool Total WDV b/f 50, , ,000 Addition (after IA of 60% x $100,000 = $60,000) 40,000 60,000 Less: Sales (30,000) Sub-total 50, , ,000 AA (5,000) (52,000) (84,000) 141,000 WDV c/f 45, , , ,000 Note 2: Industrial building allowance Total New building cost of construction 880,000 IA 20% x 880, , ,000 15

16 AA 4% x 880,000 35,200 35, ,200 (b) (i) Interest income from financial institutions in Hong Kong is exempt by virtue of the Exemption from Profits Tax (Interest Income) Order (Cap 112T). Dividend income is either exempt under section 26(a) or is offshore in nature. (ii) The legal fee related to arranging the initial lease of business premises of $8,000 is capital in nature under section 17 and thus not deductible. However, the legal fee for arranging banking facilities from banks in Hong Kong of $7,000, and the taxation fee for the preparation and submission of the company tax return of $15,000, are both deductible under section 16. (iii) Loose tools are purchased on a replacement basis and thus are fully deductible in the year of purchase under section 16(1)(f). (iv) The loss on sale of investments of $70,000 is capital in nature under section 17 and thus not deductible. 16

17 5. On 1 April 2009, Edward signed a provisional sales and purchase agreement to purchase a house in the New Territories for $4,200,000. On 1 May 2009, Edward went to the solicitor s office to sign the formal sales and purchase agreement. Conveyance took place on 1 June On 1 July 2009, Edward let the property to a tenant for a period of four years at a monthly rent of $30,000 each month, and at a premium of $240,000 payable on 1 July During the year ended 31 March 2010, Edward incurred the following expenditure on the property: Government rates $4,950 per quarter Government rent $2,700 per quarter Management fees $3,000 per month Mortgage interest $8,000 per month New carpet $6,000 total Edward is a single taxpayer and has no dependents. He is retired and has no other income. REQUIRED: (a) (b) (c) Explain Edward s chargeability to stamp duty on the property transaction and the rental transaction, and compute the stamp duty payable on both transactions. Prepare Edward s property tax computation for the year of assessment 2009/10. Advise Edward how he can reduce his overall Hong Kong tax liability for the year of assessment 2009/10. Support your answer with computations. (d) Edward is planning to purchase another rental property and wishes to minimise his overall stamp duty exposure in any transaction subsequent to acquisition. Advise Edward what he could do in order to minimise his overall stamp duty exposure in any transaction subsequent to acquisition and what other factors he needs to consider in his planning. (Note: Ignore provisional tax and any rebate announced in the 2010/11 Budget in your answers.) 17

18 5. (a) The provisional Agreement for Sale (AFS) is chargeable under Head 1(1A). Stamp duty payable on the provisional AFS = $90,000 + ($4,200,000 - $4,000,000) x 10% = $110,000. The formal AFS is signed more than 14 days after the provisional agreement; therefore it is also chargeable under Head 1(1A). Stamp duty payable on the formal sales and purchase agreement = $100. Conveyance on sale is chargeable to stamp duty under Head 1(1). Since conveyance on sale is in conformity with an AFS, stamp duty payable on conveyance on sale = $100. A written lease of immovable property in Hong Kong is chargeable to stamp duty under Head 1(2). Stamp duty payable on the lease = $240,000 x 3.75% + ($30,000 x 12 x 1%) = $12,600 (b) Edward Property tax computation Year of assessment 2009/10 Premium ($240,000 x 9/36) 60,000 Rent ($30,000 x 9) 270,000 Assessable value 330,000 Less: Rates ($4,950 x 3) 14, ,150 Less: Statutory deduction (20%) 63,030 Net assessable value 252,120 Property tax (15%) 37,818 (c) Edward may apply for personal assessment. Edward Personal assessment computation Year of assessment 2009/10 Net assessable value 252,120 Less: Interest on rental property ($8,000 x 9) 72,000 18

19 Reduced total income 180,120 Less: Single person allowance 108,000 Reduced total income after personal allowance 72,120 Tax at standard 27,018 Tax at progressive rates 3,048 Tax payable 3,048 (d) Edward may consider setting up a property holding company. The stamp duty rate for transfer of shares is only 0.2%, whereas the maximum rate for conveyance on sale/afs of residential property is 3.75%. However, Edward should consider the cost of incorporation and the maintenance costs of the company, such as the cost of an annual audit. Alternatively, Edward could consider setting up an offshore company with register of members kept overseas to avoid stamp duty altogether. 19

20 6. (a) Explain the differences between the requirements for an objection under section 64 of the Inland Revenue Ordinance and a revision claim under section 70A of the Inland Revenue Ordinance. (b) Explain the possible actions that the Inland Revenue Department may take against a taxpayer for the understatement of income, and the associated penalties that may be levied. 6. (a) Objection under section 64: Objections under section 64 are very broad. As long as a taxpayer is not satisfied with the assessment (including an estimated assessment), he or she may lodge an objection. An objection will be allowed if the grounds are valid. The time for lodging an objection is within one month after the date of the assessment. The Commissioner may extend the objection period. Revision under section 70A: Revisions under section 70A are very restrictive. A taxpayer may rely on this claim only when an error or an omission has been made in any return or statement submitted to the IRD. An error refers to an arithmetical error or an error of law. An omission refers to forgetting to do something such as forgetting to claim an allowance or deduction. If no return or statement is submitted, there can be no error or omission under section 70A. If an assessment is made under the prevailing practice at the time of the assessment, no error is regarded as having been made. The time limit for lodging a section 70A claim is within six years after the end of the year of assessment for which the revision is made, or within six months after the date of the assessment, whichever is later. There is no provision for extension of the time limit for lodging a claim under section 70A. (b) The taxpayer may be prosecuted for understatement of income without any reasonable excuse under section 80(2). 20

21 Such a person shall be charged with a fine at level 3 of $10,000 and incur a maximum penalty of three times of the tax undercharged. The Commissioner may compound the offence to a smaller amount under section 80(5). If no prosecution has been instituted under section 80(2) and section 82 in respect of the same facts, the IRD may invoke section 82A. A section 82A penalty may be imposed on a taxpayer who, without reasonable excuse, commits the same offences as under section 80(2). Section 82A imposes a penalty in the form of additional tax, which may be three times the tax undercharged. Section 82A additional tax can only be imposed by the Commissioner or a Deputy Commissioner personally. The taxpayer may be prosecuted for understatement of income where he has committed fraudulent acts under section 82. The penalty for offences prosecuted by summary conviction is a fine at level 3 of $10,000 and three times the tax undercharged, and imprisonment for up to six months. The penalty for offences prosecuted by indictment is a fine at level 5 of $50,000 and three times the tax undercharged, and imprisonment for up to three years. END 21