Professional Level Options Module, Paper P6 (HKG)

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1 Answers

2 Professional Level Options Module, Paper P6 (HKG) Advanced Taxation (Hong Kong) December 2010 Answers The suggested answers are of 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 indirect, incidental, consequential or any other damages relating to the use of the suggested answers. 1 Report to the Board of Directors of Joiner Ltd ( Joiner ) To: Board of Directors From: Tax Adviser Date: 6 December 2010 Subject: Hong Kong stamp duty and profits tax implications on the acquisition of Property X and a 50% shareholding in Business Ltd and review of its profits tax positions I refer to the proposed acquisition by Joiner of a Hong Kong property through the holding of shares in New Ltd, followed by a further acquisition of a 50% shareholding in Business Ltd ( Business ) from Vendor Ltd ( Vendor ). In relation to this, I advise below on the Hong Kong stamp duty implications on the relevant transactions and give comments on the profits tax positions of Business based on its profits tax computations prepared for 2008/09 and 2009/10. (a) Property and share transfers (i) The Hong Kong stamp duty cost, if any, at each phase of transferring Property X from its current ownership to the proposed ultimate ownership by Joiner Under the current structure, Property X is held by Business which is 100% held by Vendor. The proposed steps leading to the ultimate structure at the final phase include: Step 1 Business to establish a wholly owned subsidiary, New Ltd. Step 2 Business to transfer Property X to New Ltd. Step Business to transfer its 100% shareholding in New Ltd to Joiner. Under the Hong Kong Stamp Duty Ordinance (SDO), stamp duty is payable on instruments under the following four Heads of Charge: Head 1 Immovable property in Hong Kong (including sale, transfer and lease). Head 2 Hong Kong stock (sale and purchase). Head Hong Kong bearer instruments. Head 4 Duplicates and counterparts of chargeable instruments. The incorporation of New Ltd constitutes an issuance of shares, not a sale or purchase of shares. As a result, the transaction under step 1 is not chargeable to stamp duty although capital duty would be payable on the amount of New Ltd s authorised capital. Under step 2, Business is required to transfer Property X to New Ltd. As Property X is located in Hong Kong, the agreement for sale and purchase of Property X will be liable to ad valorem duty under Head 1(1A) of the SDO at the rate of 75% on the greater of the consideration or the unencumbered value of Property X. The formal assignment executed in conformity with the stamped agreement will only be liable to duty at the fixed rate of $100. Based on the information available, assuming Property X is to be transferred at the estimated market value of $600 million, the stamp duty would be $22 5 million. However, an exemption under s.45 is available under the SDO where the property is transferred between associated corporations and certain conditions are met. Two corporations are associated where one is the beneficial owner of not less than 90% of the issued share capital of the other, or a third corporation is the beneficial owner of not less than 90% of the issued share capital of each of them. In the current structure, the transferor is Business and the transferee is New Ltd. Since the transferor is the 100% beneficial owner of the transferee at the time of transfer, both companies are associated corporations for the purpose of s.45. In these circumstances, stamp duty may be exempted, provided that (i) the consideration for the purchase is not provided by an unassociated company (other than a bank in its ordinary course of business); (ii) the consideration is not received by an unassociated company and the beneficial interest in the property was not previously conveyed, transferred, purchased or sold, directly or indirectly by an unassociated person; and (iii) the transferor and transferee do not cease to be associated as a result of a change in shareholding of the transferee within two years after the date of execution of the instrument (s.45(4) and s.45(5a)). Proviso (iii) would be relevant in the current proposal in particular, when the shares in New Ltd are transferred from Business to Joiner. New Ltd is the transferee under step 2, and upon transferring the shares in New Ltd from Business to Joiner, New Ltd and Business will no longer be associated. Should this cessation of associated relationship be intended to occur (s.45(4)) or, though not so intended, actually occur (s.45(5a)) within two years after the date of execution of the instrument under step 2, the s.45 exemption would be withdrawn and stamp duty of $22 5 million would become payable within 0 days. The transfer of shares in New Ltd to Joiner in the Final Phase will also trigger stamp duty under Head 2 on the basis that New Ltd is a Hong Kong incorporated company and thus, its shares are registered in Hong Kong. The contract notes 15

3 (bought and sold notes) executed for the transfer would be liable to stamp duty at 0 2% in total on the consideration or the value of the shares transferred. In determining the consideration for this purpose, any liability that may be incurred by New Ltd in acquiring Property X from Business under step 2 would be taken as consideration for the transfer if the liability is to be assumed by Joiner. As such, assuming that the estimated market value of Property X has been used for step 2 regardless of whether liability is incurred in New Ltd, stamp duty of $1 2 million would also be payable upon the share transfer under step. Based on the above, assuming the above steps are followed, as proposed there will be a double-stamp duty charge payable by virtue of the first transfer of Property X followed by the second transfer of shares in New Ltd. The Board is therefore advised to re-consider the purpose of holding Property X under New Ltd, as the transfer mechanism will be more tax effective if Property X is transferred directly from Business to Joiner. In this case only the 75% or $22 5 million of stamp duty would be payable. (ii) The Hong Kong stamp duty cost, if any, of transferring 50% of the shares in Business from Vendor to Joiner The transfer of a 50% shareholding in Business by Vendor to Joiner will also be subject to stamp duty under Head 2, similar to the transfer of shares in New Ltd under (i) above, as Business is a Hong Kong incorporated company and thus its shares are registered in Hong Kong. The contract notes (both bought and sold notes) will, therefore, be liable to stamp duty at the rate of 0 2% on the consideration or the value of the shares bought and sold. Based on the balance sheet position as at 1 December 2009, the net asset value of Business is $26,054,000. Assuming that the transfer of the 50% shareholding is valued based on net asset value, the estimated consideration would be $1,027,000. Stamp duty of 0 2% thereon is $26,054. (iii) The Hong Kong profits tax implications to Business arising from the transfer of Property X to New Ltd as in Phase I, followed by a transfer of New Ltd to Joiner In Phase I, Property X is transferred from Business to its wholly owned subsidiary, New Ltd, at the estimated market value of $600 million. An accounting profit of $252 million would be made by Business. The profit would be taxable on Business in Hong Kong unless it represents a profit from the sale of a capital asset. Based on the information given, Property X has been used by Business to earn lease rental income from its director. It also appears that Property X has been held by Business for more than 1 years ($200,000,000 x 2% x 1 years = $52,000,000 (depreciation balance)). Therefore, the property is likely to be regarded as a capital asset for tax purposes unless there is evidence to support that there has been a change of intention by Business, which is difficult to ascertain in the absence of further information. Unless this is the case it can be expected that no profits tax would arise to Business on the transfer of Property X to New Ltd. (iv) The Hong Kong profits tax implications to Vendor arising from the transfer of 50% of its shares in Business to Joiner Following the acquisition of Property X, Joiner is also interested in acquiring 50% of the shareholding in Business from Vendor. Vendor is incorporated in the BVI, which is offshore Hong Kong. However, the information on hand is not sufficiently complete to determine whether Vendor is carrying on business in Hong Kong. This is a question of fact to be justified by a number of factors including the place of management and control of the company. I advise that more information needs to be obtained from Vendor on this aspect. Should it be considered necessary to outline the detailed factors separately, please let me know. If Vendor is not carrying on business in Hong Kong, there is no tax implication (except for the stamp duty as discussed in (ii) above) to Vendor in respect of the sale of 50% of its shareholding in Business. However, if Vendor is carrying on business in Hong Kong, the profit, if any, arising from the sale of the 50% shareholding in Business would need to be reported to the Inland Revenue Department (IRD); but it may be claimed as a non-taxable profit on the basis that it arises from a capital transaction. In particular, if Vendor has been holding the shares in Business for investment purposes over a number of years, it is probable that the capital profit argument may be sustained, unless there is a change of intention of Vendor from holding the shares for a capital investment purpose to a profit-making trading purpose (this is similar to the tax position of Business upon the disposal of its property to New Ltd as in (iii) above). (b) Tax treatment of various items by Business in the years of assessment 2008/09 and 2009/10 (i) Share trading gain Under the Hong Kong profits tax regime, any profit earned by a company carrying on business in Hong Kong, other than that earned from the disposal of a capital asset, is taxable in Hong Kong if the profit arises in or is derived from Hong Kong. The determination of source is not straightforward and there is no rule of thumb. In general, the broad guiding principle as established in the Hang Seng Bank case and HK-TVBI case is that one looks to see what the taxpayer has done to earn the profit and where he has done it. The approach taken by the IRD in assessing the source of profits is indicated in the Departmental Interpretation and Practice Note (DIPN) No. 21 (as revised in March 1998 and latest in December 2009). In the case of listed shares the source of profits is determined by the location of the stock exchange where the shares in question are traded. In this case Business earned the profits from the trading of shares in the Hong Kong Stock Exchange, thus, the profits are considered as sourced in Hong Kong, and so taxable in Hong Kong. As the activity is a kind of speculation Business was engaged in an adventure in the nature of trade. There are not grounds to argue that the shares from the disposition of which the gain was derived are capital assets and the gain is a capital gain. Therefore, the gain should not have been adjusted in the profits tax computation. 16

4 (ii) Shareholder s loan interest and bank loan interest Neither interest expense was adjusted in the tax computation, indicating that they were both claimed as tax deductible. Under s.16(1) of the Inland Revenue Ordinance, an expense is allowed to the extent that it is incurred in the production of profits chargeable to profits tax. It is also specifically provided under s.16(1)(a) that interest on money borrowed, together with other expenditures relating to the borrowings, for the purpose of producing assessable profits are deductible provided that the conditions under s.16(2) are satisfied. In the case of Business, it would be reasonable to assume that all the loan money from the shareholder or bank has been used to produce assessable profits, since based on the information provided all the company s income has been reported as taxable. Thus s.16(1)(a) is satisfied. However, in the case of interest paid to the shareholder, s.16(2)(c) requires that the interest income is taxable in the hands of the shareholder lender. Should Vendor not be a company carrying on business in Hong Kong and thus, not taxed in Hong Kong in respect of the interest received from Business, the interest expense would not be allowed as tax deductible by Business. It would, therefore, need to be adjusted back in the tax computation. In the case of interest paid to the bank, the interest would be tax deductible if (a) the bank loan is not secured by any deposit or loan which derives non-taxable income in Hong Kong (s.16(2a); and (b) no arrangement is in place whereby any interest payment is ultimately paid back to Business or any connected person (s.16(2b)). In the case of Business the information shows that the bank loan is secured partly on the property and partly by the director s personal guarantee. As such, it is reasonable to conclude that the interest paid on the bank loan satisfies all the conditions and therefore is allowable, assuming no bank deposit by the director was included in his personal guarantee. If this is the case then the bank interest has been treated correctly in the tax computation. (iii) Charitable donations Business has made a $00,000 charitable donation each year to the Tung Wah Group of Hospitals which is an approved charitable organisation in Hong Kong. However, there are other conditions that need to be satisfied before a tax deduction is allowed under s.16d. In particular, the donation must be in the form of money without conferring any benefit at all upon the donor, and the deduction is limited to 5% of the assessable profits after depreciation allowance but before charitable donations. In the case of Business, even assuming that the donation is a pure donation in money form, the fact that Business has incurred a loss in the year of assessment 2008/09 would deny the deduction for that year. The donation of $00,000 should first be added back in the tax computations of both years, and subject to any other tax adjustments, if an assessable profit is made before the donation deduction, the amount of donation not exceeding 5% of the assessable profits would be subsequently deducted. Accordingly, the donations need to be adjusted in Business profits tax computation. I trust that the above addresses all the Hong Kong stamp duty and profits tax implications arising from the proposed transactions. Should there be any questions, please let me know. End of Report 2 Tax consultant [Address] Mr and Mrs Chan [Address] [Date] Dear Mr and Mrs Chan, Thank you for engaging us to review your tax position for the year of assessment 2009/10. Based on the information you supplied, I outline our advice as follows: (a) 2009/10 Hong Kong tax positions During the year ended 1 March 2010, both you and Mrs Chan were employed under Hong Kong employment and thus any remuneration representing a reward for your employment is within the scope of salaries tax. In general, s.9(1)(a) of the Inland Revenue Ordinance (IRO) provides that taxable remuneration includes any wages, salary, leave pay, fee, commission, bonus, gratuity, perquisite or allowance, regardless of whether it comes from the employer or from some other person. The tax treatment of certain specific benefits are provided in the law, including benefits that are capable of being converted into cash by the employee and those amounts that represent the assumption by the employer of an employee s personal liability. In certain circumstances, case law needs to be referred to in order to ascertain the taxability of an item of income. Mr Chan s employment Your monthly salary is obviously taxable as it represents a reward for your employment. The amount assessable should be the gross salary of $100,000 per month (or $1,200,000 per annum). Your contribution to the retirement scheme is however specifically allowed as a concessionary deduction subject to a maximum of $12,000 annually. Also, upon withdrawal from the scheme at a later date, the full portion as attributable to your own contribution will not be taxed again. Your bonus is also taxable as a reward for your employment. But the question arises as to when a particular bonus should be taxed and in which year. Under s.11d(b), an income accrues to a person when he is entitled to receive it, whether he actually receives it or not. As your bonus is discretionary, it will not accrue until it is made known to you that it will be paid 17

5 and, in the absence of a stated date of payment, will accrue when actually paid. Therefore, your bonus paid in April 2009 would fall within the year of assessment 2009/10 in which it is paid, although it may relate to your employment for 2008/09. Moreover, s.11d(a) further provides that an income is deemed to have been received by a person when it has either been made available to him or has been dealt with in accordance with his instructions. This is relevant to your December 2009 payment of $100,000 which would be deemed as having been received by you although the same amount has been paid into the retirement fund according to your instruction. The medical insurance scheme provided by your Company is a contractual obligation between the Company and the insurance company, and thus the annual premium paid by the Company is discharging its own liability rather than yours. Thus, both the premium and any benefit for the services are not taxable. In relation to the extra premium of $5,000 paid by you for your son s coverage, the expenditure is regarded as your personal expense and thus is not deductible in computing your assessable income. Compensation for leave untaken is regarded as an income from your employment rendered during the leave and therefore, is taxable. However, the benefit of the holiday flat as provided by the Company would not be taxable to you on the basis that the benefit is not convertible into cash and the monthly rental payment is a discharge of the Company s own liability. In respect of your apartment, you will be entitled to a deduction of the bank mortgage loan interest against your assessable income on the basis that the interest is paid on a loan of money obtained from a bank wholly or partly for the acquisition of a dwelling solely owned by yourself, and used by you as a place of residence. However, there is a maximum deduction of $100,000 for each year of assessment. In your case, as part of your property is used for a car-park, which has been leased out, the portion of interest as attributable to the car-park area strictly speaking does not qualify for home loan interest deduction. That said, it is still advantageous for you to make a deduction claim for the aforesaid portion of the interest paid as it would reduce your assessable income. Note also that a similar home loan interest deduction may be claimed in the years elected by you subject to the maximum of ten years. If you have not made the claim in your prior years tax return and you desire to make claims for those years, you may write to the assessor stating the claim as an error or omission under s.70a, within six years after the end of the particular year of assessment or within six months after the service of the notice of assessment for the year of assessment, whichever is the later. Rental from leasing the car-park is subject to property tax in Hong Kong on the basis that the car-park is regarded as land and building located in Hong Kong. The standard rate of 15% would apply on the property s net assessable value which is determined under s.5b as any consideration payable in money or money s worth in respect of the right to use the land or/and buildings as reduced by rates and a statutory standard allowance of 20%. Based on the monthly rental of $,000, the annual consideration is $6,000. Due to the government concessions in recent years, no rates should have been payable by you. Government rent and property management fees are not allowable. The net assessable value of the car-park for property tax purposes is thus $28,800 and the property tax liability is $4,20. No mortgage interest is deductible under property tax, although an interest deduction may be allowed under personal assessment, as explained further below. If you have not reported the car-park rental in your prior years tax returns, you should inform the Inland Revenue Department (IRD) immediately. This will help mitigate your being challenged as evading tax should the IRD find out that the lease was not reported. Mrs Chan s employment Mrs Chan s salary as a shop assistant is also taxable under salaries tax. As the annual salary of $96,000 is lower than the basic personal allowance any shortfall unutilised would be forfeited. It is therefore advisable for you and Mrs Chan to elect for joint assessment so that the net chargeable income of both of you is aggregated and a single assessment is raised. In doing so, the full amount of the married person s allowance of $216,000 may be fully claimed against the aggregated income, in effect utilising the said shortfall. Other available deductions Child allowance is available in respect of your daughter but not for your son, for the reason that he is not studying on a full-time basis. In respect of the fee paid for the maintenance of Mrs Chan s mother, you would not be eligible for dependent parent allowance, for the reason that Mrs Chan s mother is not ordinarily resident in Hong Kong (D116/99). Moreover, elderly residential care expenses would not be claimable as the nursing home in Mainland China is unlikely to be an approved nursing home in Hong Kong. (b) Hong Kong tax implications if Mrs Chan acquires and runs the convenience store under sole-proprietorship If Mrs Chan acquires the convenience store business and operates it under her sole name as sole-proprietress she will be regarded by the IRO as carrying on a business in Hong Kong and will therefore be subject to profits tax in respect of her profits arising from that business. The current profits tax rate for unincorporated business such as a sole-proprietorship is 15%. However, the ultimate applicable tax rate may differ if personal assessment is elected as explained below. In the current situation, Mrs Chan is an employee of the store business that is not owned by her and the salary received by her is taxable under salaries tax. However, should Mrs Chan become the sole proprietress of the business, any salary payable to Mrs Chan would be regarded as a withdrawal of profits from the business. Withdrawals of profit are not taxable under salaries tax but the same amount [technically it is not salary or a cost] would not be deductible in calculating the business profits subject to profits tax. Any loan interest payments made to Mrs Chan or yourself would also not be tax deductible by the business. Mrs Chan would not be assessed on the salary under salaries tax. 18

6 Should there be any loss incurred in future years, the loss could be carried forward and used to offset against any future taxable profits arising from the same business carried on by Mrs Chan. However, such a loss may be transferred to offset other sources of income if personal assessment is elected, as explained below. Personal assessment Personal assessment allows an individual taxpayer to be assessed on his or her total income from different sources including salary, business profits (for unincorporated businesses only) and property income. In your case, there may be advantages by electing personal assessment so that any profit or loss from the sole-proprietorship business of Mrs Chan may be aggregated with your employment income and car-park lease rental; and the mortgage interest can be claimed as deductible against the assessable property income. The total income will then be subject to concessionary deductions (i.e. home loan interest and retirement contributions in your case) and other personal allowances (i.e. married person s allowance and child allowance for your daughter) before the progressive rates from 2% to 17% apply. The overall tax liability would still be subject to the maximum of 15% on income before personal allowances. Conclusion It is advisable for you to write to the IRD to claim the home loan interest deduction and report the rental income from leasing your car-park. Joint assessment should also be elected to maximise the personal allowance entitlement. Depending on the loan interest portion attributable to your car-park, it may also be advisable to elect personal assessment, in particular if the convenience store business is to be acquired under sole-proprietorship. Should you require further assistance in these aspects, please let us know. Yours sincerely, For and behalf of Xxx Tax Advisers Consultant X (a) For an objection to be valid under s.64(1), it must: (i) be in writing and addressed to the Commissioner; (ii) state precisely the grounds for the objection; (iii) be received by the Commissioner within one month after the date of the notice of assessment; and (iv) be accompanied by a proper tax return, including a nil return, if the assessment was an estimated assessment under s.59() of the Inland Revenue Ordinance. In this case, requirement (iii) may pose a problem because the one month period has already expired. Prima facie the objection cannot be made. However, s.64(1) proviso (a) requires the Commissioner to accept the objection after the one month period if he is satisfied that the taxpayer is prevented from making the objection within such period due to absence from Hong Kong or other reasonable cause. This would be relevant to Mr Ip and thus it is advisable that Mr Ip should lodge the objection as soon as possible and state the period of absence with evidence. (b) An illustrated example of a notice of objection: The Commissioner of Inland Revenue [Address] Dear Sir/Madam, Notice of objection for assessment for 2009/10 under charge no. xxxx I refer to the above Notice of Assessment to salaries tax dated 1 October I hereby write to object to the assessment on the following grounds: The income as assessed represents fee income paid by xxx Securities Company to me as its financial analyst under an independent service agreement. There is no employer employee relationship between myself and the company. The fee income was not derived from any source of employment under the charging section of s.8(1)(a) of the Inland Revenue Ordinance ( IRO ). The income received should be subject to profits tax, not salaries tax as assessed. To substantiate this, I attach my profits tax return duly completed. Due to my work commitments, I have not been able to file the profits tax return on time and would sincerely request that the return be accepted for the purpose of this objection. Please note that I carry out the services as a financial analyst on a self-employed basis and my business registration number is xxxx. A copy of the business registration is also attached for your reference. Moreover, I apologise for the delay in submitting this objection on the grounds that I have been absent from Hong Kong since xx September 2010 on a two-month trip to Europe. The notice of assessment was found to have been delivered on 1 October 2010, before I returned to Hong Kong at the end of November. To substantiate my absence from Hong Kong, I also attach copies of my passport for your information. In view of the above, I request that this late objection be accepted in accordance with s.64(1) of the IRO. I would be grateful if you would consider my objection and cancel the notice of assessment before the tax payment is due. In the meantime, I would also request the tax demanded to be held over unconditionally pending the settlement of the objection. 19

7 Should there be any questions, please let me know. Yours truly, [signed] (Tutorial note: The above format is for illustration. Any other format serving the same purpose will be accepted.) (c) The question of whether Mr Ip renders his services as a financial analyst as an employee or an independent contractor is a question of fact. In the former case, there is employer employee relationship between Mr Ip and the securities company, and the governing contract is regarded as a contract of service. In the latter case, there is no employer employee relationship and the governing contract is generally regarded as a contract for services. Based on various case laws, a number of factors would be considered and each case should be determined on its own merits. Factors to be considered include whether Mr Ip provides his own equipment, whether he hires his own helpers, what degree of financial risk he runs, what degree of responsibility he has and whether he has an opportunity to benefit from sound management: Ready Mixed Concrete case. These factors are generally referred as the economic reality test. The question is not sufficiently clear for these factors to be fully assessed and more information is required before an analysis can be done. The service agreement should be obtained as this will indicate the nature and scope of his services and other terms including the payment mechanism and any indemnity or liability clause would also be important to illustrate the intention of both parties at the time of entering into the agreement. Prima facie, the fact that Mr Ip has obtained a business registration certificate is strong evidence that he has the intention to carry out business as an independent contractor. However, this may not be sufficient to evidence that his relationship with the securities company is one of an independent nature. He also claimed that he was not required to adhere to the company s working hours. As flexible working hours are not uncommon in Hong Kong s workplaces, this factor may or may not add weight to his argument depending on whether it is specifically mentioned in the agreement, what kind of mode of operation the securities company has, and what is being required of the other employees of the securities company. Unfavourable evidence to Mr Ip includes his name card bearing the name of the securities company and his position assigned by the company. He is also assigned a workplace within the office of the company. Moreover, he is entitled to the medical benefit as well as the holiday flat provided by the company. These would demonstrate that to a certain extent, Mr Ip is regarded or recognised as one of the members of the company. This is generally referred as the integration test which seeks to analyse the degree of integration between the two parties. Should it be the genuine intention of Mr Ip to work as an independent contractor for the company, he is advised to produce sufficient information to illustrate that the provision of these benefits is a common practice within the industry, and similar benefits would also be available to him if he were to be engaged by a different securities company. He should also produce information to convince the Commissioner that the provision of benefits is in the interests of both parties e.g. the name card bearing the position and name of the company, which would enhance his identity and his convenience for work. This is particularly the case when he is not allowed to serve other competitors, and thus it is reasonable to assume that part of the reason why the securities company provides the related benefits to Mr Ip is to enhance the relationship with him. 4 (a) From the perspective of HK Co, at the time when a share option or share award is granted by UK Co, UK Co recharges the fair value of the option or award by issuing a debit note to HK Co. HK Co records the recharge as an expense in its income statement, and on the other hand, records the liability to pay in the inter-company current account with UK Co. However, no payment has ever been made by HK Co to settle the accrued payable. The tax deductibility of the recharge expense by HK Co depends on the general deduction rule under s.16(1), i.e. a deduction will only be allowed when (i) the liability is an outgoing or expense, (ii) it is incurred, and (iii) it is in the production of assessable profits. Given the fact that the liability arises from the grant of an award to staff members of HK Co and assuming that the related staff member is providing services to HK Co in producing HK Co s assessable profits, test (iii) of in the production of assessable profits should be satisfied. HK Co receives a debit note from UK Co evidencing the occurrence of a liability and the amount involved. Moreover, the liability is recorded by HK Co as payable to UK Co. and expensed as staff cost in its income statement. This demonstrates that HK Co has recognised the liability to pay the amount to UK Co, and this liability represents an operating cost against its business. This satisfies test (i) that the liability is an expense or outgoing. Test (ii) requires that the liability must be incurred. In general, an expense is considered incurred when it becomes due and payable or when the company becomes definitely committed to the expense even though payment may not be due until later. In circumstances where a liability only accumulates but is not paid or never paid, like in the case of HK Co, it would strictly speaking be difficult to demonstrate that the liability has indeed been incurred, unless there are evidences to establish that the expense in the income statement actually represents a specific provision for a liability that has accrued with substantial accuracy. In the case of HK Co, it is advisable for the accumulated accrued balance to be settled or paid in order to demonstrate that the liability is genuinely accrued and incurred in order to satisfy test (ii). (b) From the perspective of the staff members of HK Co, both awards, share options and share awards, are taxable as they are received in compensation for their employment services provided to HK Co. However, the timing of assessment and value to be assessed may be different depending on the circumstances. 20

8 In the case of the share option benefit, the taxability is governed by s.9(1)(d) of the Inland Revenue Ordinance (IRO). The option benefit will be taxed on the gain realised through the exercise, assignment, or release of the option. For this purpose, the option right is only taxed if it is granted at a time when the staff member is holding a Hong Kong employment or as a result of a Hong Kong employment. At the time of exercising, assigning or releasing the option right, the difference between the market price of the shares at the time of exercise, assignment or release and the cost paid for the option will be taken as the taxable gain for salaries tax purposes. Any gain arising from the subsequent sale of the shares is considered as a return from investment rather than employment, and thus is disregarded. In the case of the share award benefit, the taxability is governed by the general charging provision of s.9(1)(a) as perquisites. As such, the timing of taxing the award would depend on the timing at which the perquisite accrues to the staff. In situations when there is no vesting period, that is the staff member is entitled to the shares and will have their names registered upon being granted the shares, the time of assessment is at the time of grant. This approach is regarded as the upfront approach by the Inland Revenue Department (IRD) under DIPN 8 (issued March 2008). The taxable value of this award would be based on the market value of the shares at the time of grant. However, if the award is granted with a vesting period and the staff member is not fully entitled to ownership of the shares until the end of the vesting period, the time of assessment will be based on the time at which the vesting period is completed. In contrast with the upfront approach, this is regarded as the back-end approach. The taxable value will therefore be the market value of the shares at the time when all the conditions are fulfilled. 5 Company A has incurred a fee expense of $ million based on one invoice issued by an offshore associate in December 2008 but subsequently partially waived after the year end. As a result, the total invoice value was recorded as an expense for the year ended 1 December 2008 and the waived portion was recorded as income for the year ended 1 December Prima facie, the transaction was fully supported by documents (e.g. invoice/credit note) and thus the legality cannot be denied. However, the excessive portion of the invoice was so significant that it could have turned the company from its loss position in 2008 to a profit position. Unless there are genuine commercial reasons to justify the waiver, the transaction is thus, subject to the risk of being challenged under the anti-avoidance provisions. There are generally two anti-avoidance provisions under the Inland Revenue Ordinance (IRO), s.61 and s.61a. Under s.61, the Assessor is empowered to disregard a transaction and assess the taxpayer accordingly, if (a) there is a transaction, being the whole transaction rather than the part of it; (b) the transaction is artificial or fictitious, generally referred to as a transaction which is not commercially realistic (for artificial transaction) and not given effect to (for fictitious transaction); and (c) the transaction has the effect of reducing the tax payable. In the case of Company A, transaction could refer to the excessive portion of the $ million fee accrued but subsequently waived and could be regarded as artificial or fictitious unless there is commercial reason to justify the acts and the parties really intend to effect the payment of the amount of $ million. In respect of the year 2008/09, the tax payable for that year has indeed been reduced. On this basis, s.61 would likely apply. However, there is a possibility that condition (c) above is interpreted in a different way such that the tax payable is effectively postponed rather than reduced. In this case, s.61 may not be applicable. A more comprehensive general anti-avoidance provision, s.61a was introduced in For s.61a to apply, there must be a transaction which includes a transaction, operation or scheme whether or not they are enforceable by legal proceedings, and covers single, multiple or composite transactions; the taxpayer and/or any other person must obtain a tax benefit which is defined to include (i) the avoidance of tax liability, (ii) the postponement of tax liability by shifting the tax to a later year, or (iii) a reduction in the amount of tax by altering the assessable profit/income to a lower level; and having regard to the seven specific matters, the transaction must be entered into or carried out for the sole or dominant purpose of enabling the taxpayer to obtain a tax benefit. Applying DIPN 15 (revised) the seven specified matters could be seen as follows: (i) The manner in which the transaction was entered into or carried out: In the case of Company A, the December invoice was actually issued during 2008 but subsequently partially waived or cancelled after the year end. (ii) The form and substance of the transaction: The legal form of the transaction would be the invoice and letter of waiver. This legality would be compared to the substance of the transaction, i.e. the reason for the waiver; and the genuine amount of fee as commensurate with the services provided in (iii) The result that would have been achieved by the transaction if without s.61a: Without s.61a, the excessive amount of the December invoice would have become an expense for the year 2008, resulting in a tax loss incurred by the company for 2008/09. (iv) Any change in the financial position of the relevant person that has resulted, will result, or may reasonably be expected to result, from the transaction: The transaction has changed the financial position of Company A to the extent that tax for 2008/09 has been deferred to later years. (v) Any change in the financial position of any person who has, or has had, any connection with the relevant person: The transaction also gives rise to a change in financial position of the corresponding associate who would have recorded the excessive fee income in It is, however, noted that the associate is offshore Hong Kong. 21

9 (vi) Whether the transaction has created rights and obligations which would not normally be created between persons dealing with each other at arm s length under a similar transaction: Although the waiver of excessive obligation is not uncommon in commercial transactions, the relevant transaction in the case of Company A and its associate involves an amount that is too significant and excessive to justify its arm s length nature. (vii) The participation in the transaction of a corporation resident or carrying on business outside Hong Kong: The offshore associate of Company A plays a significant part in the transaction, and its associate relationship with Company A is relevant in this context. Based on DIPN 15 (revised), each of the above matters would be considered and weighed in order to draw a conclusion whether the transaction was entered into for the sole or dominant purpose of obtaining a tax benefit. Each matter does not necessarily carry equal weighting and each case has to be considered on its own merits. Based on the above analysis, it is possible that the transaction would be considered as carried out for the sole or dominant purpose of obtaining a tax benefit. The consequences to Company A would be an assessment to be made by the Assistant Commissioner on the basis either that the transaction did not take place; or that an arm s length value is substituted. As a result, the excessive portion of the December invoice to the extent it is waived (i.e. $2 5 million) might be disregarded and only $0 5 million deemed as valid and deductible for 2008/09 purposes. In doing so, Company A would become assessable for 2008/09 in the amount of $0 5 million instead of a loss of $2 million. Therefore, no tax loss is available to be carried forward to 2009/10. For 2009/10, Company A would incur a tax loss of $1 million instead of a taxable profit of $1 2 million. (Tutorial Note: Based on the Court of Final Appeal ruling in Shui On Credit Co Ltd case, 0 November 2009, s.61a (and s.61) is not a separate, self-contained charging provision, but it is meant to extend the scope of the ordinary charging provisions in the IRO. In the Shui On case, the deferred expenditure was considered as capital in nature and not deductible under s.16 or s.17. As a result, s.61a cannot apply as there is no tax benefit in the statutory sense. In the case of Company A, the significantly excessive fee of $ million expensed in 2008 as compared to normally $0 5 million in prior years could be challenged by the IRD under s.16 by virtue of the extent to which the expense is incurred in the production of assessable profits. Should it be established that the fee level of $ million is excessive, the deduction would be restricted to the level that is justified and reasonable. Sections 61 or 61A in this circumstance may not apply.) Note: Appropriate marks would also be awarded to alternative answers based on knowledge of the updated case development and case law. 22

10 Professional Level Options Module, Paper P6 (HKG) Advanced Taxation (Hong Kong) December 2010 Marking Scheme Available Maximum 1 (a) (i) Incorporation of company not subject to stamp duty 1 Stamp duty on property transfer Liability to ad valorem duty/consideration 1 5 Liability on formal assignment 1 Calculation of stamp duty payable at 75% 0 5 Section 45 exemption Definition of associated persons 1 Application to New Ltd and Business 0 5 Conditions Cessation of association between New Ltd and Business 1 Withdrawal of s.45 relief 1 Stamp duty on transfer of New Ltd Liability to ad valorem duty 2 Calculation of stamp duty payable 0 5 Double stamp duty payable/comment on tax effectiveness (ii) Stamp duty on 50% shareholding transfer Stampable documents and rate (as in (i)) 1 Consideration 1 Calculation of duty payable 1 (iii) Profits tax implication on property transfer Accounting profit 0 5 Not taxable if capital nature 0 5 Use of property for lease rental 0 5 Period of holding, including calculation 1 Conclusion 0 5 (iv) Profits tax implication on share transfer Carrying on business in Hong Kong issue, including need for further information 1 Not taxable if no business in Hong Kong 1 Need to report if carrying on business in Hong Kong 1 Not taxable if capital nature (b) (i) Share trading gain Source rule 1 Place of listing 1 No grounds to treat as a capital asset 0 5 No adjustment 0 5 (ii) Shareholder and bank loan interest General deduction rule 1 Application to Business/s.16(1)(a) satisfied 1 Loan interest to shareholders (s.16(2)(c)) 0 5 Effect of shareholder not carrying on business in Hong Kong 1 5 Bank loan interest deduction rules 1 Application to Business Ltd/treated correctly

11 Available Maximum (iii) Charitable donation Approved charitable organisation 0 5 In form of money 0 5 5% limit 0 5 No deduction when loss incurred 1 Add back and adjust 0 5 Appropriate format and presentation 1 Effectiveness of communication 1 2 Total 6 2 (a) General principles of s.9(1)(a) 1 Convertible to cash 0 5 Discharging personal liability 0 5 Mr Chan s employment Monthly salary at gross without deduction of 5% 0 5 Contribution to retirement scheme $12,000 1 Bonus taxable but accrued upon payment 1 April payment within 2009/ Income deemed to be received when made available or dealt with per instruction 1 December payment taxable 0 5 Medical insurance premium not taxable 1 Extra premium for son not deductible 1 Leave pay taxable 1 Holiday flat not taxable 1 Home loan interest deductible excluding car-park portion 1 Maximum $100,000 for ten years 1 Section 70A claim 2 Car-park rental subject to property tax 1 Net assessable value 2 No interest deduction 0 5 Section 70A claim for car-park rental 1 Mrs Chan s employment Salary taxable but lower than basic allowance 1 Joint assessment more effective 1 Child allowance for daughter not for son 1 No dependent parent allowance 1 No elderly residential care expense (b) Sole proprietorship business subject to profits tax at 15% 1 Mrs Chan s salary as withdrawal of profits and non deductible 0 5 Withdrawal of profits and salary to Mrs Chan not taxable 0 5 Loan interest and rent payment not deductible 1 Position of losses 1 Personal assessment more effective 1 5 Progressive rates and subject to maximum 15% Appropriate format and presentation 1 Effectiveness of communication Total 0 24

12 Available Maximum (a) Objection in writing 0 5 With grounds 0 5 Within one month 0 5 Accompanied by tax return 0 5 Late objection if reasonable grounds 1 (b) Notice of objection Subject 0 5 Date of assessment 0 5 Income not derived as employment income 0 5 No employer employee relationship 0 5 Subject to profits tax instead 0 5 Attach profits tax return 0 5 Business registration number and copy 0 5 Late objection grounds 0 5 Reply before tax due date 0 5 Request unconditional holdover Note: the letter format is not required in part (b) (c) Question of fact 0 5 Employer employee relationship as contract of service 1 No employer employee relationship as contract for service 1 Various factors/reference to case law principles 1 Economic reality test 1 Service agreement terms 1 Business registration helpful but not sufficient 1 Flexible working hours 0 5 Name card 0 5 Workplace 0 5 Medical benefit and holiday flat 0 5 Integration test 1 Common industry practice 1 Benefit to both parties/exclusively for company Total 17 25

13 Available Maximum 4 (a) General deduction rule/tests 2 Satisfy in the production of assessable profits test 1 Satisfy outgoing and expense test 1 May not satisfy incurred test as not paid 2 Recommendation (b) Both are taxable employment income 1 Share option taxed under s.9(1)(d) 1 Timing of assessment Hong Kong employment 1 Taxable gain calculation basis 1 Disposal gain disregarded 1 Share award taxed as perquisite 1 Timing based on when accrued 1 If no vesting period, at time of grant 1 Upfront approach 0 5 Value based on market price at time of grant 1 If vested, at time when vesting period ends 1 Back-end approach 0 5 Value based on market price when conditions fulfilled Total 17 5 Effect of turning loss into profit/risk of challenge 1 Section 61 provisions 2 Application of conditions to Company A (1 mark each) Section 61A provisions Application of DIPN specified matters to Company A (1 mark each) 7 Conclusion s.61a applicable 1 Consequences Excessive portion and waiver disregarded 1 Effect of limiting deduction to unwaived portion Total 17 26