Professional Level Options Module, Paper P6 (HKG)

Transcription

1 Answers

2 Professional Level Options Module, Paper P6 (HKG) Advanced Taxation (Hong Kong) December 2012 Answers Cases are given in the answers for educational purposes. Unless specifically requested, candidates are not required to quote specific case names to obtain the marks, but are required only to provide the general principles involved. The suggested answers are in the nature of general comment only. They are not offered as advice on any particular matter and should not be taken as such. No reader should rely on the suggested answers as the basis for any decision. The examiners expressly disclaim all liability to any person in respect of any indirect, incidental, consequential or any other damages relating to the use of the suggested answers. 1 Report to Green HK Ltd To: CEO of Green HK Ltd (Green-HK) From: Tax Advisor Date: 7 December 2012 Subject: Cessation of business of Green-HK We refer to our discussion with you on the proposed cessation of Green-HK s retailing business and the related tax issues arising therefrom. As requested, we are presenting below our comments on the respective issues. (a) (i) Sale of land and store building Based on s.40(1) of the Inland Revenue Ordinance (IRO), broadly speaking, any building or structure other than an industrial building or structure is defined as a commercial building. In the case of Green-HK, the building has been occupied and used as a retail store, which does not fall within the qualifying uses for industrial building allowance. As a result, the building qualifies as a commercial building for depreciation allowance purposes. Unlike an industrial building, no initial allowance is granted for a commercial building, but an annual allowance of 4% would have been granted for each year of assessment in which Green-HK has had a relevant interest in the building which is used by Green-HK for the production of its assessable profits at the end of the basis period for the year of assessment. Green-HK acquired the building in July 2006 and has been using the building for the production of its assessable profits since that date; thus an annual allowance would have been granted from the year of assessment 2006/07 up to and including 2010/11, the year preceding the proposed year of sale of the building. The IRO requires that the 4% annual allowance is to be calculated based on the capital expenditure incurred on construction of the building and structure, and the cost or value of the land is excluded. However, where a building was bought unused from a property developer, the net price paid on the building portion is deemed to be capital expenditure qualifying for the annual allowance. This applies to Green-HK, such that 50% of the original purchase cost of the land and building qualifies for annual commercial building allowance. Based on the cost of $10,000,000, the annual allowance claimable is: $200,000 ($10,000,000 x 50% x 4%) per annum. If the building is to be disposed of in 2011/12, a total of five years allowance would have been claimed for the years 2006/07 to 2010/11 inclusive. Tutorial note: The above calculation is based on the prevailing practice, unless the IRD has the evidence of the exact amount of qualifying expenditure. In the disposal year of 2011/12, the balance of qualifying cost for annual allowance brought forward from the preceding year would be regarded as the residue of expenditure before sale, and this would be compared with the sale proceeds attributable to the building portion. If the residue before sale exceeds the sale proceeds, a balancing allowance would be granted (subject to s.33b(2)(b) as discussed in (a)(ii) below) and available for deduction against any assessable profits of Green-HK in that year. An estimated calculation of the balancing allowance of $3,000,000 is shown in Appendix 1. (ii) The purchaser s counter-offer Under s.35(2)(b)(ii), if a building is demolished for purposes unconnected with or not in the ordinary course of conduct of the business in relation to which the building was used to qualify for the annual allowance, no balancing allowance would be granted. Therefore, if Green-HK were to demolish the store building in order to vacate the landsite for its disposal, no balancing allowance would be granted to Green-HK. This would imply that Green-HK would forfeit the deduction of $3,000,000 balancing allowance in the year of assessment 2011/12. Whether or not this represents a tax disadvantage to Green-HK would depend on whether it is expected to make a significant net assessable profit in the final year before the deduction of the $3,000,000. As Green-HK already has tax losses brought forward from the previous year, it is likely that Green-HK s net position in the final year (before balancing allowance but after set-off of the previous year s tax loss) would remain as a loss. In this case, the balancing allowance may not be of immediate value, and it may be worthwhile to consider forfeiting the balancing allowance in return for a higher price for the land transaction. Alternatively, if Green-HK s management is keen to preserve the overall tax losses for future use, it would be helpful not to demolish the building before sale and to claim the balancing allowance, as Green-HK s tax loss position would not jeopardise the claim. In the event that the building is demolished prior to the sale of the land, a gain would arise, being the difference between the land s purchase cost of $5,000,000 and the final sale proceeds. This gain is likely to be non-taxable on the basis that the land is a capital asset of Green-HK. The cost incurred for demolishing the building, however, would not be tax deductible. 13

3 (iii) Annual deprecation allowance available to the purchaser You are also interested in knowing the purchaser s tax depreciation allowance position following his acquisition of the building. Assuming that the portion of the sale proceeds attributable to the building is $1,000,000, an allowance of $47,619 would be available to the purchaser for each year until the year of assessment 2031/32, as shown in Appendix 2. (b) (i) Donation of equipment A charitable donation is accepted as a tax deduction by a specific provision (s.16d) in the IRO, and is subject to limitations. In brief, the donation must be made in money terms to an approved charitable organisation. The payment must be a pure donation that does not confer any benefit on the donating party. Other than a minimum of $100, there is a ceiling for deductible donations, which is 35% of the taxpayer s assessable profits after depreciation allowance but before charitable donation. Finally, the donation must not qualify for a deduction under any other part of the IRO. In the case of Green-HK, the donation of equipment to a charitable organisation would not by itself be tax deductible on the basis that first, the donation is not in money terms, and second, and more importantly, Green-HK does not have assessable profits to enable the donation to qualify for the 35% ceiling threshold. However, as all of the equipment is included in the plant and machinery pools subject to tax depreciation allowance, all the remaining tax written down value would be allowed as a tax deductible balancing allowance on the basis that the pool assets have been disposed of for zero value. In other words, it would be the tax written down value rather than the net book value that would be tax deductible, but as a balancing allowance, not as a charitable donation. (ii) Alternative suggestion for the donation The alternative suggested by the CEO would not help the position but rather may make the transaction more tax ineffective. As explained above, no tax deduction would be granted for a charitable donation if Green-HK incurs losses. This would hold true even if Green-HK sold the equipment and donated the sale money to the charitable organisation. On the other hand, the sale money of the equipment would be deducted from the tax depreciation pools. If the sale money exceeds the tax written down value, the excess would be assessable as a balancing charge which would be offset in computing the assessable profits of Green-HK by the loss of the year, if any, and the loss brought forward from prior years. If the tax written down value exceeds the sale money, the remaining balance would still be allowed as a deductible balancing allowance, but the amount would be reduced accordingly. (c) (i) Sale of trading stock to Green China Ltd (Green-China) Section 15C contains specific provisions to govern the sale of trading stock by a business on its cessation. Where the stock is sold to a person who will use the stock in a business carried on in Hong Kong and will be claiming the purchase cost as a deductible expense, the actual proceeds from the sale of the stock would be accepted as taxable proceeds for the ceasing business. However, in any other situation, the value of the trading stock is deemed to be the stock s open market value at the date of cessation. In the case of Green-HK, the stock would be sold upon the cessation of business, and thus s.15c should apply. The target buyer, Green-China, is a company carrying on business in China but not in Hong Kong, and it is not likely to be chargeable to profits tax in Hong Kong; hence the acquisition cost of the stock will not be deductible for Hong Kong profits tax purposes. As a result, the Inland Revenue Department (IRD) would require that the sale of the stock to Green-China be assessed on the market value of the stock. If the sale is effected at a price below the market value, the IRD would disregard the actual sale price, and replace it with the then market value of the stock based on the value that Green-HK would have received if the stock had been sold on the market. Also, the IRD may invoke s.20 which empowers the IRD to deem Green-China to be carrying on business in Hong Kong and assess Green-China, in the name of Green-HK as an agent of Green-China, on the profits from the trade in the stock. For this purpose, Green-HK and Green-China are closely connected by virtue of the fact that they are both wholly owned by the Parent. (ii) Transfer pricing principle You are also interested in the current development of the transfer pricing principle in Hong Kong and its applicability to this sale transaction. Based on the fact that Green-HK and Green-China are owned by the same US parent, setting aside s.15c, the sale of trading stock below market price would likely be challenged by the transfer pricing principle and, as stated above, s.20. The IRD may invoke s.20 to counter-act a transaction conducted between a resident and a non-resident, who are closely connected, in such a manner that the profits that would otherwise arise in Hong Kong to the resident are either nil or less than might be expected. The consequence of applying s.20 would be that the IRD would deem the non-resident (i.e. Green-China) to be carrying on business in Hong Kong, and the profits on the stock would be deemed to derive from the business carried on in Hong Kong and taxable in Hong Kong in the name of the resident (i.e. Green-HK) as if it were the agent of the non-resident (i.e. Green-China). A tax assessment would be issued to the resident (i.e. Green-HK) who has the obligation to pay the tax demanded. The transfer pricing principle in Hong Kong is laid down in DIPN 46. Two enterprises are regarded as associated if one enterprise participates directly or indirectly in the management, control or capital of the other enterprise, or the same persons participate directly or indirectly in the management, control or capital of both enterprises. No reference is made to the shareholding threshold or residency. Green-HK and Green-China would be associated enterprises as a result of 14

4 their common holding by the same US parent. When two associated enterprises enter into a transaction, it should be transacted at a price comparable to that which would be transacted by independent enterprises dealing with a comparable transaction in comparable circumstances. This is referred to as the arm s length price. Otherwise, tax adjustments may be made by the IRD to bring the understated revenue or over-claimed deduction in line with the arm s length position. In determining the appropriate arm s length price, consideration would be given to factors such as the functions performed by both enterprises, assets and resources applied to the transaction and types and degrees of risks assumed by both enterprises. In order for Green-HK to defend itself against any transfer pricing challenge, it would be required to justify the 30% discount given to Green-China by demonstrating that, for example, Green-China would be required to invest additional cost to re-package the stock according to the China market requirements, or to assume additional risk that would not have been required by Green-HK in Hong Kong. In the absence of valid justification, the IRD may seek to raise an assessment on Green-HK as if the sale to Green-China were effected for the market value. In the extreme situation where the IRD has reasons to suspect that a tax avoidance intention exists, s.61a may be invoked. (d) Waiver of inter-company balance Green-HK has a significant amount owing to its US parent company (the Parent) from the purchase of goods in previous years for sale in the Hong Kong store. As all the sales in the Hong Kong store have been returned as assessable profits for Hong Kong tax purposes, it is reasonable to assume that all purchases, including those from the Parent despite being unsettled, would have been claimed as a deduction against Green-HK s sales income. If the Parent is to waive the claim against this balance, the waiver would trigger a credit entry in Green-HK s income statement, representing a sundry income. This effectively is a discharge of Green-HK s obligation to pay a trade debt. Section 15(2) specifically provides for bringing the waived amount into assessable profits to the extent that the amount has previously been allowed as a deduction in computing the assessable profits. Since the trade debt has been deducted in earlier years, the subsequent discharge would become assessable profits in the year in which the discharge occurs, i.e. in the final year of assessment 2011/12. Given the size of the amount to be waived, $15,000,000, all of the current and previous years tax losses would likely be utilised, with the likely result that Green-HK would be in a net chargeable position in its final year. Therefore, from the tax perspective, such a waiver is not tax efficient. It is recommended that Green-HK repays the debt due to the Parent with the surplus cash realised from the sale of its assets, including the sale of land and building. The waiver should then be restricted to any unpaid balance which hopefully would not be too significant relative to the tax losses to be absorbed. (e) Redundancy payment and additional gratuity The general rule for the deductibility of expenses under s.16(1) requires that the expense and outgoings must be incurred during the basis period for the year of assessment in the production of profits chargeable to profits tax. Section 17(1)(c) also applies to disallow an expense which is capital in nature. However, the IRO does not define a capital expense, and thus the rules generated from common law would have to be observed. In the case of redundancy payments made in accordance with the statutory requirement, it has been established in CIR v Cosmotron Manufacturing Company Limited that, despite the payment being made at the time of cessation of a business, the payments represented a discharge of statutory obligations incurred in the running of the business prior to its cessation. More importantly, since it is statutorily required, the liability to pay will have accrued as a cost of employing staff from the time the staff is employed, even though this liability does not crystallise until actual payment is made. On this reasoning, the redundancy payment made under the statutory requirement will be tax deductible to Green-HK. As for the additional gratuity, the extent to which it is deductible depends on the nature and purpose of its payment. If it represents a reward for past services like a bonus, or something within Green-HK s policy of paying employees being sacked, it would be tax deductible. However, if it represents a compensation paid upon the cessation of the business in excess of the amount payable according to Green-HK s past policy in sacking its staff, no tax deduction would be allowed. To avoid a tax dispute, Green-HK is recommended to articulate the true purpose of making the gratuity, and justify it by way of calculation and documentation. We trust that the above addresses all the Hong Kong profits tax implications arising from the proposed transactions. Should there be any questions, please let us know. End of Report 15

5 APPENDIX 1 Balancing allowance upon sale of the store building $ Cost of construction 5,000,000 Annual allowance: $5,000,000 x 4% = $200,000 Total annual allowance from 2006/07 to 2010/11, $200,000 x 5 (1,000,000) 4,000,000 Year of assessment 2011/12 (year of cessation): $ Residue before sale 4,000,000 Sale price (building portion) (1,000,000) Balancing allowance 3,000,000 APPENDIX 2 Annual building allowance available to the purchaser on acquisition of the building Year of assessment 2011/12: $ Residue before sale 4,000,000 Balancing allowance made to Green-HK (3,000,000) Residue after sale 1,000,000 Annual allowance each year from 2011/12 onwards ** 47,619 ** Year of assessment in the basis period for which the sale takes place 2011/12 25th year after 2006/07 (year of first use) 2031/32 No. of years from 2011/12 to 2031/32 21 yrs Annual allowance, 2011/12 onwards: $1,000,000 x 1/21 $47,619 Final year of allowance for the purchaser 2031/32 ($47,620) 2 (a) Tax position of Antony (1) The lump sum payment is an inducement payment to join Modern Home Ltd (MHL), and is in substance a payment for future services and so chargeable to salaries tax if the employment is located in Hong Kong (see (2) below). Tutorial note: In Glantre Engineering v Goodhand, an inducement sum was held taxable as an emolument of the new employment because it was not severable from the other benefits of the employment. (2) As MHL is a company resident in Hong Kong, Antony s employment is obviously located in Hong Kong and his monthly salary of $100,000 is chargeable to salaries tax in full. Only the mandatory contribution made by Antony to the MPF scheme qualifies for a concessionary deduction: s.26g(3). The remaining payment beyond the maximum amount ($12,000) is a non-deductible private expense. MHL s contributions to the MPF scheme are not taxable. (3) The issue is whether the housing allowance of $360,000 is taxable in full, or whether it is subject to tax on the basis of the concessional rental value provisions, which would deem the taxable benefit to be, generally, 10% of Antony s other taxable emoluments. The concession applies only if the housing allowance can be properly characterised as a rental refund : s.9(1a)(a). On the facts, it is difficult to say that this amount was paid to Antony on the basis that it was intended to constitute a refund of rent actually paid by him. For example, his employment contract states that it can be used not only to pay rent, but also to subsidise a home purchase. Also, whatever the employment contract says, the employer does not require that the amount actually be spent on the provision of housing, as evidenced by the fact that Antony has spent only $300,000 out of the $360,000 on rent (including government rates and management fees). The whole of the $360,000 is therefore taxable in full. The fact that the employer requires Antony to provide a copy of the lease and monthly rental receipts does not alter the situation: see Page v CIR. (4) The provision of the company car is not taxable, although Antony used it for private purposes it is not convertible into money and in purchasing the car MHL was discharging its sole liability: s.9(1)(a)(iv) and Tennant v Smith. The payment relating to private motoring is taxable unless, before purchasing the petrol, Antony makes it clear to the petrol station attendant that the contract for the purchase of petrol is made solely between MHL (the party to the credit card arrangement) and the petrol station. As a practical matter, this may be difficult to prove: Richardson v Worrall. Also as a practical matter, in DIPN 16 the Commissioner states that where an employee uses a credit card for private purposes, he considers that the benefit obtained is chargeable to salaries tax. 16

6 (5) Payment for the club membership is taxable as the employer is discharging Antony s liability: s.9(1)(a)(iv), unless it can be argued that Antony joined the club on behalf of MHL and thus MHL was simply discharging its own liability. The amount reimbursed for client entertainment should not be taxable, provided that Antony can prove that the entertainment was truly business-related. On the other hand, the excess of the expenditure over the amount reimbursed by MHL ($10,000) is not incurred in the production of chargeable income and so is not deductible. (6) It is important to note that, because Antony s previous employer had the right to pay him cash instead of providing him with shares, Antony technically did not have a right to acquire shares so as to fall under the share option provisions: s.9(1)(d). This is because he could not insist on receiving shares. This is therefore a case involving a simple cash payment. The payment of $100,000 was received from Antony s previous employer with whom Antony has ceased employment in the year of assessment 2010/11. Such a payment is deemed to have accrued to Antony on the last day of his employment with Mix and Match Ltd: s.11d(b)(ii). The amount is therefore taxable with respect to the year of assessment 2010/11. The Inland Revenue Department (IRD) will raise an additional assessment for the year of assessment 2010/11 in order to tax the $100,000 received: s.11d(a). This means that no part of the $100,000 is to be brought into the tax computation for the year of assessment 2011/12. Therefore, Anthony s net chargeable income from the employment with MHL is $1,940,000. $ Inducement payment 300,000 Salary 1,200,000 Housing allowance 360,000 Petrol expenses 48,000 Club membership fee 32,000 Net assessable income 1,940,000 Less: MPF contributions (12,000) 1,928,000 Less: Married person s allowance (216,000) Net chargeable income 1,712,000 Accordingly, Antony will pay tax at progressive rates on $1,712,000 of $279,040, rather than at the standard rate on $1,928,000 of $289,200. (7) It appears that Antony is carrying on a business, or at least a profession, of writing articles (and books) for gain. It could perhaps be said that this is simply a hobby rather than a business or profession. However, the scale of his activities suggests that this is akin to a business or profession. He has written numerous articles, and he earned $90,000 during the year from such activities. Therefore, the $90,000 would be chargeable to profits tax at 15% under s.14(1). (8) The royalties arise from his business/profession as an author. The relevant issue is whether the royalties arise in or are derived from Hong Kong. It cannot be ascertained that the royalties are sourced outside Hong Kong merely because the payer is based in Singapore and because the books are being published in Singapore. It is necessary to look at the activities in which Antony engaged in order to generate the royalties. What is relevant in this regard is where he negotiated and concluded the licence agreement: HK-TVB International v CIR. In DIPN 21, the IRD states that it will regard royalties as being located at the place of acquisition and granting of the licence or right of use (paragraph 45(g)). Therefore also important is where he wrote the book, and this would appear to have been done in Hong Kong. On these facts, the royalties would likely be regarded as being sourced in Hong Kong and chargeable to profits tax at 15%, under s.14(1). Tax position of Rebecca (9) It is quite clear that a business is being carried on by Rebecca. The 20% commission received by Rebecca ($80,000) is therefore subject to profits tax at 15% as the sales services are performed in Hong Kong. (b) Compliance obligations imposed on Rebecca Under s.20a(3), any person who sells any goods in Hong Kong on behalf of a non-resident person shall furnish a quarterly return (Form BIR 52B) to the Commissioner showing the gross proceeds of such sales; and pay a sum equal to 1% of the gross proceeds or such lesser sum as the Commissioner may agree (in practice, only 0 5% is demanded). As Rebecca is selling home products in Hong Kong on behalf of a non-resident person, the Taiwan company, she will be required to comply with the requirements of s.20a(3) to furnish quarterly returns to the Commissioner and to pay over the tax due. She is therefore obliged to retain an amount, which is sufficient to meet the tax liability, before remitting the sale proceeds to the Taiwan company. For the year 2011/12, Rebecca should have retained a total of $2,000 ($80,000/20% x 0 5%) to meet the tax liability. 17

7 3 (a) Step 1 involves the transfer of shares in C Ltd to B Ltd. The shares of a Hong Kong company are Hong Kong stock: definition in s.2(1) of the Stamp Duty Ordinance (SDO). Therefore the parties effecting the sale and purchase of the C Ltd shares (A Ltd and B Ltd) must prepare and stamp contract notes for the sale and purchase and an instrument of transfer: s.19(1) and Heads 2(1) and 2(4) respectively. Duty on the contract notes under Head 2(1) is 0 2% of the amount or value of the consideration; duty under Head 2(4) on the transfer is $5. The dutiable value is $100 million, not $30 million, since, under s.24(1), consideration for stamp duty purposes includes debts waived or assigned. In this case, B Ltd has to pay an additional $70 million to settle the bank debt. Despite the $70 million not being received by the transferor, A Ltd, it is a debt assumed by the transferee, B Ltd, and thus it is also included in the consideration subject to stamp duty. If the market value of the shares is higher than $100 million, stamp duty will be levied on the market value. Under s.45 of the SDO, a transfer of stock within a corporate group, where the transferor and transferee are associated corporations, may be exempted from stamp duty. Two corporations are associated if one is the beneficial owner of not less than 90% of the other, or a third corporation is the beneficial owner of not less than 90% of each of the transferor and transferee. The fact that the parent, P Ltd, is incorporated outside Hong Kong does not mean that the exemption does not apply. In this case, A Ltd and B Ltd are both 100% held by P Ltd. Therefore, A Ltd and B Ltd are associated, and stamp duty exemption may be available. Adjudication is required under s.45(3). However, exemption under s.45 will not be available if as part of the arrangement, among others, the transferor and transferee cease to be associated by reason of a change in the percentage of the issued share capital of the transferee held by the transferor or a third corporation. Even if such an arrangement is not in existence at the time of the transfer, if the transferor and transferee cease to be associated within two years for the same reason, the stamp duty exemption previously granted will be clawed back and stamp duty becomes payable. In this case, there are two events which may or may not trigger the claw-back of the s.45 exemption: steps 2 and 3. Under step 2, B Ltd will issue shares equivalent to 10% of its new shareholding to an unrelated third party. The issue of shares does not attract any stamp duty. However, as a result of the share issue, the percentage of the issued share capital of B Ltd held by P Ltd will drop to 90%. Given that the definition of associated corporation refers to a shareholding of not less than 90%, the drop in shareholding to 90% should not by itself disqualify the s.45 exemption. As the amount raised from the issue of shares to an unrelated party will not be used in and for the acquisition of shares in C Ltd, this step will have no impact on the exemption under s.45 as s.45(4)(a) and (b) do not apply. Under step 3, A Ltd will be liquidated. As a result, P Ltd will no longer be holding A Ltd and thus, strictly speaking, A Ltd and B Ltd will no longer be associated. However, for the s.45 exemption to be disqualified, the change in shareholding is by reference to the transferee, i.e. B Ltd. Thus, any change in the shareholding in the transferor, i.e. A Ltd, should not affect the s.45 exemption. In conclusion, upon application under s.45, the restructuring should not give rise to any stamp duty liability and the subsequent events in steps 2 to 3 should not impact the stamp duty exemption. Tutorial note: Although the payment to the bank strictly breaches the pre-condition under s.45 which, among others, prohibits payment to parties outside the corporate group, the Stamp Duty Office has by concession said payment in this manner will not render s.45 not applicable. (b) The lease is dutiable in accordance with the provisions of Head 1(2). Although B Ltd and C Ltd are regarded as associated corporations under s.45, the s.45 exemption for transfers between associated corporations is not applicable to leases chargeable under Head 1(2). As the term of the lease is over three years, stamp duty is calculated at the rate of 1% of the average yearly rent. The market rent is $960,000 per year, but the actual rent payable is $600,000 plus an unascertainable amount attributable to the future turnover of the business conducted in the property. However, stamp duty can only be charged upon amounts that are ascertainable at the time the lease is entered into. At the beginning of the lease, it is not possible to ascertain B Ltd s gross turnover during the four year period of the lease. Therefore, it follows that any additional rental payable under the turnover provisions will not be subject to stamp duty. Stamp duty payable will thus be charged on the higher of the market rent and the ascertainable stated rent, i.e. $9,600 ($960,000 x 1%). A duty of $5 is payable on any duplicate or counterpart. 4 (a) The broad guiding principle governing liability to profits tax is that one looks to see what the taxpayer has done to earn the profit and where he has done it (Hang Seng Bank and HK-TVBI). This broad guiding principle has been followed in subsequent courts, and the focus is therefore on establishing the geographical location of the taxpayer s profit producing transactions themselves as distinct from activities antecedent or incidental to those transactions (Kwong Miles and ING Baring). The Commissioner s practice for determining the source of trading profits is found in paragraphs 18 to 29 of DIPN 21 and can be summarised as follows: In accordance with Hang Seng Bank, the locality of trading profits is the place where the contracts of sale and purchase are effected. Effected could not merely mean legally executed, as this would depend on formal legal rules of offer and acceptance. The Inland Revenue Department (IRD) agrees with the approach in Magna to look at all the relevant operations carried out to earn the profits, including the solicitation of orders, negotiation, conclusion, trade financing, shipment and performance of the contracts (see paragraph 21 of DIPN 21). Where both the contract of purchase and contract of sale are 18

8 effected in Hong Kong, profits are sourced in Hong Kong and fully taxable; and by corollary, where both the purchase and sale contracts are effected outside Hong Kong, the profits are sourced outside Hong Kong. However, profits are also presumed to be sourced in Hong Kong and no apportionment will be accepted where (1) a contract of sale is effected in Hong Kong; (2) a contract of purchase is effected in Hong Kong; (3) the sale is made to a Hong Kong customer; or (4) the goods are purchased from a Hong Kong supplier or manufacturer. Where the effecting of the purchase or sale contract does not require travelling outside Hong Kong but is carried out in Hong Kong by telephone, fax, etc, the contracts will be considered to be effected in Hong Kong. (b) The general charging provision, s.14, requires various cumulative conditions to be satisfied, that is (1) a business being carried on in Hong Kong, (2) profits from that business and (3) those profits arising in or being derived from Hong Kong. However, the fact that a company carries on business in Hong Kong does not of itself indicate that its profits must have a Hong Kong source. Also, the facts that management of the business and decisions as to trading (i.e. decisions as to sales and purchases) are made in Hong Kong are not relevant in determining the source of a taxpayer s profits (Mehta; Hang Seng Bank). In determining the source of profits, the broad guiding principle is that one looks to see what was the activity that gave rise to the profits (Hang Seng Bank). Put another way, one looks to see what were the operations that in substance gave rise to the profits (HK-TVBI). In the present case, it appears that Home Design Inc (HDI) does not carry on business in Hong Kong itself. However, if Buyer Ltd is its agent, then HDI would be regarded as carrying on business in Hong Kong through its agent. It seems clear that Buyer Ltd is an agent of HDI because it negotiates and concludes contracts with suppliers on behalf of HDI. Rule 5 of the Inland Revenue Rules refers to an agent who has, and habitually exercises, a general authority to negotiate and conclude contracts on behalf of (its) principal, and deems such an agent to be a permanent establishment of its principal. Although Rule 5 is technically not a charging provision, it supports the general view that HDI could be subject to tax as a result of the activities in Hong Kong of Buyer Ltd. Having concluded that HDI carries on business in Hong Kong, and there is no doubt that its profits are derived from such business, the only issue to consider is whether all or some of its profits arise in or are derived from Hong Kong. HDI is a trader, i.e. its profits are made from the purchase and sale of furniture. A trader s profits are made where the purchase contracts and the sale contracts are effected (Hang Seng Bank). In HDI s case, its purchase contracts are negotiated and concluded in Hong Kong and therefore are effected in Hong Kong. Turning to HDI s sales contracts, the majority of these are negotiated and concluded by HDI itself in the USA. We assume for this purpose that, when buyers visit the Hong Kong showroom, no negotiations take place between Buyer Ltd and the buyer as to sales terms. If such negotiations did occur, this could lead the IRD to regard these sales contracts as being effected in Hong Kong also. So, the position is that purchase contracts are effected in Hong Kong but sales contracts are effected outside Hong Kong. In this case, the IRD would initially presume that the profits are taxable (see paragraph 23(c) of DIPN 21). However, DIPN 21 goes on to state that the IRD will have regard to other factors to determine the source of such profits, such as how goods are procured and stored, how sales are solicited, how orders are processed, how goods are shipped, how financing is arranged and how payment is effected. These factors appear to occur largely outside Hong Kong. This suggests that the profits from such sales may have an offshore source and will not be subject to tax. However, the issue is a fine one. The ultimate test should be carried out in a manner similar to what the court has done in Magna where all of the steps involved in purchasing and selling would first be found by the court and then evaluated as to their respective importance in earning the trading profits. If the more important steps happen to be in Hong Kong, the trading profits are derived from a source in Hong Kong and chargeable to profits tax. Otherwise, the source is outside Hong Kong and the trading profits are not chargeable to profits tax. That being said, the IRD in DIPN 21 refers to a scenario, for which no profits tax is in the view of the IRD chargeable, where a non-resident, such as HDI, conducts buying activities in Hong Kong through an agent, such as Buyer Ltd, provided that neither HDI nor Buyer Ltd conducts selling activities in Hong Kong (see paragraph 29 of DIPN 21). In view of the fact that a showroom is maintained in Hong Kong to display goods to potential buyers, HDI cannot confidently rely on this concession. Should the IRD assess HDI to profits tax, a simple way to avoid liability to profits tax is to restrict HDI s activities in Hong Kong to purchasing activities only. As mentioned above, in its DIPN 21, the IRD acknowledges that, if a non-resident merely conducts buying activities in Hong Kong (either itself or through an agent), and the buying office or agent is not engaged in selling activities, then the buying activities will not give rise to a tax liability. To take advantage of this concession, Buyer Ltd should not operate a showroom in Hong Kong. Its activities should be restricted to purchasing only. HDI should conduct all sales activities outside Hong Kong. 5 (a) Based on the Inland Revenue Ordinance (IRO), the general rules governing the treatment of tax losses incurred by a company carrying on business in Hong Kong include: (1) Any excess of deductible expenses over taxable income will be regarded as tax losses. (2) For the losses to be deductible and carried forward to offset against the company s future assessable profits, the losses must have arisen in and be derived from Hong Kong. The same principles as those applicable to determining the source of income would also apply to losses. 19

9 (3) The losses must also have arisen from the company s trade, profession or business, although at the time of utilising the tax losses, the trade, profession or business is not necessarily the same as that from which the losses are incurred. (4) The losses must be revenue in nature. (5) The losses cannot be carried backward to offset against prior years taxable profits. (6) There must not be any duplication of losses to be utilised by the same company. The losses used to offset against taxable profits in one year of assessment cannot be used again for any other year. (7) The amount to be used to offset against taxable profits must not exceed the amount of actual tax losses suffered. (8) There is no provision for group loss relief in Hong Kong to enable losses incurred by one company in a group to be used to offset against the taxable profits earned by another company in the same group. (Notes to marker: Marks may be awarded for any other rules that are relevant and correct.) (b) (c) Strictly speaking, tax losses incurred by a company carrying on business in Hong Kong would continue to be carried forward under the name of the company, regardless of the fact that the shareholders of the company or their shareholdings may change. Thus, losses would continue to be available to carry forward to offset against the company s future assessable profits earned after the change in shareholders. However, by virtue of s.61b, the ability to carry forward tax losses may be denied if the following conditions are met: (1) when there has been a change in shareholding of the company, and as a direct or indirect result of this change, profits have arisen or been accrued to the company; and (2) the sole or dominant purpose of the change in shareholding is to obtain a tax benefit by utilising the tax losses sustained in the company to avoid a tax liability of the company or any other person. For condition (1) to apply, the Inland Revenue Department (IRD) must have evidence that the change in shareholding is the cause of the receipt of profits by the company, and due to the change in shareholding, profits are being transferred to the loss making company. For condition (2) to apply, the motive to utilise tax losses must outweigh all other non-tax motives in justifying the change in shareholding. In this context, if a change in shareholding is initiated as a result of a group restructuring, the IRD is not likely to invoke s.61b to disallow the carry forward of the tax losses. In the case of Auto Ltd, where the intention of selling the company by Mr Tan is effectively to sell the tax losses of the company, it is highly likely that after the change in shareholding, the offset against the company s future profits earned subsequent to the change in shareholding may be denied. Mr Tan has the intention to make an interest bearing loan to Auto Ltd in order to help finance its operation. From the perspective of Auto Ltd, interest is incurred on the loan. The issue of concern is whether the interest expense would be tax deductible to Auto Ltd. Under s.16(1), an expense would be 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 any condition under s.16(2), as well as the requirements under s.16(2a) and s.16(2b), are satisfied. In the case of Auto Ltd, it would be reasonable to assume that all the loan money from the shareholder, Mr Tan, would be used to produce assessable profits. This satisfies s.16(1)(a). However, in the case of interest payable to a shareholder, s.16(2)(c) requires that, for the interest to be deductible, the interest income in the hands of the shareholder lender must be income subject to Hong Kong tax. As Mr Tan is a non-hong Kong resident and is not carrying on a money lending business, interest received by Mr Tan would not be taxable in Hong Kong regardless of where the provision of credit is located. As a consequence, the interest expense would not be allowed as tax deductible by Auto Ltd by virtue of s.16(2)(c). As the loan from Mr Tan fails to satisfy the conditions under s.16(2), it is not necessary to consider the requirements under s.16(2a) and s.16(2b) in relation to his proposed loan, but they will need to be considered in relation to any alternative loan agreement which may be considered. Section 16(2A) requires that for the interest to be tax deductible, the loan must not be secured by any deposit or loan which derives non-taxable income in Hong Kong. Section 16(2B) further requires that no arrangement has been in place whereby any interest payment is ultimately paid back to the borrower, or any connected person of the borrower. Therefore for the loan interest expense to be tax deductible, Auto Ltd should consider obtaining a loan from a financial institution and ensuring that the loan is not secured by any deposit that would earn non-taxable interest income, and the loan interest would not flow back to Auto Ltd. 20

10 Professional Level Options Module, Paper P6 (HKG) Advanced Taxation (Hong Kong) December 2012 Marking Scheme Available Maximum 1 (a) Sale of land and building (i) Definition of commercial building 0 5 Store building is a commercial building 0 5 Only annual allowance of 4% 0 5 In use at the end of the year of assessment 0 5 From 2006/07 up to and including 2010/ Capital expenditure on construction 0 5 Bought unused from property developer, so net price of $5m 0 5 AA = $5m*4% = $200,000 p.a. 0 5 Entitled to a balancing allowance of $3m in 2011/ (ii) Demolished for purposes unconnected with ordinary business 0 5 No balancing allowance 0 5 Forfeit the deduction of $3m 0 5 Company may not have significant profits to absorb tax losses 0 5 May be worthwhile to forfeit the deduction 1 Unless keen to preserve tax losses for future purposes 0 5 Gain from sale of land not taxable because capital nature 1 Cost of demolition not tax deductible (iii) Residue before sale $4m 0 5 Residue after sale $1m 0 5 Y/A in which the sale takes place is 2011/ th year after 2006/07 is 2031/ No. of remaining years is 21 years 0 5 Calculation of annual allowance (b) (i) Donation in money to approved charitable organisation 0 5 Pure donation of at least $ Ceiling of 35% of assessable profits 0 5 Not qualify for deduction under other parts 0 5 Not deductible to Green-HK 1 Tax written down value allowed as a balancing allowance 1 4 (ii) Alternative not helpful or tax effective 0 5 No deduction for donation because of loss case 1 Sale money may result in taxable balancing charge 1 Or reduce balancing allowance (c) (i) S.15C actual sale proceeds where the stock is sold to a person who will claim it as a deductible expense 1 Otherwise, open market value used 0 5 Green-China unlikely to use the stock for HK tax purposes 1 Actual sale price replaced with market value 1 IRO may invoke s

11 Available Maximum (ii) S.20 between closely connected resident and non-resident 0 5 Nil or less than expected profits in HK 0 5 Deem the non-resident to carry on business in HK and taxable 0 5 Assessment issued to the resident as agent 0 5 DIPN 46 transfer pricing principles and practice 0 5 Definition of associated enterprise 1 Arm s length price comparable to independent transactions 1 Functions, assets and risks considered 0 5 Justify the 30% discount 1 Additional assessment on Green-HK based on market value 0 5 S.61A risk (d) Balance arose from purchase cost 0 5 Claimed as deduction in previous years 0 5 Waiver recorded as sundry income 0 5 Effect of s.15(2) 0 5 Discharge is taxable income in 2011/ Absorb all tax losses or give rise to a net chargeable income 0 5 Waiver not tax effective 0 5 Recommend to repay the debt with surplus cash from asset sale (e) S.16(1) general rule for deductibility 0 5 S.17(1)(c) capital expense disallowed 0 5 Statutory redundancy is discharge of statutory obligation incurred in running the business 0 5 Liability started to accrue since employment 0 5 Liability crystallised upon payment 0 5 Redundancy payment deductible 0 5 Additional gratuity depends on nature and purpose 1 If reward for past service, deductible 0 5 If compensation due to cessation of business, non-deductible Appropriate format and presentation 1 Appropriate use of appendices 1 Effectiveness of communication

12 Available Maximum 2 (a) Tax position of Antony Inducement payment for future services and taxable 1 5 Hong Kong employment, salary taxable in full 1 MPF contributions deductible ($12,000) 0 5 MHL s contributions not taxable 0 5 Issue: housing allowance v rental refund 1 Analysis of facts 2 Conclusion: housing allowance taxable in full 0 5 Provision of company car not taxable 1 Payment of petrol by credit card taxable 2 Reimbursement of club membership fee taxable 1 Reimbursement of entertainment expenses not taxable 1 Excess of expenditure over reimbursement not deductible 1 Cash payment and not share option 2 Deemed to accrue on last day of employment 1 Additional assessment for 2010/11, not 2011//12 1 Calculation of salaries tax liability 2 Carries on a business of writing articles and books 2 $90,000 subject to profits tax 0 5 Royalties arise from his business as an author 0 5 Issue: where royalties arise/are derived 1 Analysis of facts 2 Conclusion: HK source and taxable 0 5 Tax position of Rebecca Commission subject to profits tax (b) Compliance obligations imposed on Rebecca Withholding obligation under s.20a(3) 2 Rebecca to retain sufficient of sale proceeds to meet liability 1 Calculation of tax withheld (a) Shares of HK company are HK stock 0 5 Stamping of contract notes and instrument of transfer 1 Heads of duty payable; 0 2% and $5 1 Consideration includes debts waived or assigned 1 Dutiable value is $100m 0 5 Stamp duty on market value, if higher 0 5 S.45 exemption for associated corporations 1 A Ltd and B Ltd are associated 1 Adjudication required 0 5 Exemption not available if cease to be associated within two years 1 5 Issue of shares by B Ltd not stampable 1 Effect of issue of shares by B Ltd on s.45 exemption 1 5 Effect of liquidation of A Ltd on s.45 exemption 1 Conclusion (b) The lease is stampable 0 5 S.45 exemption not applicable to lease agreements 1 Stamp duty at 1% of average yearly rent 0 5 Only ascertainable amounts are stampable, i.e. $600,000 1 Explaining the ascertainability principle 0 5 Stamp duty charged on higher of market rent and ascertainable rent 1 Stamp duty payable 0 5 $5 on any duplicate or counterpart

13 Available Maximum 4 (a) Broad guiding principle 1 CIR s practice: Meaning of effected 0 5 All relevant operations 0 5 Both contracts of sale and purchase effected in HK HK source 0 5 Both contracts of sale and purchase effected outside HK offshore 0 5 Either contract effected in HK HK source 0 5 Sale to HK customer/purchase from HK supplier HK source 0 5 Contract effected via telephone, fax etc HK source 0 5 No apportionment for trading profits (b) Conditions in s.14(1) 1 Management and trading decisions in HK not relevant 1 Broad guiding principle in Hang Seng Bank 0 5 Carrying on business: agency issue 1 Buyer Ltd is agent of HDI 0 5 Implications of Rule 5 1 Condition (1) and (2) satisfied 0 5 Contract effected test applies to trading profits 0 5 Purchase contracts effected in HK 0 5 Sales contracts effected outside HK 1 Initial presumption HK sourced 1 Other relevant factors 1 Drawing a reasoned conclusion 1 5 Buying office concession 1 Advice to HDI

14 Available Maximum 5 (a) Excess of expenses over income 0 5 Losses arising in HK 0 5 Losses arising from company s trade, profession or business 0 5 Losses of revenue nature 0 5 Cannot be carried backward 0 5 No duplication of offset 0 5 Offset not to exceed actual tax losses 0 5 No group loss relief (b) Losses continue to carry forward under the company 0 5 Regardless of change in shareholding 0 5 S.61B risk tax loss offset to be denied 0 5 Change in shareholding 0 5 Lead to profits arising 0 5 Direct or indirect result 0 5 Profits transferred into the company 0 5 Sole or dominant purpose 0 5 To obtain tax benefit by utilising tax losses 0 5 Except group restructuring 0 5 Intention of Mr Tan to sell the company for its tax losses 0 5 Risk of carry forward being denied (c) S.16(1) general deductibility rule 0 5 S.16(1)(a) further conditions to be met 0 5 S.16(2) any condition to be met 0 5 Can presume s.16(1)(a) will be met 0 5 S.16(2)(c) recipient taxable in HK re interest income 1 Interest paid to Mr Tan not taxable in HK, therefore not satisfied/deductible 1 S.16(2A) loan security test 1 S.16(2B) flow back test 1 Recommend a loan from a financial institution