MODULE 2.04 HONG KONG OPTION

Transcription

1 THE ADVANCED DIPLOMA IN INTERNATIONAL TAXATION June 2018 MODULE 2.04 HONG KONG OPTION SUGGESTED SOLUTIONS

2 PART A Question 1 Part 1 According to Article 7 of the China-Hong Kong Avoidance of Double Taxation Arrangement (DTA), the profits of a Hong Kong enterprise shall be taxable only in Hong Kong unless the enterprise carries on business on the mainland through a permanent establishment (PE). If the Hong Kong enterprise carries on business through a PE on the mainland, the profits of the enterprise may be taxed on the mainland but only to the extent of those attributable to that PE. According to Article 5 of the DTA, the term PE means a fixed place of business which is defined to include: a place of management a branch an office a factory a workshop a mine, an oil or gas well, a quarry or any other place of extraction of natural resources an agency with general authority to conclude contract. For consultancy services, if the services have been furnished in one side for the same project or a connected project for a period or periods exceeding in the aggregate 183 days in any 12- month period, the provision of services will be treated as a PE in that side. PE does not cover facilities or a fixed place of business for: storage, display or delivery of goods purchasing goods advertising, collecting information or other preparatory or ancillary activities belonging to the enterprises. Part 2 AC has a PE in China according to Article 5 of the DTA, because BC is its sole fully authorized sale agent, and profits from sale products earned by AC through BC will be attributed to the PE, therefore is liable for EIT according to Article 7 of the DTA. Moreover, for provision of service, a PE would exist if the servicing period was for more than 183 days within any 12-month period. For AC, as the aggregate service-rendering period in the mainland is 190 days in 2017, i.e. exceeding 183 days, AC should be treated as a having a PE in the mainland in this regard. AC would be subject to EIT in respect of service fee attributable to the PE. Another income tax implication is for those employees conducting the services in the mainland. As the managers salary income might be treated as received from a mainland PE, they may fall into the IIT net in China, notwithstanding that they had stayed in the mainland not more than 183 days individually. Moreover, BC shall receive payment from AC at arm s length price for its providing services as a sale agent. It seems currently no such payment have been made by AC. According to Article 9, the mainland tax authority can impose transfer pricing adjustment for related party transactions which are not carried out on arm s length basis. Page 2 of 11

3 Part 3 The royalty fee received by AC for licensing the patents to BC shall be income tax in China at a limited tax rate of no more than 7% of gross amount of the fee according to Article 12 of the DTA. The fee received by AC for the rental of the moulds and production equipment to BC shall also be subject to income tax in China at a limited tax rate of no more than 7% of gross amount of the rent according to Article 12 of DTA. However, if the royalty fee and rental fee are derived from properties forming part of assets of AC s PE in mainland China or otherwise effectively connected to such PE in mainland China, these two types of income would be assessed as part of profit of the PE. On the basis that the PE did not take up the economic ownership of the properties from which the royalty fee and rental fee are derived, the reduced withholding rate would apply. Part 4 For dividend paid to a Hong Kong resident beneficial owner, which does not maintain any permanent establishment in mainland China and has been holding 25% or more shareholding of a Chinese company for a period of not less than 12 months before distribution of the dividend, the withholding EIT rate is 5%. If the above-mentioned conditions on beneficial ownership period cannot be met, the normal withholding rate of 10% will apply. However, if the Hong Kong resident company maintains a PE in mainland China and the dividend is effectively connected to the PE, the dividend will be regarded as a profit attributable to the PE and would be taxed at normal income tax rate of 25% in general. AC has maintained a PE in respect of its trading business and quality assurance services. But such PE did not take up the economic ownership of AC s shareholding in BC. Arguably, the dividend is not effectively connected to the permanent establishment carrying on these two businesses. Hence, the withholding basis would be applicable to the dividend distributed by BC to AC and it will charged to tax at 5% or 10% subject to the satisfaction to the beneficial ownership period requirement. Part 5 AC and BC have entered into a sub-contracting agreement. AC will be regarded as earning trading profits and whether its profits is derived from Hong Kong and hence taxable depends on whether its contracts of purchase and sale are effected in Hong Kong (operation test; Hang Seng Bank case; DIPN 21). If either the purchase and sale contract is effected in Hong Kong, the Inland Revenue Department s initial presumption is that the trading profits is sourced from Hong Kong (DIPN 21). AC solicited, negotiated and concluded sales orders by BC in mainland China. However, AC placed purchase orders for raw materials and finished goods in Hong Kong. Unless AC can substantiate the sales contracts effected by BC outside Hong Kong is more critical in derivation of the profits (re: Magna case and ING Baring case), all its trading profits should be taxable. AC cannot obtain any deduction of the acquisition costs of the moulds and production equipment used by BC in mainland China under section 16G. They are excluded as prescribed fixed assets as they are leased assets, that is they are used by BC, rather than AC. Also, there will be no deduction of depreciation allowances under section 39E for the moulds and production equipment because the assets are leased assets and used outside Hong Kong by BC, not AC. Part 6 AC developed the patent in Hong Kong. Though the patent was used outside Hong Kong, the royalty received from BC should be regarded as derived from Hong Kong and subject to profits tax (re: DIPN 49). The EIT can be credited against the profits tax payable. Page 3 of 11

4 The moulds and equipment were used in mainland China and hence the rental fee should be regarded as sourced outside Hong Kong and non-taxable (re: DIPN 21). The corresponding VAT was not incurred in the production of assessable profits and thus non-deductible. No tax credit for the EIT is available. The service fee were received for services performed in mainland China and hence derived outside Hong Kong and non-taxable (re: Whampoa Dock case). Page 4 of 11

5 Question 2 To: the Board of Directors of Benson Holding Company From: xxx CPA firm BHL s Hong Kong business plan include consignment sales, Hong Kong branch and Hong Kong subsidiary. The respective tax analysis is set-out below: Consignment sales Consignment sales is subject to profits tax in Hong Kong under section 20A(3) The consignee is required to: Furnish a quarterly return, showing gross sale proceeds; and Withhold and pay profits tax on behalf of its consignor at a sum upto 1% of such proceeds (section 20A(3)). In practice, only 0.5% of the gross proceeds is demanded. The Inland Revenue Ordinance does not stipulate that the 0.5% is the final tax liability. The non-resident, LFL [BHL], can produce financial statements to support its liability if it is less than that demanded. Tax issues in setting up a Hong Kong branch rather than a subsidiary A branch constitutes a permanent establishment (PE) of the non-resident principal according to IRR 5. If a branch is established in Hong Kong, LFL will be regarded as carrying on business in Hong Kong through a PE and the profit derived from Hong Kong will be taxable. However, a subsidiary is a separate entity from its holding company. Hence, merely setting-up a subsidiary in Hong Kong would not by itself make the holding company subject to profits tax in Hong Kong. Instead, the subsidiary itself would be subject to Hong Kong profits tax if it carries on business in Hong Kong and has derived profits from Hong Kong from such business. PE s profits tax. Hong Kong does not impose any withholding tax on PE s profits remitted to the home country. An overseas corporation carrying on business through a PE is taxed in the same manner and at the same rate as a Hong Kong corporation. Provided the PE s accounts accurately reflect profits of the PE derived from sources in Hong Kong, the method of income and expenditure allocation between the PE and its head office is no different as between a subsidiary and its parent. On the other hand, IRR 5(2) provides the method of ascertainment of PE s assessable profits: (i) (ii) (iii) If accounts are prepared for the PE, assessable profits will be calculated based on the accounting profits before taxation with appropriate tax adjustments. Failing the provision of accounts, or where the accounts do not show the true position for the Hong Kong PE, the assessable profits may be ascertained by adjusting the worldwide profits to conform to profits tax principles and apportioning them on the basis of Hong Kong turnover to worldwide turnover. Failing (i) and (ii), which would be exceptional, the assessor is empowered to fix the assessable profits as a fair percentage of the Hong Kong turnover. It should take note that interest expenses charged by LFL to its Hong Kong branch/pe is not allowable because it is not incurred according to the Banque National de Paris case. However, the interest expense charged by LFL to the new Hong Kong subsidiary will also be nondeductible as section 16(2)(c) will not be satisfied because LFL will not carry on business in Hong Kong at the time interest is charged. The royalty charged to the Hong Kong branch is non-deductible, being a notional expense. The royalty charged to the branch will not be taxable under section 15(1)(b) either as it is not a receipt/payment, but merely a notional charge. The royalty charged by BHL to the Hong Kong Page 5 of 11

6 subsidiary will be incurred in the production of assessable profits of the subsidiary and thus deductible under section 16(1). The royalty will be deemed as taxable under section 15(1)(b). The relevant assessable profit is 100% of the royalty under section 21A because BHL and the new subsidiary are associated company, and BHL has been carrying on business in Hong Kong by way of consignment sales. The new Hong Kong subsidiary needs to withhold, report and pay tax under section 20B for BHL. Home country loss set-off. If the tax rules of the home country permit foreign source losses of a domestic corporation to offset other taxable income of that corporation, and if losses are anticipated in initial years, it may be advantageous to establish operations initially as a PE in order to derive home country tax advantages from the losses. Using a branch may not be necessary if the home country's taxation legislation allows group loss relief, i.e. loss of the Hong Kong subsidiary is allowed to set-off profit of BHL. Deferral of home country tax. If the tax rate in Hong Kong is lower than the tax rate in the home country (as like the case), and home country taxation can be deferred through the establishment of a Hong Kong subsidiary, but not through a PE, and if the investment is expected to generate taxable income, then it would be advantageous to establish operations in the form of a Hong Kong subsidiary. However, there may be risk under controlled-foreign corporation rules (which usually exist in residence jurisdictions like Country A) where non-distributed profits of the Hong Kong subsidiary will be deemed as taxable income to BHL in Country A, if the relevant conditions are satisfied. Tax treaties. Hong Kong has entered into comprehensive taxation agreements with over 20 countries [over 35 jurisdictions]. A subsidiary, which is usually regarded as a Hong Kong resident company and will normally, be entitled to the treaty benefits, whereas such benefits will not be available to a branch which normally is not constituted as a Hong Kong resident company. It is however possible for home country taxation advantages to be available where investments are structured in Hong Kong through a PE of a company incorporated in a jurisdiction having a tax treaty with the home country. Page 6 of 11

7 PART B Question 3 Part 1 The CUP method establishes an arm s length price by reference to sales of similar products made between unrelated persons in similar circumstances. Suitable if: It is the preferred method if such comparable sales exist. Widely used for pricing oil, iron ore, wheat, and other goods sold on public commodity markets. Also useful for pricing manufactured goods that do not depend substantially for their value on special know-how or brand names. Not suitable if: It is not well adopted for pricing many intermediate goods, such as custom-made automobile parts that are not generally sold to unrelated parties. Also not suitable for setting the price on sales of goods that are highly dependent for their value on the trade name of the producer. As FJ performs all product research and development and the products are manufactured under special patents, there may not be any comparable sales and CUP may not be available to the case. The sales to PC is not comparable instead, as FL undertaken all marketing function in mainland market. If the profits is based on highly integrative operations as like the case, the profit-split method may be more suitable. Part 2 The Inland Revenue Department could rely on the following provisions/principles to attack transactions which are not carried out on arm s length basis: Section 16(1) - Deduction rules: payment made to related parties which are inflated and hence not to the extent in the production of assessable profits. Such inflated payment would be disallowed, Section 20(2) A Hong Kong resident carries on a business with a closely- connected non-resident which results in the Hong Kong resident deriving less than normal or no chargeable profits in Hong Kong. The overseas resident would be deemed carrying on business in Hong Kong and chargeable to profits tax in respect of profits derived from the business carried on with the Hong Kong resident. Section 61 - Artificial and fictitious transactions which reduce tax liability would be disregarded. Section 61A - Tax-motivated transactions could be disregarded and re-characterized (including prices adjustment) so as to counteract the tax benefit. Sharkey rule disposal of trading stock not at arm s-length could be replaced by market prices. Page 7 of 11

8 Part C Question 4 Part 1 AL and BL are associated companies in terms of section 45(2) of the Stamp Duty Ordinance (SDO). However, the relief under section 45(1) does not apply because it seems that the conveyance was made in connection with an arrangement, under which the consideration was to be received by a person who is not an associated corporation (section 45(4)(a)). That is AL would apply the sales proceeds for repayment of a loan borrowed from Peter, who is not an associated corporation to AL and BL. Ad valorem duty (AVD) payable: The total consideration is cash and loan waiver (section 24(1)): $(5,000, ,000,000) x 15%* = $3,000,000 However, relief can be applied under section 24(2) which allows using the property value for stamp duty purposes. The instrument must be adjudicated by the Collector of Stamp Duty. If section 24(2) applies, AVD payable is: $16,000,000 x 15% = $2,400,000 Part 1 of Scale 1 rate applies, as the property is not acquired by a Hong Kong permanent resident (HKPR). Special stamp duty (SSD) is not applicable as the property was acquired by AL on 1 November 2014 and it was as assigned on 1 November 2017, i.e. 36 months and 1 day. Buyer s Stamp Duty (BSD) is payable as the property is not acquired by HKPR. BSD payable: $16,000,000 x 15% = $2,400,000 The disposal gain should be capital in nature as AL has been holding it for about three years since acquisition, used it as staff quarters and claimed commercial building allowances [no any mention before]. Applying the test of badges of trade, the gain is likely to be capital in nature and not taxable under section 14 of the IRO. Balancing adjustment needs to be made for disposal of the property. Part 2 BL and CL are not associated companies in terms of section 45(2) of the SDO. The relief under section 45(1) does not apply. AVD payable on the sale agreement: $25,000,000 x 15% = $3,750,000. AVD payable on the deed of assignment: $100 Applying Zung Fu case, the consideration of $25,000,000 will be used for charging AVD, instead of the market value of Property-1 on date of conveyance of $30,000,000. SSD would be chargeable: $25,000,000 x 20% = $5,000,000 The holding period was 6 months (1 November 2017 to 30 April 2018). BSD payable: $25,000,000 x 15% = $3,750,000 BL is very likely being challenged by the Inland Revenue Department (IRD) being subject to profits tax in respect of the disposal gain of $5,000,000 [?] in view of short period of ownership. Page 8 of 11

9 Question 5 Part 1 16(2)(g) will be satisfied if the following conditions are satisfied Part 2 The lender is a non-hong Kong associated corporation. Interest expenses were incurred by the Hong Kong borrower on intra-group financing business. Interest received by or accrued to the non-hong Kong associated corporation is subject to tax in overseas at a rate not lower than Reference Rate (16.5% or 8.25% if the Hong Kong company is a qualified corporate treasury centre). The associated corporation (lender) must be the beneficial owner (BO) of the interest. That is the lender should has real control over the interest and does not need to pass the interest to someone else. If the non-hong Kong associated corporation borrows money from another entity and on-lends the sum to the Hong Kong associated corporation, then the non-hong Kong associated corporation is NOT the BO. For section 16(2)(g), deduction will be restricted under section 16(2CA) if arrangements are in place by which the relevant interest is payable to a related person, who is: (i) (ii) neither subject to profits tax in Hong Kong nor subject to a similar tax outside Hong Kong; or subject to profits tax in Hong Kong or a similar tax outside Hong Kong at a rate less than the Reference Rate. The disallowed amount under section 16(2CB) = interest expense x (no. of days interest flowed back) /(no. of days loan was borrowed for the basis period) Also, for section 16(2)(g), there is utilization of tax loss restriction under section 16(2CC). There would no interest deduction if the main purpose or one of the main purposes of the borrowing is to utilize a loss in order to avoid, postpone or reduce any liability, whether of the HK borrower or another person, to profits tax in Hong Kong. Section 16(2CC) may be applicable to the following situation: if the non-hong Kong associated company is expected to sustain a loss, and the Hong Kong corporation borrowed money from such non-hong Kong associated company; seemingly the main purpose is to utilize the loss of the non-hong Kong associated corporation (for it would receive interest income) and to avoid tax liability of the Hong Kong company (for it would have deduction of the interest payment, if allowed). Page 9 of 11

10 Question 6 Mr Fung Salaries Tax Computation, Year of Assessment 2017/18 $ $ Salary 600,000 Insurance benefits ($6,000 x 12) 72,000 Holiday journey ($51,000 + $1,000) /2 - $1,000 25,000 Share award (10,000 x $12 x 0.95) 114, ,000 Rental value ($811,000 - $25,000 - $72,000) x10% 71,400 Less: Rent suffered ($1,200 x 12) (14,400) 57,000 Share option gain [($10-$5) x 30,000 - $10,000] 140,000 Assessable income 1,008,000 Less: Motor car expenses ($50,000 x 50%) (25,000) Depreciation allowance ($144,000 x 50%) (72,000) Self-education expense (50,000) (147,000) Net assessable income 861,000 Less: Concessionary deductions Elderly residential care expenses (70,000) Contribution to retirement scheme (18,000) (88,000) 773,000 Less: Personal allowances Married person's allowance (264,000) Child allowance (100,000) Dependent parent allowance - aged 56 (23,000) (387,000) Net chargeable income 386,000 Tax at progressive rates $(386, ,000) x 17% + $9,450 52,120 Tax at standard rate 115,950 Salaries tax payable 52,120 Less: Tax reduction (75%, max $30,000) (30,000) Final tax payable 22,120 Page 10 of 11

11 Question 7 Part 1 The manufacturing profits were in fact derived from the trading operation of KL, i.e. the place where contracts of purchase and sale were effected (DIPN No. 21). KL sold raw materials and bought back finished goods. Hence, it is an import processing arrangement rather than a contract processing arrangement. The independent production activities carried out by BPE in mainland China is irrelevant in determining source of KL s trading profits (Datatronic case), notwithstanding KL s production managers provided technical support to BPE. These technical supports though commercially essential, were antecedent and incidental operation rather than critical steps generating trading profits to KL. All suppliers of KL are located in Hong Kong. KL accepted sale orders from customers and placed purchase orders to BPE in Hong Kong. The contracts of purchase and sale were effected in Hong Kong. As such, the manufacturing profits were derived from Hong Kong. Part 2 Interest from bank deposit in Hong Kong, $80,000 - Interest income derived from a bank deposit in Hong Kong is exempt from payment of profits tax under the Interest Exemption Order in general. However, there will be no exemption if the deposit has been used to secure for borrowing and interest expenses on such borrowing is deductible. The deposit in the case has been used to secure for a loan of BPE, which did not carry on business in Hong Kong. The interest expense of the BPE s loan should not be deductible. Hence, the deposit interest should still be exempt from profits tax. Compensation income, $2,000,000 - On the basis that the sole office s tenancy agreement was a long-term contract that would constitute the fundamental operating structure of KL, the agreement should be regarded as a capital asset to Kl. The compensation paid for early termination should be also capital in nature (Aviation Fuel Supply case). The fact that the sum was arrived at based on the loss of profit should not affect the nature of the income. Part 3 Cost of acquiring the proprietary interest of Patent-1 from BPE is NOT deductible under section 16E as KL and BPE are associated companies. Hence, the sale proceed of the patent was not taxable. Profits on disposal of the patent is capital in nature and non-taxable. The development cost of Patent-2 should be deductible under section 16B though it is capital in nature. The fact that it was used outside Hong Kong would not affect the deduction as there is no requirement that the patent must be used in Hong Kong under section 16B. Part 4 Interest on Loan 1 for purchase of a machine is deductible under section 16(1)(a), 16(2)(d) and (2)(e). Restriction under section 16(2A) is not applicable as the loan was secured by shares of BPE rather than by any deposit/loan generated non-taxable interest. Also section 16(2B) does not apply because there is no flow-back of non-taxable interest income. Interest on Loan 2 for purchase of trading stock is deductible under section 16(1)(a), (2)(d) and (2)(e). However, restriction under section 16(2A) applies as the loan was secured by deposit of Mr. Chan. Interest income derived from such deposit should not be taxable as Mr. Chan did not carry on business in Hong Kong. Section 16(2B) does not apply. Non-deductible interest expense should be $100,000. Page 11 of 11