C Ltd. was a wholly-owned subsidiary of A Ltd. In other words, A Ltd. held 100% of the issued share capital of C Ltd.

Transcription

1 SECTION A CASE QUESTIONS Answer 1 The test generally applied for determining the source of interest received by a business, other than a financial institution or a money lender, is the provision of credit test. The provision of credit test provides that the place of derivation of interest is the place where the funds from which the interest is derived were provided to the borrower. In the present case, the funds from which A Ltd. derived the interest income originated from a fixed deposit with Bank D, and such deposit was placed with an overseas branch of the bank. Following the provision of credit test, the interest income should be regarded as having a source outside Hong Kong, and should not be chargeable to profits tax in Hong Kong under section 14 of the IRO. Further, as the interest income was not derived from Hong Kong, it could not be deemed to be a trading receipt by virtue of section 15(1)(f) of the IRO. Answer 2 C Ltd. was a wholly-owned subsidiary of A Ltd. In other words, A Ltd. held 100% of the issued share capital of C Ltd. A Ltd. and C Ltd. were thus associated companies in terms of section 45(2) of the Stamp Duty Ordinance ( SDO ). Therefore, by virtue of section 45(1) of the SDO, stamp duty under head 1(1) should not be charged on the conveyance of the Land from A Ltd. to C Ltd. Strictly speaking, the fact that C Ltd. had arranged a loan from Bank D for the purpose of acquiring the Land might trigger the application of section 45(4)(a) of the SDO to deny the exemption under section 45(1). However, the Collector of Stamp Revenue has issued a ruling (see Law Society of Hong Kong Circular No. 1/83), stating that as long as he is satisfied that the loan was made by Bank D in the ordinary course of business, and that the bank did not have any interest in the Land other than as security, the provision of funds by the bank would not result in the exemption being lost. After the conveyance, A Ltd. and C Ltd. had to remain associated for at least two years. Otherwise, the stamp duty exemption would be revoked and duty would be payable under section 45(5A) of the SDO. Module D (May 2010 Session) Page 1 of 10

2 Answer 3 [Draft] Mr. X C Ltd. [Address] [Date] [Our Reference] Dear Mr. X, We refer to your recent engagement with this firm to handle the enquiry raised by the IRD. As I understand, the enquiry concerned the deductibility of the land cost of $800 million and the interest expenses of $15 million. We summarise below our understanding and comments thereon for your information. The Facts (1) Land cost (a) The cost was incurred in respect of the Land which was acquired from A Ltd., the parent company of C Ltd. (b) The cost included two elements, namely the initial cost of $200 million and the variable cost of 60% of the net profits realised by C Ltd. from the redevelopment of the Land. According to the information supplied by you, the variable cost amounted to $600 million. (c) At the time of acquisition by C Ltd., the market value of the Land was $500 million. (2) Interest expenses (a) The interest was incurred in respect of a loan from Bank D. (b) The purpose of the loan was to finance the initial cost of the Land. (c) The loan was secured by a fixed deposit from A Ltd. The deposit was placed with an overseas branch of Bank D, and generated interest income of $10 million for the year ended 31 December Issues raised Whether, and if so, to what extent the above land cost and interest expenses were deductible for profits tax purposes? Module D (May 2010 Session) Page 2 of 10

3 The Law (1) Sections 16 and 17 of the IRO (a) Section 16(1) allows deduction of any outgoings and expenses to the extent that they were incurred in the production of chargeable profits. Section 17(1)(b) prohibits deduction of any expenses which were not expended for the purpose of producing chargeable profits. (b) As regards interest expenses, section 16(1)(a) permits their deduction if the money borrowed is for the purpose of producing chargeable profits. But in addition to this general condition, the interest expenses must also meet at least one of six criteria as specified under section 16(2). A loan borrowed from a financial institution for the purchase of trading stock can satisfy the conditions under section 16(2)(d) and (e). However, if the payment of the principal and interest in respect of that loan was secured by a deposit made by the borrower or its associate, and the interest income derived from that deposit is not chargeable to tax, then by virtue of section 16(2A), the interest deduction will be reduced on a basis as is most reasonable and appropriate in the circumstances of the case. (2) Section 61A of the IRO (a) (b) Section 61A provides that if it can be concluded that the transaction was entered into or carried out for the sole or dominant purpose of enabling the relevant person, either alone or in conjunction with others, to obtain a tax benefit, the person shall be assessed as if the transaction or any part thereof had not been entered into or carried out, or in such other manner as appropriate to counteract the tax benefit. In Commissioner of Inland Revenue v. Tai Hing Cotton Mill (Development) Limited [2008] 2 HKLRD 40, the Court of Final Appeal held that if the effect of a transaction was that the tax liability to tax is less than it would have been on some other appropriate hypothesis, the taxpayer concerned would be regarded as having obtained a tax benefit. In that case, the Court held that the Commissioner could adopt the market value to determine whether the taxpayer had obtained a tax benefit from its acquisition of a land. Our comments Based on the above statutory provisions and legal principles, our comments on the deductibility of the land cost and interest expenses are as follows: (1) Land cost (a) The land cost included a variable dependent on the profits realised by C Ltd. from the redevelopment of the Land, making the total land cost far exceed the market value upon acquisition. The Commissioner may consider that the payments which exceeded the market value of the Land were not expenses incurring in the production of the profits from the redevelopment project but an appropriation of the profits. They should be disallowed pursuant to sections 16(1) and 17(1)(b) of the IRO. Module D (May 2010 Session) Page 3 of 10

4 (b) Alternatively, the Commissioner may invoke section 61A of the IRO and take the view that the sole or dominant purpose of the transaction, being the purchase of the Land from A Ltd. in the terms stated in the question, was to confer a tax benefit on C Ltd. by enabling it to deduct a land cost more than it could have done if the sale had been at market value. In our view, it is clearly open for the Commissioner to arrive at this conclusion, having regard to the following features of the transaction: (i) (ii) A Ltd. and C Ltd. were parent and subsidiary. As held in Tai Hing, they were the same enterprise under the same direction in economic terms and plainly not dealing at arm s length. The considerations for the Land consisted of an element for the appropriation of the profit derived from the redevelopment project. It was unusual for companies to have entered into such an agreement if they were dealing at arm s length. (iii) The ultimate considerations paid by C Ltd. in respect of the Land were commercially unrealistic and grossly excessive when compared with the market value. (iv) The above circumstances are strong indicators that the purpose of the transaction is to mop up a large portion of C Ltd. s profits and transfer them tax free to A Ltd. In order to counteract the tax benefit conferred on C Ltd., the Commissioner is entitled to restrict the amount of land cost allowable to C Ltd. to the market value of the Land. (2) Interest expenses (a) (b) (c) (d) The relevant loan was borrowed by C Ltd. to finance the acquisition of the Land for redevelopment. Thus, there should be no dispute that section 16(1)(a) is satisfied. As the loan was borrowed from Bank D (i.e. a financial institution) whilst the Land, being acquired for redevelopment, was the trading stock of C Ltd., section 16(2)(d) and (e) are also satisfied. The loan was secured by a fixed deposit from A Ltd., an associate of C Ltd., which generated interest income of $10 million. As the deposit was placed with an overseas branch of Bank D, the interest income should be exempt from tax in the hands of A Ltd. Due to the above circumstances, the deductible amount of the loan interest should be reduced on a reasonable basis by virtue of section 16(2A). According to DIPN No.13A, the amount of interest expenses allowable in the circumstances should be reduced by $10 million, being the tax-free interest earned by A Ltd. Module D (May 2010 Session) Page 4 of 10

5 Conclusion The above only provides our initial assessment on the deductibility of the relevant expenses. It may not reflect the actual determination by the Commissioner, who may take a different view if any additional facts of the case are later provided for his consideration. We are pleased to advise further on the issues should this be required. We trust the above will be of assistance to you. Should you have any questions, please feel free to contact me at [telephone number] or Mr./Ms. Y, Tax Manager of this office, at [telephone number]. Yours sincerely, Partner E & Co. Answer 4(a) In Kwong Mile Services Limited v. Commissioner of Inland Revenue [2004] 3 HKLRD 168, the Court of Final Appeal emphasised the need to grasp the reality of each case, focusing on effective causes without being distracted by antecedent or incidental matters in deciding the question of source of profits. In the present case, what C Ltd. did in the Mainland was to enter into the underwriting agreement and assume an underwriting risk. But the assumption of risk did not earn C Ltd. any profits, it was an antecedent activity which provided the company with an opportunity to earn the profits. What C Ltd. did to realise the profits were its exertions in the form of its activities in marketing the Mainland property, and those activities took place in Hong Kong. Hence, the profits of C Ltd. from underwriting the sale of the Mainland property arose in or were derived from Hong Kong, and they should be chargeable to profits tax. Module D (May 2010 Session) Page 5 of 10

6 Answer 4(b) For an exchange loss to be allowable, the loss: (a) must have arisen in the production of chargeable profits in Hong Kong from a trade, profession or business carried on in Hong Kong; and (b) must be of revenue and not capital in nature. In the present case, the exchange loss arose from the remittance of the guaranteed sum by C Ltd. to the Mainland developer. It should be allowable because: (a) the payment of the guaranteed sum to the Mainland developer should form part of the obligations of C Ltd. under the underwriting arrangement, by which C Ltd. derived its underwriting profits. Plainly the loss arose from the production of C Ltd. s chargeable profits. (b) the loss was an additional outlay for the payment of the guaranteed sum, which was a cost for earning the underwriting profits. The loss should thus be revenue in nature. Answer 5(a) It is not disputed that Mr. X s salary under Contract A should be chargeable to salaries tax by virtue of section 8(1)(a) of the IRO. The relevant employment should be located in Hong Kong, and as required under Contract A, Mr. X was to render services in Hong Kong. What Mr. X may argue is that he had another employment with C Ltd. under Contract B. Though the employment was also located in Hong Kong, he had rendered all the services in connection with that employment in the Mainland. By virtue of section 8(1A)(b)(ii) of the IRO, the salary from that employment should be exempt from salaries tax. On the facts given in the question, the Commissioner may not accept Mr. X s claim that he had rendered all his services under Contract B in the Mainland. The reasons are as follows: (a) Under Contract B, Mr. X was required to report direct to the Chairman of A Ltd., who was stationed in Hong Kong. (b) During the year ended 31 December 2008, C Ltd. underwrote the sale of a Mainland building and for such purposes, it organised certain promotion exercises in Hong Kong. Being the managing director of C Ltd., it is very unlikely that he would not take part in those marketing activities. (c) During the year of assessment 2008/09, Mr. X was on business trips to the Mainland for 45 days only. In other words, for most of the days during the year of assessment 2008/09, Mr. X stayed in Hong Kong. It would be highly unlikely that Mr. X had only worked for the local property development projects during his presence in Hong Kong. Module D (May 2010 Session) Page 6 of 10

7 Alternatively, even if Mr. X is accepted to have rendered all his services under Contract B in the Mainland, the Commissioner may form the view that the sole or dominant purpose of the alleged dual employment arrangement between Mr. X and C Ltd. was to enable Mr. X to obtain a tax benefit by claiming full exemption of his salary under Contract B. In order to counteract the tax benefit, the Commissioner may invoke section 61A to assess Mr. X as if he had only one Hong Kong employment with C Ltd. Since Mr. X rendered part of his services in connection with this employment in Hong Kong, the exemption under section 8(1A)(b)(ii) is not applicable, and all his salaries under Contracts A and B should be chargeable to salaries tax. Answer 5(b) The share option gain is income from employment as stipulated under section 9(1)(d) of the IRO. By virtue of section 9(4) of the IRO, the gain should be chargeable to salaries tax in the year of exercise (i.e. 2008/09). On the authority of Commissioner of Inland Revenue v. Sawhney, Subhash Chander [2006] 3 HKLRD 21, the fact that Mr. X had exercised the share option after his cessation of employment would not affect the chargeability of the share option gain. * * * END OF SECTION A * * * Module D (May 2010 Session) Page 7 of 10

8 SECTION B ESSAY / SHORT QUESTIONS Answer 6(a) Emma is carrying on a business on her own account in Hong Kong. She is not under any contract of services. Therefore, she is chargeable to profits tax under section 14 of the IRO and is thus liable to pay Hong Kong profits tax. She is not liable to pay salaries tax. Answer 6(b) Computation of assessable profits for the year of assessment 2008/09: $ Tuition fees 1,000,000 Less deductible expenses: Rent for studio (600,000) Utilities for studio (10,000) Office expenses studio (200,000) Assessable profits 190,000 Answer 6(c) Rent for the apartment, utilities (apartment), travelling (personal), hiring of domestic helper and other personal expenses are private in nature and are not incurred in the production of chargeable profits. Thus they are not deductible under section 16 and section 17(1)(a). Answer 6(d) On the facts available, it should be advantageous for Emma to elect for personal assessment. If no election is made, her profits will be taxed at profits tax standard rate. Whereas by electing personal assessment, she can have the benefit of personal allowance and subject to progressive tax rates which should be below the standard rate. Answer 6(e) Since the services were rendered in London, such gratuities are not arising in and/or derived from Hong Kong even if they are attributable to her business carried on in Hong Kong. Therefore, such offshore income would not be taxable under section 14 of the IRO. This is also in line with the guidelines in DIPN 21. The related expenses such as travel, hotel accommodation and miscellaneous expenses would not be deductible as they were not incurred in the production of chargeable profits. If Emma recorded her performance in her studio in Hong Kong and the recording was broadcasted in London, the gratuities received by her should be taxable. Following the principle in the Hang Seng Bank case, we look at what the taxpayer has done to earn the profits. In her case, the income earning operation is her performance/recordings in the studio in Hong Kong. Therefore the profit derived from there would be assessable. Module D (May 2010 Session) Page 8 of 10

9 Answer 7 According to the Hong Kong Companies Ordinance ( CO ), the first annual general meeting of a newly incorporated Hong Kong company must be held within 18 months of its incorporation and the company's financial statements (i.e. profit and loss account and balance sheet) must be tabled at the company's annual general meeting. From the Hong Kong profits tax perspective, if the taxpayer s first accounts are for a period exceeding a year, in practice, the Commissioner would apportion the taxpayer s profits with reference to the normal accounting date. This is consistent with the provisions in section 18C(1)(b). In the present case, the company was incorporated and commenced business on 1 January 2010 and its financial year end date is 30 June annually (i.e. the first accounts would be up to 30 June 2011). The company s assessable profits derived during 1 January 2010 to 30 June 2010 would be assessed in the year of assessment 2010/11 whilst the assessable profit derived for the period from 1 July 2010 to 30 June 2011 would be assessed in the year of assessment 2011/12. There would be no assessment for the year of assessment 2009/10. For the subsequent years of assessment, the normal basis period for a profits tax assessment is the accounting period ending in the assessment year (i.e. the current year basis) (refer to section 18B(2)). Based on the above, the basis period for the year of assessment 2012/13 would be 1 July 2011 to 30 June 2012 (i.e. financial year ending 30 June 2012). Therefore, for NT Co, the basis period likely to be adopted by the IRD would be as follows: 2009/10 NA (No assessment) 2010/11 1 January June /12 1 July June /13 1 July June 2012 If the accounting year end date is changed, section 18E(1) provides that the Commissioner has the discretion in deciding the tax basis periods for the year of change and the preceding year. At times, this may result in double taxation. If NT Co intends to change its accounting year end date, it should assess the above risk of double taxation. Losses in the accounting period would not be allowed twice, irrespective of the basis period adopted. Answer 8(a) The losses incurred by HKCO Ltd., if agreed by the IRD, (i.e. all income is taxable and all expenses are allowable), can be carried forward for set off against future assessable profits in line with the provisions in section 19C(1). There is no time limit on the loss carried forward for set-off purposes. Module D (May 2010 Session) Page 9 of 10

10 Answer 8(b) HKCO Ltd. is a subsidiary of Kowloon Ltd. Kowloon Ltd. has a projected profit of $100 million for the year ending 30 June Kowloon Ltd. cannot utilise the losses in HKCO Ltd. (section 19C of the IRO). There are no provisions in the Inland Revenue Ordinance for group relief. The tax position is the same for the case where Kowloon Ltd. is a subsidiary of HKCO Ltd. Parent company s tax losses cannot be used for setting off subsidiary s assessable profits. There are no provisions in the Inland Revenue Ordinance for group relief. Answer 8(c) If HKCO Ltd. is a partner in HK Kowloon Partnership, its losses can be used for setting off against its 50% share of the assessable profits in the HK-Kowloon Partnership (section 19C (4)). HKCO Ltd. can utilise its own losses to set off against its share of profits in the HK Kowloon Partnership (i.e. limiting to $20 million assessable profits for the year of assessment 2011/12). Answer 8(d) (1) If the management decided to close down HKCO Ltd. in 2012 and leave it dormant, the agreed tax losses could still be carried forward. There is no time limit for the setting off of losses. Once the company is reactivated, the carried forward losses could still be used to set off against future assessable profits. (2) If the management decided to liquidate the company, the losses will lapse. (3) If the shareholders decided to sell their investment in HKCO Ltd. to Paris CO, the tax losses in HKCO Ltd. would still be carried forward. If there are commercial reasons for Paris CO to acquire the shares in HKCO Ltd., and the sole or dominant purpose is not for the purpose of utilising the tax losses, then the anti-avoidance provisions in section 61B of the IRO would not be applicable and the agreed tax losses in HKCO Ltd. can still be carried forward for setting off against its future assessable profits. * * * END OF EXAMINATION PAPER * * * Module D (May 2010 Session) Page 10 of 10