CASE. Buying agent. The suppliers, clients and MPL were all unrelated parties. Final Examination (June 2014 Session) Paper II 1 of 9

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1 CASE Chungking Manufacturing Enterprise Limited ( CKM or the Group ) is a listed company in Hong Kong with a global presence. The Group was established by the Chan family half a century ago. In the past, the board of directors consisted of members of the Chan family only. It had a very simple governing structure where the most senior person in the Chan family led the rest of the family to run the business. The family first diluted its interest in the Group when it got listed 30 years ago. Since then, a number of strategic shareholders have been brought in and, after several share placements and share restructuring, the Chan family s interest in the Group was reduced to less than 10%, though the family still maintained the only 3 executive board seats of CKM until now. The Group principally engages in manufacturing for its overseas clients all over the globe. Supplementing the operations and supply chains, the Group also provides sourcing and buying agent services to its clients. Its Dongguan factory is a major manufacturing base in mainland China because of its proximity to Hong Kong. The Group has a financial year end at 31 December. The annual financial statements of CKM for the year ended 31 December 2013 were approved and issued on 1 April Buying agent Marketing Perfect Limited ( MPL ) is a wholly owned subsidiary of CKM and acts as the buying agent of its South East Asia clients. Suppliers are from Europe and the United States. Since 2007, MPL would, via its fellow subsidiary, arrange for delivery of the products from the suppliers to MPL s clients and conduct quality control of these products. In return, MPL charges 7% of the value of the goods supplied to its clients under the agreement between MPL and its clients, which is negotiated and signed in Hong Kong. To ensure a real time response to client s requests, MPL has a web-based interface for its South East Asia clients to take their orders 24-hours a day. Once the order is received, the web-based interface will automatically send details to its fellow subsidiary for processing and purchase from a supplier. As soon as the client s request is matched with a confirmed purchase from a supplier, shipment is arranged directly from the supplier to client with the quality control work performed before it reaches the client, and an invoice will be generated automatically for the client at the same time. In 2007, MPL entered into an agency agreement with a fellow subsidiary, Charming Ltd ( CL ). CL is incorporated outside Hong Kong and operates offshore. It offers services to MPL so that MPL can fulfil its committed services to its clients. It is agreed that 3% of the value of the goods supplied to MPL s clients will be paid by MPL to CL as a service fee. CL provides such services for MPL solely outside Hong Kong. In the relevant years of assessment, MPL reported in its Profits Tax Return that all of its service income was offshore income and should not be subject to Hong Kong Profits Tax. The Inland Revenue Department ( IRD ) disagreed with the filing basis submitted by MPL and opined that the difference of 4% earned by MPL is profit from a Hong Kong source and should be taxable in Hong Kong. The suppliers, clients and MPL were all unrelated parties. Final Examination (June 2014 Session) Paper II 1 of 9

2 Patent disputes In 2008, Fast Patent Limited ( FPL ), a subsidiary of a well-known technology company, went to court alleging that CKM and its subsidiaries have infringed a number of patents held by FPL in relation to a number of manufacturing processes and knowhow which could enhance manufacturing efficiency and reduce wastage. This has been a nightmare for CKM and has taken up a significant amount of management attention and incurred significant legal costs up to now. From the beginning, the Group has been vigorously defending the case because management believed that they have strong grounds to defend themselves. Accordingly, there is only disclosure about the uncertainty of the disputes but there is no provision made for the disputes. Unfortunately, the judgement from the court ruled in favour of FPL recently, and the penalty and royalties on the patent in question as calculated by the expert witness appointed by the court are very significant to the Group which might cast doubt as to the sustainability of the current business model. IRD Field Audit The IRD conducted a Field Audit ( FA ) against MPL in 2009 and the case has not yet closed as at today. The IRD has issued Notices of Assessment to MPL for the relevant years of assessment. MPL lodged an objection against the said Notices of Assessment and requested a holdover of the tax demanded. It was agreed by IRD that 50% of the tax in dispute should be heldover unconditionally while purchases of tax reserve certificates were required to match the remaining 50% of the tax in dispute. China tax matters MPL has a subsidiary, Super Power Limited ( SPL ), in China for certain manufacturing functions supplementing the Group operations. For the year ended 31 December 2012, SPL recorded a profit of RMB 14 million and a dividend of RMB 8 million was declared and payable to MPL. Mary Siu is employed by MPL and is the quality control manager of MPL s Dongguan factory. Mary works in the Mainland and returns to Hong Kong every Saturday and Sunday. She has paid the required Individual Income Tax ( IIT ) in China, in accordance with the relevant IIT regulations. Acquisition of target company CKM is considering the acquisition of the controlling stake in Target Company Limited ( TCL ), a company engaged in a similar business as CKM but of a smaller operational scale. The Chief Financial Officer ( CFO ) of CKM is now assigned with the responsibility of performing a business valuation of TCL and shaping the structure of the acquisition which include how to acquire the controlling stake of equity interests from the existing shareholders of TCL, the terms and conditions of the acquisition and the pricing of the acquisition. The Board of Directors of CKM have agreed and determined in the board meeting held in September 2013 that the consideration of the acquisition would equal the fair values of assets acquired or liabilities assumed. According to the memorandum and articles of association of CKM, the acquisition and disposal of subsidiaries require majority votes of CKM shareholders. In October 2013, CKM commenced negotiation with all the shareholders Final Examination (June 2014 Session) Paper II 2 of 9

3 of TCL for CKM to acquire all of the shares in TCL. As of 30 October 2013, TCL is held by four shareholders, Mr. Andrew Chan, Mrs. Yvonne Lee, ABC Company Limited, and XYZ Trust which own 15%, 12%, 18% and 55% equity interests in TCL, respectively, and XYZ Trust had control over TCL. On 28 November 2013, CKM s board of directors entered into a tentative sale and purchase agreement with each of the shareholders of TCL. The tentative sale and purchase agreement specifies that the acquisition would become effective as of 1 December 2013 and that CKM is entitled to all profits after 1 December On 16 December 2013, CKM s shareholders approved the acquisition in the shareholders meeting; however, only Mr. Andrew Chan, Mrs Yvonne Lee and ABC Company Limited agreed and signed the final sale and purchase agreement for the sale of their equity shares in TCL. Subsequent to the shareholders meeting on 16 December 2013, CKM management continued to negotiate with XYZ Trust for the sale of its shares in TCL. On 14 February 2014, XYZ Trust tentatively agreed the amended terms and conditions for the sale of all of its shares in TCL. This acquisition was approved by CKM s shareholders on 28 February 2014, and on the same day, both XYZ Trust and CKM agreed and signed the final sales and purchase agreement. Financial information of acquisition target A summary of the relevant financial information of TCL is set out below: Year 2012 HK$ million (Actual) Year 2013 HK$ million (Forecast) Earnings before interest and tax ( EBIT ) Net profit 52 Depreciation 10 Capex 20 Increase in net working capital 8 Interest-bearing debt 35 n.a. Cash 10 n.a. Corporate tax rate 15% 15% Market comparables of listed companies in similar businesses are set out below: Historic price to earnings ( PE ) ratio: 7 times 10 times Historic enterprise value ( EV ) to EBIT multiple: 6 times 9 times Final Examination (June 2014 Session) Paper II 3 of 9

4 SECTION A CASE QUESTIONS (Total: 75 marks) Answer ALL of the following questions. Marks will be awarded for logical argumentation / calculation and appropriate presentation of the answers. Question 1 (25 marks approximately 45 minutes) (a) (b) What is the possible valuation range of TCL using the PE ratio (price to earnings ratio) approach based upon the information provided in the case? (2 marks) What is the possible valuation (equity value) range of TCL using the discounted cash flow approach based upon the information provided in the case (the Free Cashflow to Firm ( FCFF ) model)? Note: Assume FCFF grows at a constant rate of 3% p.a. (worst case scenario) to 5% p.a. (best case scenario). The WACC (Weighted Average Cost of Capital) of CKM of 12% is used in the valuation. (7 marks) (c) (i) What are the limitations in using the PE ratio approach in business valuation; and (ii) In addition to choosing a PE with similar business activities and scale, what can be done in selecting an appropriate PE ratio? (8 marks) (d) (e) (f) Based on the PE ratio approach and the DCF (discounted cash flow) approach, what is the reasonable valuation range of TCL? (2 marks) The Chief Financial Officer ( CFO ) of CKM was advised that using the WACC of CKM to value TCL may not be appropriate. Suggest two possible reasons behind this advice. (2 marks) While realising every valuation methodology has its own shortfalls, the CFO of CKM seeks to cross-check the valuation arrived at against some market comparables to ensure its reasonableness. Suggest how to do this and show your computations. (4 marks) Final Examination (June 2014 Session) Paper II 4 of 9

5 Question 2 (25 marks approximately 45 minutes) Assume you are the Chief Financial Officer of CKM, write a report to the Board of Directors and the Audit Committee of CKM in respect of the following matters: (a) (b) (c) Determine the acquisition date (as defined in HKFRS 3) relating to the acquisition of TCL. (5 marks) Advise with analysis and explanation on how the acquisition of shares of TCL would be accounted for in CKM s consolidated financial statements for the year ended 31 December 2013 and for the year ending (15 marks) If CKM successfully acquired the controlling stake in equity interests in TCL during 2013, briefly describe how the acquisition of TCL should be accounted for and disclosed in its consolidated financial statements for the year ended 31 December (5 marks) Question 3 (6 marks approximately 11 minutes) Using the case background, briefly explain the importance of corporate governance, identify the triggers for improving corporate governance of the Group, and give specific examples which you would expect the Group has adopted to improve its corporate governance since its establishment. (6 marks) Question 4 (6 marks approximately 11 minutes) Explain the responsibility of the auditor under each of the following scenarios: (i) (ii) assume the judgement from the court about the patent disputes was handed down after the balance sheet date, but before the auditor s report date; and assume the judgement from the court about the patent disputes was handed down after the auditor s report date, and that management has determined not to amend the financial statements because the current form of the financial statements together with the auditor s report are about to be published to the public in a few hours. (6 marks) Final Examination (June 2014 Session) Paper II 5 of 9

6 Question 5 (13 marks approximately 23 minutes) An audit team member reviewed the buying agent business and concluded that the Group in fact carried out the business as principal in the transactions. After a preliminary discussion with one of the accountants, he has doubts as to the reliability of the web-based interface, automatic transfer of information to fellow subsidiaries and generation of invoices. Furthermore, he also suspects that there might be significant cut-off errors for sales and purchases in the buying agent business because of diverse trading terms with clients and suppliers. However, management is very confident that its internal control is sufficient to ensure everything is in proper order. Required: Assuming you are the audit manager, explain to the audit team member, (i) the typical information technology general controls and specific application controls one would expect in a group with proper controls to address the risks set out above; and (ii) propose audit procedures to address the risks. (13 marks) * * * * * * * * Final Examination (June 2014 Session) Paper II 6 of 9

7 End of Section A

8 SECTION B ESSAY QUESTIONS (Total: 25 marks) Answer ALL of the following questions. Marks will be awarded for logical argumentation / calculation and appropriate presentation of the answers. Refer to the Case information. Question 6 (12 marks approximately 21 minutes) (a) Assume: (i) a settlement is reached between MPL and the Inland Revenue Department ( IRD ) under the Field Audit exercise; (ii) it was agreed that a certain percentage of the service fee from MPL s clients is taxable in Hong Kong; and (iii) there was no fraudulent and wilful intention or evasion of tax in the case. What will be the tax implications for MPL? What penal actions can the IRD take against MPL and what may be the quantum of penalty? (4 marks) (b) (c) On the other hand, if MPL cannot reach a compromise settlement with the IRD, what could MPL do to appeal against the assessments to be raised by the IRD? (2 marks) As a tax advisor of MPL, explain the chance of success of the above appeal case for consideration by MPL s management. (6 marks) Final Examination (June 2014 Session) Paper II 8 of 9

9 Question 7 (5 marks approximately 9 minutes) MPL s management are considering entering into some complex transactions possibly leading to uncertain tax implications. What alternative is available to reach a consensus on the tax implications with the IRD before actual transactions are carried out to minimize any protracted correspondence with the IRD in future? Advise on the procedures and documentation to kick-off the proposed alternative, with the associated costs, and whether the suggested alternative is legally binding. (5 marks) Question 8 (3 marks approximately 6 minutes) In the context of the Double Tax Arrangement entered between Hong Kong and mainland China, advise MPL regarding the China withholding tax implications of the dividend from the China company, Super Power Limited ( SPL ). (3 marks) Question 9 (5 marks approximately 9 minutes) Advise as to the Hong Kong Salaries Tax implications, if any, in the case of Mary Siu, MPL s Quality Control Manager who works in the Dongguan factory. (5 marks) * * * END OF EXAMINATION PAPER * * Final Examination (June 2014 Session) Paper II 9 of 9