CASE. Background of the company

Transcription

1 CASE Background of the company Panda Holding Company ( Holdco ) was incorporated in the Cayman Islands and has been listed on the Main Board of the Hong Kong Stock Exchange since Holdco has a 31 December financial year end and the financial statements are prepared in accordance with the Hong Kong Financial Reporting Standards. Holdco is generally managed and controlled in Hong Kong. The controlling shareholder of Holdco Group ( the Group ), comprising Holdco and its subsidiaries, is Mr Elden Lee who owns a 65% shareholding in Holdco. Mr Lee is the Chairman and the founder of the Group. The Group is engaged in the property management business. The Group is subject to Hong Kong profits tax at 16.5% and China Enterprise Income Tax (also known as Corporate Income Tax ( CIT )) at 25%. Acquisition of Entity X Mr Lee and his business partner set up a Hong Kong incorporated company, Entity X in 2011, in which Mr Lee and his business partner owned 80% and 20% equity interest respectively. On 30 September 2014, Holdco entered into a sale and purchase agreement with Mr Lee under which Holdco agreed to acquire an 80% equity interest in Entity X from Mr Lee at a cash consideration of HK$30 million. Upon completion of the acquisition, Holdco was able to appoint one representative to replace the former sole director. Rental activities of Entity X Entity X acquired a factory unit in Tsuen Wan in 2012 at a consideration of HK$18 million. The factory unit is partitioned into 5 mini-stores and currently these stores are all leased out to generate rental income. The unexpired periods of these leases range from 1 month to 2 years. Upon the signing of the rental agreements of these stores, a rent-free period of 2 to 5 days is granted to the tenants depending on the size of the mini-store leased and the lease period. Once the rental agreement is signed, the tenant has to pay a one-month deposit and one-month rental in advance. Payment must be made to Entity X directly by cheque. All of the mini-stores are leased out during this year. Mr Philip Chan is employed as an accounting clerk by Entity X to manage all of the daily operations. He is authorised to sign the rental agreement with tenants on behalf of Entity X and he prepares a leasing record summary based on the terms as stated in the signed rental agreements. He records rental income when he receives the cheques from the tenants and he also cross-checks them to the leasing record summary on a weekly basis to ensure all of the tenants have properly and punctually settled the rent. Mr Chan uses a notebook computer provided by Entity X to maintain the leasing record summary and prepares the financial statements using different spreadsheet files. All lease and rental information is only saved in the notebook computer for easy access by Mr Lee and his business partner. Mr Lee, his business partner and the accounting clerk use the same login user name and password to access the files saved in the notebook computer. Final Examination (December 2015 Session) Paper II 1 of 13

2 Accounting for factory unit The management of Entity X classifies the factory unit as an investment property and measures it using the fair value model. The management does not have any specific plans to sell the factory unit and may sell it depending on the market condition and the value of the factory unit. The management has engaged an independent qualified professional valuer to carry out the valuation of the factory unit at the end of each reporting period. Entity X has not yet received the valuation report of the factory unit from the independent qualified professional valuer (the Valuation Report ) 2 weeks before the consolidated financial statements of Holdco are approved by the Board of Directors. The fair value recorded is based on the management's estimates. Since the Valuation Report is material to Holdco s consolidated financial statements, the audit senior of the external auditor, ABC Audit Firm ( ABC ), considers that a qualified opinion may have to be issued if the Valuation Report is not available. The accounting clerk understands that ABC also provides valuation services and discusses with the audit senior whether ABC can perform the valuation of the factory unit for the purpose of the audit. Acquisition and disposal of Entity D Entity D is a limited company established in China and it engages in the provision of manned security services in China. With the intention to have Entity D listed on the Shenzhen Stock Exchange as the Group's strategic expansion in the security service industry, Holdco acquired a 75% equity interest in Entity D in two stages: In 2012, Holdco acquired a 40% equity interest for a cash consideration of HK$40 million (the First Acquisition ). Holdco classified the interest as an associate under HKAS 28 (2011), Investments in Associates and Joint Ventures. At the date that Holdco acquired its interest, the fair value of Entity D's identifiable net assets was HK$80 million. From 2012 to 2013, Holdco used the equity method to account for its share of undistributed profits totalling HK$5 million, and included its share of a revaluation gain of HK$3 million in other comprehensive income in accordance with HKAS 16, Property, plant and equipment. In 2014, Holdco acquired a further 35% equity interest for a cash consideration of HK$55 million (the Second Acquisition ). Entity D had identifiable net assets at a fair value of HK$120 million. Holdco elected to measure the non-controlling interest (which represents present ownership interests) at fair value of HK$30 million. On the date of acquisition, the previously held 40% interest had a fair value of HK$50 million. All the negotiations and conclusion of the share purchase agreements with respect to the First and Second Acquisitions in 2012 and 2014 took place in China, but the relevant formal share purchase agreements were signed in Hong Kong. The acquisition of the equity interest was financed by Holdco s own resources. In 2015, Holdco sold the 75% equity interest in Entity D for a consideration of HK$120 million to a third party in response to a very attractive unsolicited offer from the third party, Group X. The negotiation, conclusion and signing of the relevant sale contract took place in Hong Kong. Final Examination (December 2015 Session) Paper II 2 of 13

3 Management and governance of Entity D The Board of Directors of Entity D comprises five individuals. The directors are responsible for monitoring the daily business operations. Whenever there are any major transactions such as acquisition or disposal of subsidiaries, associates and joint operations, a change of company name or business strategies, dividend policy and amendments in the articles of association, approval has to be obtained from shareholders by a simple majority. At each stage of an acquisition, two representatives from Holdco were appointed as directors of Entity D replacing two of the former directors. As a result, upon the completion of the Second Acquisition, four representatives from Holdco in total were sitting on the Board of Directors of Entity D. One of them was elected as the Chairman and acted as the Chief Executive Officer of Entity D. In addition, Holdco has rights to variable returns in Entity D and all shareholders can share the returns of Entity D. Upon completion of the disposal in 2015, all the representatives from Holdco resigned from the Board of Directors of Entity D on the same date. Final Examination (December 2015 Session) Paper II 3 of 13

4 Appendix to Case Extract from double taxation arrangement ( DTA ): THE ARRANGEMENT BETWEEN THE MAINLAND OF CHINA AND THE HONG KONG SPECIAL ADMINISTRATIVE REGION FOR THE AVOIDANCE OF DOUBLE TAXATION AND THE PREVENTION OF FISCAL EVASION WITH RESPECT TO TAXES ON INCOME Article 4 - Resident 1. In this Arrangement, the term resident of One Side means: (1) in the case of the Mainland of China, any person who, under the laws of the Mainland of China, is liable to tax thereon by reason of his domicile, residence, place of head office, place of effective management or any other criterion of a similar nature. This term, however, does not include any person who is liable to tax on the Mainland of China in respect only of income from sources on the Mainland of China; (2) in the case of the Hong Kong Special Administrative Region: (i) any individual who ordinarily resides in the Hong Kong Special Administrative Region; any individual who stays in the Hong Kong Special Administrative Region for more than 180 days during a year of assessment or for more than 300 days in 2 consecutive years of assessment one of which is the relevant year of assessment; (ii) a company incorporated in the Hong Kong Special Administrative Region, or if incorporated outside the Hong Kong Special Administrative Region, being normally managed or controlled in the Hong Kong Special Administrative Region; (iii) any other person constituted under the laws of the Hong Kong Special Administrative Region, or if constituted outside the Hong Kong Special Administrative Region, being normally managed or controlled in the Hong Kong Special Administrative Region. 2. Where by reason of the provisions of paragraph 1, an individual is a resident of both Sides, then his status shall be determined as follows: (1) he shall be deemed to be a resident only of the Side in which he has a permanent home available to him; if he has a permanent home available to him in both Sides, he shall be deemed to be a resident only of the Side with which his personal and economic relations are closer ("centre of vital interests"); (2) if the Side in which he has his centre of vital interests cannot be determined, or if he does not have a permanent home available to him in either Side, he shall be deemed to be a resident only of the Side in which he has an habitual abode; Final Examination (December 2015 Session) Paper II 4 of 13

5 (3) if he has an habitual abode in both Sides or in neither of them, the competent authorities of both Sides shall resolve by mutual agreement. 3. Where by reason of the provisions of paragraph 1, a person other than an individual is a resident of both Sides, then it shall be deemed to be a resident only of the Side in which its place of effective management is situated. Article 13 - Capital Gains 1. Gains derived by a resident of One Side from the alienation of immovable property referred to in Article 6 and situated in the Other Side may be taxed in that Other Side. 2. Gains derived from the alienation of movable property forming part of the business property of a permanent establishment which an enterprise of One Side has in the Other Side, including such gains from the alienation of such a permanent establishment (alone or with the whole enterprise), may be taxed in that Other Side. 3. Gains derived by an enterprise of One Side from the alienation of ships or aircraft or land transport vehicles operated in shipping, air and land transport or movable property pertaining to the operation of such ships, aircraft or land transport vehicles, shall be taxable only in that Side. 4. Gains derived from the alienation of shares in a company the assets of which are comprised, directly or indirectly, mainly of immovable property situated in One Side may be taxed in that Side. 5. Gains derived from the alienation of shares, other than the shares referred to in paragraph 4, of not less than 25% of the entire shareholding of a company which is a resident of One Side may be taxed in that Side. 6. Gains derived from the alienation of any property, other than that referred to in paragraphs 1 to 5, shall be taxable only in the Side of which the alienator is a resident. Article 21 - Methods for Elimination of Double Taxation 1. On the Mainland of China, double taxation shall be avoided as follows: Hong Kong Special Administrative Region tax paid in the Hong Kong Special Administrative Region in accordance with the provisions of this Arrangement in respect of income derived from sources in the Hong Kong Special Administrative Region by a resident of the Mainland of China shall be allowed as a credit against Mainland tax imposed on that resident. However, the amount of the credit shall not exceed the amount of Mainland tax in respect of that item of income computed in accordance with the tax laws and regulations of the Mainland of China. Final Examination (December 2015 Session) Paper II 5 of 13

6 2. In the Hong Kong Special Administrative Region, double taxation shall be avoided as follows: Subject to the provisions of the tax laws of the Hong Kong Special Administrative Region relating to the allowance of a deduction and a credit against the Hong Kong Special Administrative Region tax of tax paid in any territory outside the Hong Kong Special Administrative Region, Mainland tax paid in the Mainland of China in accordance with the provisions of this Arrangement in respect of any item of income derived from sources in the Mainland of China by a resident of the Hong Kong Special Administrative Region shall be allowed as a credit against Hong Kong Special Administrative Region tax imposed on that resident. However, the amount of the credit shall not exceed the amount of Hong Kong Special Administrative Region tax in respect of that item of income computed in accordance with the tax laws and regulations of the Hong Kong Special Administrative Region. 3. Where a company which is a resident of One Side pays dividends to a company which is a resident of the Other Side and the company which is a resident of the Other Side controls, directly or indirectly, not less than 10% of the shares of the company which pays the dividends, the credit that the company which is a resident of the Other Side is entitled shall include the tax paid by the company which pays the dividends in respect of the profits from which such dividends are derived (and not exceeding the appropriate portion of profits incidental to the derivation of such dividends). Final Examination (December 2015 Session) Paper II 6 of 13

7 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 (9 marks approximately 16 minutes) As the accounting manager of the Group, write a memo to the Chief Financial Officer of Holdco to advise whether the acquisition of Entity X should be accounted for in accordance with HKFRS 3 (Revised), Business Combinations, or Accounting Guideline 5 (AG 5), Merger Accounting for Common Control Combinations; and explain the accounting treatment accordingly. (9 marks) Question 2 (14 marks approximately 25 minutes) Assume you are the audit manager of ABC Audit Firm and you are auditing the consolidated financial statements of Holdco for the year ended 31 December Required: (a) Discuss the audit approach in auditing the revenue of Entity X. For three different audit assertions for revenue you have considered, suggest three audit procedures to address them respectively. (8 marks) (b) List three internal control issues that you have identified in Entity X and suggest remedial actions for each of the issues identified. (6 marks) Final Examination (December 2015 Session) Paper II 7 of 13

8 Question 3 (17 marks approximately 31 minutes) (a) (b) (c) Discuss whether ABC Audit Firm should perform the valuation of the factory unit. (5 marks) Discuss whether a qualified opinion should be issued by ABC Audit Firm in case Entity X does not receive the Valuation Report before the consolidated financial statements of Holdco are approved by the Board of Directors. (2 marks) Entity X has subsequently received the Valuation Report before the consolidated financial statements of Holdco are approved by the Board of Directors. Based on the Valuation Report, the fair values of the factory unit at 30 September 2014 and 31 December 2014 were HK$25 million and HK$27 million respectively. The cost of construction is HK$10 million and tax allowance has been claimed starting from the year Required: (i) (ii) (iii) Discuss the factors that ABC Audit Firm has to consider in assessing whether reliance can be placed on the valuation performed by the independent qualified professional valuer engaged by Entity X. (4 marks) Advise as to the impact of deferred taxation on the factory unit under HKAS 12, Income Taxes. (4 marks) With regard to the factory unit, calculate the temporary difference and the deferred tax asset/liability to be recognised in the consolidated financial statements of Holdco for the year ended 31 December Note: Assume Entity X enjoys an annual allowance for industrial building of 4% for Hong Kong tax purposes. (2 marks) Final Examination (December 2015 Session) Paper II 8 of 13

9 Question 4 (10 marks approximately 18 minutes) Note: Ignore deferred taxation in this question. (a) Discuss whether it is appropriate to classify by Holdco the acquisition of the 40% equity interest in Entity D in 2012 as interest in associate and explain the accounting treatment of the acquisition. (3 marks) (b) In respect of the acquisition of a further 35% equity interest in Entity D in 2014, explain the accounting treatment of the acquisition in the books of Holdco. Calculate the goodwill and gain or loss from the acquisition, if any. Note: Ignore any tax effect in this question. (5 marks) (c) Explain how to treat the revaluation gain of property, plant and equipment on Holdco s books upon the disposal of the 75% equity interest in Entity D in (2 marks) Final Examination (December 2015 Session) Paper II 9 of 13

10 Question 5 (25 marks approximately 45 minutes) Entity D has a daily fixed cost of trading marketable securities of HK$1,000. The interest rate is 0.05% per day, and the daily volatility (standard deviation) net cash flows is estimated at around HK$50,000. The Chief Executive Officer ( CEO ) has set a lower limit of HK$2 million on cash holdings. Required: (a) Based on the information given and using the Miller-Orr model, (i) (ii) calculate the return point (target cash balance) and the upper limit; and describe how the Miller-Orr model could be applied to the daily cash balances. (8 marks) (b) What are the main reasons for an entity to hold cash and what is the major cost of holding cash to the entity? (4 marks) (c) Entity D is considering to invest in a new machine. The new machine will bring additional cash inflow of HK$2 million per year. The Chief Financial Officer ( CFO ) estimated that the machine has a 6-year economic life no matter when Entity D buys the machine. It also will become obsolete 6 years from today. The current price of the machine is HK$6 million. Its price will decrease by HK$1 million per year until it reaches HK$2 million where it will remain. Required: If Entity D's required rate of return is 10%, should Entity D buy the machine? At what point in time should Entity D buy the machine in order to attain the highest net present value ( NPV ) of the project? Show the calculation leading to your choice. (7 marks) (d) (e) It is commonly believed that diversification is not a good reason for a merger. Why is diversification not a good reason for a merger? (4 marks) What is wrong with the following statement? "In an efficient market, takeovers will not happen because market prices reflect the true value of corporations, so bidding firms could not justify paying premiums above market prices for target firms." (2 marks) * * * * * * * * Final Examination (December 2015 Session) Paper II 10 of 13

11 End of Section A

12 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. You are the tax advisor to Holdco. Question 6 (7 marks approximately 13 minutes) Advise Holdco s CEO regarding the potential Hong Kong profits tax exposure on the gain upon the disposal of the 75% equity interest in Entity D. (7 marks) Question 7 (3 marks approximately 5 minutes) If Holdco had borrowed to finance the acquisition of the 75% equity interest in Entity D, explain whether the interest expense incurred by Holdco during the period of ownership would be deductible from a Hong Kong profits tax perspective. (3 marks) Question 8 (4 marks approximately 7 minutes) What is Holdco s Enterprise Income Tax ( EIT ) exposure in China upon disposal of the 75% equity interest in Entity D under the EIT Law? Note: Assume Holdco does not have any establishment in China. Also, ignore the impact of the Double Taxation Arrangement between mainland China and Hong Kong. (4 marks) Question 9 (4 marks approximately 7 minutes) Would Holdco be entitled to any tax benefits under Article 13 (Capital Gains) and Article 21 (Methods for Elimination of Double Taxation) of the Double Taxation Arrangement between mainland China and Hong Kong with respect to the gain under Question 8? Note: Refer to the extract from double taxation arrangement ( DTA ) included in the Appendix to the Case for your answers to this question. (4 marks) Final Examination (December 2015 Session) Paper II 12 of 13

13 Question 10 (7 marks approximately 13 minutes) Holdco owes a third party, Entity E, a sum of HK$100 million and Holdco intends to settle the sum by issuing its new shares to Entity E. Required: Comment as to whether the shares of Holdco is Hong Kong stock under the Stamp Duty Ordinance and advise if any stamp duty will be payable in Hong Kong upon the issuance of the shares? Explain the reasoning behind your answer. Will the answer be different if instead of issuing new shares to Entity E, Holdco transfers the shares in another Hong Kong incorporated company (owned by Holdco) to Entity E to satisfy the debt? (7 marks) * * * END OF EXAMINATION PAPER * * * Final Examination (December 2015 Session) Paper II 13 of 13