THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND ADMINISTRATORS

Transcription

1 THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND ADMINISTRATORS International Qualifying Scheme Examination HONG KONG TAXATION DECEMBER 2015 Suggested Answer The suggested answers are published for the purpose of assisting students in their understanding of the possible principles, analysis or arguments that may be identified in each question 1

2 SECTION A Ruby Limited (RL) carries on a business of trading in household appliances in Hong Kong. Its profits are returned as assessable in Hong Kong. Its accounting profit after tax for the year ended 31 March 2015 is $3,100,000, which is arrived at after taking the following items into account: Note $ Income: Commission 1 25,000 Dividends 24,600 Interest income 2 85,800 Unrealised gain on securities 3 56,000 Expenses: Amortisation of trademark 4 140,000 Bad debts 5 112,570 Contributions to MPF scheme 6 695,000 Depreciation 274,000 Exchange differences 7 17,000 Interest expenses 8 322,000 Profits tax 317,000 Repairs and maintenance 9 103,650 Notes to the accounts: During the year, RL was appointed by Creative Limited (CL), a company carrying on business in Taiwan, to be its sole agent selling a new vacuum cleaner in Hong Kong on consignment basis. The sales were not promising and RL terminated the agency agreement on 31 March The total sales made on behalf of CL during the period were $200,000. RL has remitted the net sales (after deducting commission income of $25,000) to CL. $ 2. Interest income: Interest on deposits placed with DBS Bank in Singapore (Principal of $4,000,000) 53,500 Interest on i-bonds issued by the Hong Kong Government (Principal of $4,000,000) 25,000 Interest on short-term qualifying debt instruments (issued in 2013) 7,300 85, RL invested part of its surplus fund in securities which are listed on the Stock Exchange of Hong Kong. It was agreed that profits from the trading in these 2

3 securities are chargeable to profits tax. In the preparation of the financial statements, the securities held by the company were measured at fair value at the accounting date and the unrealised gain was recognised in the income statement. 4. During the year, RL acquired a trademark which was registered both in Hong Kong and the Mainland at a total cost of $2,000,000. Legal expenses of $100,000 were incurred. The values of the trademark registered in Hong Kong and in the Mainland were $1,000,000 each. RL entered into a contract with an independent manufacturer in the Mainland to produce a specific product bearing that trademark. The products were sold in the Hong Kong market. The total acquisition costs of the trademark were amortised over 15 years for accounting purposes. 5. Bad debts: Increase in allowance for doubtful accounts computed at specified percentages of trade debts according to their age 33,000 Write-off of trade debt due from a customer in liquidation 79, , Contributions to Mandatory Provident Fund (MPF) scheme: Ordinary contribution at 10% of employees remuneration 595,000 One-off contribution to mark the company s 20 th anniversary 100, , Exchange differences: Unrealised loss on revaluation of time deposits 48,500 Gains on settlement of trade debts (31,500) 17, Interest expenses: Bank interest paid on a loan of $8,000,000 from DBS Bank in Hong Kong 217,000 Interest paid on a shareholder s loan 105, ,000 3

4 The general banking facilities with DBS Bank were secured by the deposits placed with the bank in Singapore and the i-bonds (see note 2 above). Interest on the shareholder s loan was charged at 3% on the amount due to Keith Chan when the company acquired a factory unit from him in 2013 and used it as a warehouse. 9. Repairs and maintenance: $ Replacement of carpet 37,000 Renovation to convert a meeting room into a showroom 50,000 General repairs and maintenance for office equipment 16, ,650 Additional information: The depreciation allowance (other than that arising from the information given in the notes above) agreed with the assessor for the year of assessment 2014/15 is $746,000. On 20 November 2015, RL received a notice dated 18 November 2015 issued by the Commissioner alleging that he proposed to issue additional tax under section 82A of the Inland Revenue Ordinance because the company had failed to submit the profits tax return for the year of assessment 2013/14 by the specified date. RL submitted the profits tax return two months after the deadline due to the pregnancy of the accounting manager. RL has not objected to the assessment and the profits tax was duly paid. REQUIRED: 1. (a) Calculate the Hong Kong profits tax liability of Ruby Limited for the year of assessment 2014/15. Ignore provisional tax. (14 marks) Ans (a) Ruby Limited Profits tax computation 4

5 Year of assessment 2014/15 Basis period: Year ended 31 March 2015 (section 18B(1)) $ $ Profit per accounts 3,100,000 Add: Amortisation of trademark 140,000 Depreciation 274,000 Profits tax 317,000 Increase in allowance for doubtful trade debts 33,000 Special contribution to MPF scheme ($100,000 x 4/5) 80,000 Unrealised loss on time deposits 48,500 Interest paid to DBS Bank 53,500 Interest paid on a shareholder's loan 105,000 Renovation expense 50,000 1,101,000 4,201,000 Less: Dividends (24,600) Interest on deposits with DBS Bank (53,500) Interest on i-bonds (25,000) Unrealised gain on securities* (56,000) Trademark [($1,000,000 + $50,000) / 5] (210,000) (369,100) 3,831,900 Less: Depreciation allowance (746,000) Commercial building allowance ($50,000 x 4%) (2,000) (748,000) Assessable profits 3,083,900 Profits tax at 16.5% on ordinary receipts (3,076,600 = 3,083,900 7,300) 507,639 Concessionary rate on QDI receipts ($7,300 x 8.25%) ,241 Less: One-off tax reduction (20,000) Profits tax payable 488,241 * Alternate treatment of offering the gain as assessable in accordance with IRD s interim administrative measure is acceptable if this treatment is properly justified in part (b) of the answer. 5

6 1. (b) Advise the profits tax implications arising from the information given in note 1, including any obligations of Ruby Limited under the Inland Revenue Ordinance and the consequence of it failing to meet these obligations. (5 marks) Ans (b) For RL, commission income was earned for the agency services it has provided in Hong Kong and is taxable CL will be considered to be carrying on a business in Hong Kong through the agent it has appointed in Hong Kong, RL, which has a stock of merchandise in Hong Kong from which RL regularly fills orders on CL s behalf Section 20A(3) requires an agent who makes consignment sales to submit a quarterly return to the Commissioner showing gross proceeds of such sales and at the same time to remit a sum equal to 1% of the gross proceeds or such lesser sum as the Commissioner may agree In practice, only 0.5% of gross proceeds is demanded CL s profits tax liability in Hong Kong is $200,000 x 0.5% = $1,000 Alternatively, CL s tax liability may also be ascertained in accordance with Inland Revenue Rule 5 and it is open to CL to produce accounts to show that its liability is in fact less than 0.5% of the gross sales proceeds RL shall retain out of any assets in its possession or control a sufficient amount to meet the tax liability under section 20A(2) The tax chargeable is recoverable by all means out of the assets of the non-resident or from the agents (section 20A(1)); hence RL may be liable to settle the consignment tax as it has failed to withhold and pay the tax before remitting the proceeds to CL 1. (c) Analyse the proper tax treatments for the items given in note 2 to 9 above. Ans (c) Interest income (note 2) (16 marks) Interest income received by or accrued to a corporation is taxable under section 15(1)(f) if the person carries on a business in Hong Kong and the interest income arises from Hong Kong While RL carries on a business in Hong Kong, interest on deposits placed with DBS Bank in Singapore is sourced outside Hong Kong as the provision of credit is outside Hong Kong; such interest is not chargeable to profits tax 6

7 Interest income from i-bonds issued by the Government under the Loans Ordinance is exempt from profits tax under section 26A(1)(b) Interest income on short-term qualifying debt instruments issued on or after 25 March 2011 is subject to a reduction of tax rate by 50% under section 14A Unrealised gain on securities (note 3) RL held the securities for trading purposes and the unrealised gain is of revenue nature Per DIPN No. 42, the IRD took the view that in determining the assessable profits, it would follow the accounting treatment stipulated in HKAS 39 and any unrealised gain recognised in the income statement is taxable The Court of Final Appeal in CIR v Nice Cheer Investment Ltd (2013) ruled that the word profits connotes actual or realised and not potential or anticipated profits; furthermore, neither profits nor losses may be anticipated; hence, unrealised gains were held as not taxable The IRD announced that, as an interim measure, it would accept the tax return for the years of assessment 2013/14 and 2014/15 filed on the fair value basis, but these could be re-computed if the taxpayer subsequently adopts the realisation basis It would be beneficial for RL to exclude the unrealised gain from profits tax on the basis of the court decision Trademark (note 4) The cost of acquisition of the registered trademark for use in the production of chargeable profits is deductible under section 16EA(2) effective from the year of assessment 2011/12; this cost includes the legal expenses incurred on the acquisition The deduction is allowed by five equal instalments Section 16EC(4)(b) stipulates that that no deduction is allowable if, at any time when the trademark is owned by a taxpayer, another person holds rights as a licensee, and the trademark is used wholly or principally outside Hong Kong by a person other than the taxpayer 7

8 The Hong Kong registered trademark was used by RL itself for selling the finished goods to produce profits chargeable to tax in Hong Kong; section 16EC(4)(b) is therefore not applicable and RL can deduct one-fifth of the purchase costs in the year of assessment 2014/15 The Mainland registered trademark was used by the contractor for the production of goods in the Mainland; as such, section 16EC(4)(b) is applicable and the purchase price for the Mainland registered trademark is not deductible Bad debts (note 5) Bad debts incurred are deductible under section 16(1)(d) if the trade debts are proved to have become bad, or are estimated to the satisfaction of the assessor to have become bad during the basis period, and they have been included as taxable trading receipts Actual write-off of trade debts for a customer in liquidation is therefore deductible However, a general allowance for doubtful accounts which is roughly estimated (specified percentages of the amounts outstanding) is not regarded as incurred and cannot be deducted Contributions to MPF scheme (note 6) Any ordinary contribution to a recognised retirement scheme for employees is deductible up to an amount of 15% of the employee s remuneration under section 17(1)(h); the contribution of 10% is not excessive Payment of a special contribution can be deducted over five years of assessment under section 16A Exchange differences (note 7) An exchange gain arising from trade debts is revenue in nature and is taxable However, an exchange loss on revaluation of foreign currency time deposits is capital in nature and therefore not deductible under section 17(1)(c) Interest expenses (note 8) 8

9 To be deductible, under section 16(1)(a) interest expenses must be incurred in the production of chargeable profits Interest paid to DBS Bank is on money borrowed from a financial institution and satisfies the condition under section 16(2)(d) The borrowings were secured by the deposits placed with the bank in Singapore earning non-taxable interest income; hence, the deduction is to be restricted under section 16(2A) The amount of interest related to the loan secured by the deposit with DBS Bank in Singapore that is deductible is $217,000/2 - $53,500 = $55,500; the amount of interest related to the loan secured by the i-bond is fully deductible For the interest on the shareholder s loan, the condition under section 16(2)(c) is relevant because the lender is a person other than a financial institution Since interest received by the lender is not taxable under section 15(1)(g), assuming Keith does not carrying on business in Hong Kong himself, the condition under section 16(2)(c) cannot be fulfilled and the interest paid to him cannot be deducted Repairs and maintenance (note 9) Carpet falls under the category of implement, utensil and article ; expenditure incurred on its replacement can be deducted under section 16(1)(f) Capital expenditure on the refurbishment of non-domestic buildings can be deducted over five years under section 16F; however, this does not apply to expenditure incurred to enable the building to be used for a purpose different from that it was used for immediately before the expenditure was incurred Instead, a commercial building allowance at 4% of the expenditure can be claimed 1. (d) Advise Ruby Limited of the applicable penalties under the Inland Revenue Ordinance and the rights it has in respect of an assessment of additional tax under section 82A. (5 marks) (Total: 40 marks) Ans (d) Under section 51(1), an assessor may give notice to any person requiring him within a reasonable time stated in such notice to furnish a tax return 9

10 Failing to comply with section 51(1) without reasonable excuse is an offence under section 80(2) A taxpayer is liable on conviction to a fine at level 3 and a further fine of treble the amount of tax undercharged or would have been undercharged In D13/85, the Board of Review described the concept of reasonable excuse as what one would expect a reasonable person to do in all of the circumstances ; the lack of accounting staff or the fact that the staff are incompetent were not accepted as reasonable excuses (e.g. D26/99 and D26/89) In this case, the pregnancy of the accounting manager is not a reasonable excuse for non-compliance with section 51(1) Instead of instituting prosecution under section 80(2), the Commissioner may impose additional tax for an amount not exceeding treble the amount of tax which has been or would have been undercharged under section 82A Before making an assessment of additional tax, the Commissioner or a deputy commissioner shall give notice to the taxpayer informing him of the alleged failure, and the taxpayer has the right to submit written representations by a date not earlier than 21 days from the date of service of the notice The Commissioner or deputy commissioner shall consider and take into account the submitted representations before making the assessment A person who has been assessed to additional tax under section 82A(1) shall not be liable to be charged on the same facts with an offence under section 80(2) or 82(1) The taxpayer has the right to lodge an appeal to the Board of Review within one month after the notice of assessment is given to him on the following grounds: - he is not liable to additional tax, for example, he can prove that the return was submitted on time or there was a reasonable excuse for late submission; - the amount of additional tax assessed on him exceeds the amount for which he is liable; or - the amount of additional tax is excessive having regard to the circumstances 10

11 SECTION B 2. Phillip Wein is an Australian resident. He is employed by an Australian-based company, Brilliant Corporation (BC), as a regional manager. He is required to oversee the operations of various group companies in East Asia. The Inland Revenue Department has agreed that Phillip has a non-hong Kong sourced employment. Phillip s travel record during the year ended 31 March 2015 was as follows: Hong Kong Chinese mainland Japan Australia Other countries 123 days 95 days 30 days 92 days (including 30 days annual leave) 25 days Phillip has provided you with the following information for the year ended 31 March 2015: 1. He received an annual salary of $730, He also received a travel allowance of $50,000 which he used fully for air tickets for his home leave. 3. Phillip was provided with a hotel room during his stay in Hong Kong. Total hotel charges of $123,000 were paid by BC. It was agreed that 5% of the hotel charges would be deducted from his payroll. 4. Phillip joined a social club which he used to entertain clients while he was in Hong Kong. He paid an annual subscription fee of $7,000 and obtained a full refund for this from BC. 5. He was also provided with a corporate credit card on which he could charge all business entertainment expenses. During the year, a total amount of $156,000 was charged to the credit card, including $12,000 for a diamond ring which he bought for his wife as a souvenir. All the credit card bills were paid by BC. 11

12 6. He was enrolled in the company s medical insurance scheme. His medical bills for Chinese medicines of $5,000 were not accepted by the insurance company. After negotiation, he claimed a refund from BC. 7. During the year, BC paid the following tax bills on Phillip s behalf: Hong Kong salaries tax $31,000 Chinese income tax $43, On 1 July 2014, Phillip was unconditionally granted an option to acquire 100,000 shares in BC at $5 each. On 1 August 2014, he sold one-half of the option and received $250,000. On 2 March 2015, he exercised the option for the remaining shares and sold the shares two days afterwards. The market values per share were as follows: 1 July 2014 $8 1 August 2014 $11 2 March 2015 $9 4 March 2015 $10 9. Phillip is enrolled in BC s retirement scheme in Australia and has contributed $73,000 to the retirement scheme during the year. REQUIRED: 10. Phillip is married and his wife is a nurse working in Australia. They have a son, aged 17 during the year, who attends school in Australia. 2. (a) Based on the information provided, advise Phillip Wein of his Hong Kong salaries tax position, including the basis of assessment and how his assessable income is to be determined. (8 marks) Ans (a) The IRD has agreed that Phillip has a non-hong Kong sourced employment; his salary will be chargeable to Hong Kong salaries tax under section 8(1A)(a) in respect of income derived from his services rendered in Hong Kong Since he has spent more than 60 days in Hong Kong in the year of assessment, the exemption under section 8(1A)(b) and 8(1B) does not apply even though he may be regarded as a visitor for tax purposes 12

13 Phillip s assessable income will be computed on a time-apportionment basis; this applies to all income and benefits derived from his employment However, since Hong Kong only imposes salaries tax on Phillip s income derived from services rendered in Hong Kong, his Hong Kong salaries tax paid by the employer (a discharge of his personal liability) is fully taxable without apportionment On the other hand, it is likely that his Chinese income tax paid by the employer is for his services rendered outside Hong Kong and is wholly not taxable Under section 8(1A)(a), leave pay attributable to services rendered in Hong Kong is also taxable; although Phillip took his annual leave in Australia, the number of days of leave which is attributable to Hong Kong services will be taken into account in apportioning his assessable income Since Phillip was provided with a room in a hotel in Hong Kong, the rental value of 4% on his assessable income (after time -apportionment) will be taxable, but the rental value can be reduced by his contribution to his employer His travel allowance is used for his home leave (holiday journey) and is taxable Although Phillip entertained clients at the club, joining a social club is not essential to his performance of duties; the club subscription fee is not wholly, exclusively and necessarily incurred for the purpose of producing chargeable income and is not deductible under section 12(1)(a); the refund represents a cash allowance and is taxable The purchase of a diamond ring which Phillip has charged to the corporate credit card which was settled by the employer is taxable; in ordinary usage, the cardholder has a liability to pay for the goods received which have been effectively discharged by the employer The refund of the medical bills of $5,000 from the employer is also taxable because the sum is derived from his employment and for services rendered For the share options, any gain realised upon the exercise, assignment or release of the option will be subject to salaries tax under section 9(1)(d) 2. (b) Calculate Phillip s Hong Kong salaries tax liability for the year of assessment 2014/15. Ignore provisional tax. Round the number of days to 13

14 the nearest integer in your calculation. (12 marks) (Total: 20 marks) Ans (b) Phillip Wein Salaries tax computation Year of assessment 2014/15 $ $ Annual salary 730,000 Travel allowance 50,000 Refund of club subscription 7,000 Personal expense charged to credit card 2,000 Refund of medical bills 5, ,000 Assessable income under time-apportionment* ($804,000 x 134 / 365) 295,167 Hong Kong salaries tax paid by employer 31, ,167 Rental value ($326,167 x 4%) 13,047 Less: Rent suffered ($123,000 x 5%) (6,150) 6,897 Share option gain: - assignment 250,000 - exercise [50,000 x ($9 $5)] 200, ,000 Apportioned on the number of days ($450,000 x 134/365) 165,205 Total assessable income 498,269 Less: Concessionary deductions Contribution to retirement scheme - 498,269 Less: Personal allowances Married person's allowance (240,000) Child allowance (70,000) (310,000) Net chargeable income 188,269 Tax at progressive rates 20,005 Tax at standard rate (15%) 74,740 Salaries tax payable at progressive rate 20,005 14

15 Less: One-off tax reduction (75%) (15,004) 5,001 * No. of days chargeable to salaries tax No. of days in Hong Kong 123 Leave days attributed to Hong Kong services (30 days x 123 / 335)

16 3. As of 1 July 2015, Wonderful Limited wholly-owned Beautiful Limited and Peaceful Limited. Beautiful Limited in turn wholly owned Graceful Limited. All these companies are incorporated in Hong Kong. The group chart is shown below: Wonderful Limited (WL) 100% Beautiful Limited (BL) Peaceful Limited (PL) 100% Graceful Limited (GL) Due to business re-structuring, the following transactions have been carried out: REQUIRED: Analyse the Hong Kong stamp duty implications arising from the above transactions. In your analysis, you are required to: - discuss whether stamp duty is payable, - calculate any stamp duty payable, - indicate the time within which the stamp duty should be paid, and - address the consequence of failing to pay the duty within that time. (Total: 20 marks) 3. (a) On 2 July 2015, BL sold all its shareholding in GL to PL for a consideration of $20,000,000. Upon receiving the sale proceeds from PL on 16 July 2015, BL distributed $10,000,000 as dividends to WL. On 3 August 2015, WL sold 15% of its interest in PL to a third party, Jumbo Limited, for a cash consideration of $5,000,000. Jumbo Limited also took up a bank loan of $2,000,000 borrowed by PL and due to HSBC. (13 marks) 16

17 Ans (a) Disposal of shares in GL by BL to PL (2 July 2015) For the transfer of Hong Kong stock, stamp duty is payable at 0.1% on both the bought note and sold note under Head 2(1) However, an exemption can be sought under section 45 of the Stamp Duty Ordinance for the transfer between associated bodies corporate BL and PL were associated bodies corporate because a third body corporate, WL, was the beneficial owner of not less than 90% of the issued share capital of BL and PL Section 45(4)(a) provides that an exemption shall not apply if the instruments are executed in connection with an arrangement under which part of the consideration is provided or received, directly or indirectly, by a person other than an associated body corporate of the transferor or transferee Upon receiving the sale proceeds, BL distributed $10 million as dividend to its shareholder, WL; as WL wholly owns BL, this may not affect the exemption However, if WL in turn distributes the dividend to its shareholders as part of the arrangement, the section 45 exemption would be lost Disposal of 15% interest in PL by WL to Jumbo (3 August 2015) Implications of the transaction on 2 July 2015 Section 45(4)(c) further provides that no exemption is available if, as part of the arrangement, the transferor and transferee were to 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 body corporate WL has sold 15% of its interest in PL to Jumbo Limited, a third party; PL therefore ceased to be an associate after the share transfer and hence the exemption for the transfer of the shares on 2 July 2015 would be lost BL and PL must notify the Collector of Stamp Revenue that they have ceased to be associated within 30 days after the date of the cessation (section 45(5A)) if prior exemption has been sought On the assumption that the purchase consideration represents the fair 17

18 market value of the shares transferred, stamp duty payable is: $20,000,000 x 0.2% = $40,000 The instrument of transfer is stampable at $5 under Head 2(4) Disposal of 15% interest in PL by WL to Jumbo (3 August 2015) Stamp duty on the transaction Under section 24(3), where there is a transfer of shares in a body corporate and the transferee assumes a liability of that body corporate, the amount of liability so assumed is taken as part of the consideration chargeable with stamp duty Jumbo Limited took up the bank loan of $2 million due to HBSC; this should be included in the consideration chargeable with stamp duty Stamp duty payable is: $7,000,000 x 0.2% + $5 = $14,005 Consequence of late stamping For the transfer of Hong Kong stock, all bought and sold notes should be stamped within two days if the sale and purchase is effected in Hong Kong, while the instrument of transfer should be stamped before execution Since stamp duty has not been paid in respect of all the transactions, a penalty for late stamping will apply to the transfer of the shares between BL and PL, and that between WL and Jumbo Limited Since the delay is more than two months, under section 9 the penalty is 10 times the amount of stamp duty However, the Collector may partly or wholly remit the penalty payable depending on individual circumstances of each case In a voluntary disclosure case, if the delay was not deliberate, the following formula is adopted in calculating the reduced penalty, subject to a minimum sum of $500: 14% x stamp duty payable x (No. of days delayed / 365 days) 3. (b) On 16 November 2015, BL entered into an agreement to acquire a commercial unit in Wong Chuk Hang for $9,000,000 from a property developer. The 18

19 conveyance on sale was executed on 30 November On the same day, BL leased the unit to PL for a term of five years. The monthly rent is $50,000 with a rent-free period of two months. In addition, a lease premium and a refundable deposit of $120,000 and $100,000 respectively were paid upon the signing of the agreement. (7 marks) No stamp duty has yet been paid in respect of all these transactions. Today is 1 December Ans (b) Acquisition of Wong Chuk Hang Property by BL (16 November 2015) Effective from 23 February 2013, an agreement for sale of any non-residential property is also chargeable to stamp duty under Head 1(1A) Stamp duty on the agreement for sale is: $9,000,000 x 7.5% = $675,000 If the agreement for sale is duly stamped, the conveyance on sale is chargeable at $100 under Head 1(1) Buyer s stamp duty and special stamp duty do not apply in this case because the property involved is a non-residential property Stamp duty on the agreement for sale and conveyance on the sale of immovable property should be paid within 30 days after the execution of the instruments (i.e. not later than 16 December 2015 and 30 December 2015 respectively) Lease agreement between BL and PL on 30 November 2015 The lease of immovable property is subject to stamp duty under Head 1(2) The rate of stamp duty is 1% on the average yearly rent as the lease term exceeds three years Stamp duty payable is: Rent portion: ($50,000 x 58 / 60) x 12 x 1% = $5,800 Premium: $120,000 x 4.25% = $5,100 The duplicate copy is stampable at $5 under Head 4 The lease of immovable property must be stamped within 30 days (i.e. not later than 30 December 2015) 19

20 4. Brian Lee owns a residential property in Central which he inherited from his father a few years ago. The property was let to Tony Chan in January 2013 for two years at a monthly rent of $20,000. Tony moved out from the property in June 2014 leaving a note to Brian indicating that he decided to terminate the lease on 31 May 2014 and he was sorry that he had not paid the rent for the period from 1 February 2014 to 31 May He also failed to pay the building management fee of $5,000 which was then settled by Brian. The Inland Revenue Department has agreed that the unpaid rent debt had become bad in June Brian held two months rental deposit from Tony. Brian engaged an agent to secure a new tenant on the following terms: Duration of lease: Two years from 1 August 2014 Monthly rent: $24,000 (inclusive of rates and management fee) Rental deposit: $48,000 Lease premium: $60,000 During the year ended 31 March 2015, Brian paid the following expenses in relation to this property: Agency fees: $20,000 Building management fees: $15,000 Rates and Government rent: $11,400 and $8,640 respectively Brian owns another property, in Wanchai, which was purchased in 2013 and which he has occupied as his place of residence since then. He financed the purchase with a loan from Bank of East Asia which was secured by a charge over his property in Central. During the year ended 31 March 2015, he paid interest of $132,500 on this loan. Brian carries on a partnership business with Victor Fung in Hong Kong. For the year of assessment 2014/15, the partnership loss as agreed with the IRD was $150,000. Brian and Victor shared profits and losses in the business equally. Each of them drew an annual salary of $100,000 from the partnership. Brian also provides consultancy services as a self-employed person. The 20

21 assessable profits from this consultancy business were $260,000 for the year of assessment 2014/15. He has donated $150,000 to a university, an approved charitable institution, to set up a scholarship and has deducted the maximum amount of donation in computing the assessable profits. REQUIRED: Brian is single and he has no dependants. 4. (a) Calculate the Hong Kong property tax payable in respect of the Central property for the year of assessment 2014/15. Ignore provisional tax. (6 marks) Ans (a) Property tax computation Year of assessment 2014/15 $ Rent ($20,000 x 2) + ($24,000 x 8) 232,000 Lease premium ($60,000 x 8/24) 20, ,000 Less: Irrecoverable rent ($80,000 - $40,000) (40,000) Assessable value 212,000 Less: Rates paid by owner (11,400) 200,600 Less: 20% statutory deduction (40,120) Net assessable value 160,480 Tax payable at 15% 24, (b) Determine Brian s tax liability under personal assessment for the year of assessment 2014/15 and advise if it is advantageous for him to do the election. Show all your workings. (8 marks) Ans (b) Brian Lee Personal assessment Year of assessment 2014/15 $ Net assessable value 160,480 Net assessable income - Assessable profits 260,000 Total income 420,480 21

22 Less: Concessionary deductions Approved charitable donation ($150,000 - $140,000) (10,000) Home loan interest (100,000) 310,480 Less: Share of partnership loss ($150,000 x ½) (75,000) 235,480 Less: Personal allowance Basic allowance (120,000) Net chargeable income 115,480 Tax at progressive rates 7,857 Less: Tax reduction (75%, maximum $20,000) (5,893) Tax payable under personal assessment 1,964 Tax payable without personal assessment: $ Property tax [see part (a)] 24,072 Profits tax of sole-proprietorship business: ($260,000 x 15% - $20,000) 19,000 43,072 Tax saving with personal assessment: ($43,072 - $1,964) 41,108 The tax saving is due to the deduction of more approved donations under personal assessment, the utilisation of the share of partnership loss, and the deduction of home loan interest and personal allowance, which are available under personal assessment. 4. (c) Advise Brian on the following: (i) the requirements for the election of personal assessment; and (ii) the conditions for the deductibility of the interest paid to Bank of East Asia. (6 marks) (Total: 20 marks) Ans (c) To be eligible for personal assessment, an individual must be of or above the 22

23 age of 18, or under the age of 18 with both parents dead; and who, or whose spouse, is either a permanent resident or a temporary resident Permanent resident means an individual who ordinarily resides in Hong Kong It appears that Brian is ordinarily resident in Hong Kong (he has maintained a place of abode and with businesses carrying on in Hong Kong) and he will be eligible to be assessed under personal assessment The election must be made in writing and lodged with the Commissioner of Inland Revenue not later than two years after the end of the year of assessment concerned or one month after an assessment forming part of the total income for the year of assessment is final and conclusive; or further period as the Commissioner may allow; whichever is the later Under section 26E, home loan interest paid can be deducted from a person s income up to a maximum of $100,000 under personal assessment Brian is the owner of the property in Wanchai, which is situated in Hong Kong and which is for residential use It was used by Brian as his place of residence The lender is a financial institution The loan is secured by a charge over another property which is situated in Hong Kong 23

24 5. Bravery Limited carries on a food processing business in Hong Kong. In August 2014, it acquired a new three-storey building in Kowloon Bay and put it into the following use: Ground floor First floor Second floor Leased to a motor car company, one half of the floor was used as a showroom and the rest was used as a workshop where the cars were tuned and repaired if necessary before they were placed in the showroom. Leased to a computer distributor for storing goods. Used by Bravery Limited for food production, except for 15% of the area which was used for a small office. Bravery Limited entered into the following transactions during the year ended 31 March 2015: 1. $200,000 was incurred on leasehold improvements to the second floor of the new building. Another $50,000 was spent on installing environmentally-friendly lighting. 2. Machines used in the production processes were acquired for $167, A hybrid electric car (powered by fuel and battery) was acquired for $330,000. An old diesel motor car was sold for $67, A food processing machine (depreciation rate: 20%) was acquired under hire-purchase on the following terms: Cash price: $145,000 Down payment: $45,000 (paid on 1 September 2014) Monthly installment: $10,000 for 12 months (starting from 1 October 2014) 5. Office equipment was transferred from the Macau branch office. It had been initially acquired for $40,000 and used by the Macau office for two years before being transferred and used in the Hong Kong business. Its market value on the date of transfer was $9, New furniture and office equipment were acquired for $80,000. The tax written down values of the pooling system as of 31 March 2014 are: 20% (comprising furniture and equipment) $323,000 30% (comprising motor vehicles) $117,000 24

25 REQUIRED: 5. (a) Analyse the type of allowances available to Bravery Limited under profits tax in respect of the Kowloon Bay property. No calculation is required in this part. (8 marks) Ans (a) An industrial building is defined in section 40(1) as building or structure used for a qualifying trade, which includes, inter alia, the following: - a trade consisting of the subjection of goods or materials to any process; - a trade consisting of the storage of goods or materials which are to be used in the manufacturing of other goods or materials, or on their arrival into Hong Kong An industrial building excludes an office and showroom If the non-qualifying use amounts to not more than 10% of the total capital expenditure, such non-qualifying use can be ignored It is not necessary for the building to be used by the owner; he could claim the relevant allowance if the building is put into qualifying use by the tenant The ground floor was used by the tenant selling motor cars; the portion used as a showroom does not qualify as an industrial building; the part used as a workshop also does not qualify because the repairing activities are only incidental to the car selling business A commercial building is a building other than an industrial building Hence, Bravery Limited should be able to claim commercial buildings allowance in respect of the ground floor The tenant on the first floor carries on a computer distribution business; the trade is not one of storage; the storage of goods is only incidental to its distribution business Hence, Bravery Limited should be able to claim commercial buildings allowance in respect of the first floor Bravery Limited used 85% of the second floor for food production, which is one of the qualifying uses; the portion used as office is more than 10% and hence cannot be ignored for the purpose of calculating the industrial buildings allowance 25

26 It should be able to claim industrial buildings allowance on 85% of the expenditure in respect of the second floor, and commercial buildings allowance on the remaining 15% of the expenditure 5. (b) Discuss and compute the depreciation allowances under profits tax based on the information given for transactions 1 to 6 above. Show your workings. (12 marks) (Total: 20 marks) Ans (b) Bravery Limited may claim industrial buildings allowance for the leasehold improvement carried out in the second floor, but only up to 85% of the cost: Initial allowance: $200,000 x 85% x 20% = $34,000 Annual allowance: $200,000 x 85% x 4% = $6,800 For the portion used as office, commercial buildings allowance is available: Annual allowance: $200,000 x 15% x 4% = $1,200 Environmentally-friendly lighting qualifies for a deduction over five years under section 16I(3), i.e. the deduction is $10,000 for the year of assessment 2014/15 Machines used directly and specifically in the production processes qualify for a deduction as prescribed fixed assets under section 16G(1); the full cost of $167,000 is deductible in the year A hybrid electric car is an environmentally-friendly vehicle and the purchase cost can fully be deducted under section 16I(2) Although the food processing machine may be used directly or specifically in food processing, it was acquired under hire-purchase and therefore does not qualify for a deduction under section 16G; instead depreciation allowances can be claimed under the non-pooling system For office equipment which was not previously used for producing chargeable profits now brought into the business, the capital expenditure incurred shall be computed by deducting notional annual allowances from the original cost (section 39B(6)); its market value is irrelevant Depreciation allowances on plant and machinery 20% Pool 30% Pool $ $ 26

27 W.D.V. b/f 323, ,000 Equipment bought into use ($40,000 x 0.8 x 0.8) 25,600 Additions 80,000 Less: Initial allowance (60%) (48,000) - 380, ,000 Less: Disposal - (67,000) 380,600 50,000 Less: Annual allowance (76,120) (15,000) W.D.V. c/f 304,480 35,000 Food processing machine under hire-purchase Cost 145,000 Less: Initial allowance ($45,000 + $100,000 x 6/12) x 60% (57,000) 88,000 Less: Annual allowance (20%) (17,600) W.D.V. c/f 70,400 27

28 6. (a) Dr Wilfred Wong is an ear, nose and throat specialist. He is going to start his own private practice in form of a sole-proprietorship business. He has heard from his friend that using a service company may help him reduce his profits tax liability. Specifically, he has been told that he should set up a limited company which would provide services to his clinic in return for a management fee. He wonders if this is feasible and has approached you, as a tax consultant, for advice. REQUIRED: Advise Wilfred on the following: (i) How the service company arrangement could help reduce his profits tax payable. (6 marks) (ii) The minimum requirements that must be satisfied for the arrangement to be acceptable to the Inland Revenue Department. (6 marks) Ans (a) (i) The profits earned by the clinic will be subject to profits tax at 15%; any deduction is limited to those expenses which are incurred in the production of chargeable profits; Wilfred s personal expenses cannot be deducted With a service company, it is possible for that company to enter into an agreement with the firm (the clinic) under which the service company may provide premises, staff, plant and equipment, miscellaneous supplies (e.g. medical, stationery, etc.) or other services to the clinic in return for a management fee If the management fee paid is allowed as a deduction and exceeds the cost that would have otherwise been incurred by the firm, the assessable profits of the firm will be reduced The service company will in turn seek to minimise its exposure to tax on the excess payment by claiming deductions for tax efficient remuneration provided to the proprietor of the firm as employee or director of the service company, such as housing accommodation and other fringe benefits 28

29 which are not convertible into cash and hence not assessable under salaries tax (e.g. the use of a motor car and running costs charged to the company s account) By deducting certain private expenses of the proprietor which otherwise are not deductible by the firm, a tax saving is achieved through the service company despite the fact that any of its residual profits will be subject to a higher profits tax rate of 16.5% plus other necessary costs, such as auditing, for having a service company (ii) DIPN No. 24 sets out the minimum requirements which must be satisfied to support a claim for the deduction of a management fee The service company has to function as a separate business operating on an arm s length basis in its dealing with the firm The respective rights and obligations and dealings with each other should be properly documented The service agreement should specify the relevant services and the basis on which fees are to be paid Other documents to be kept include minutes of meetings approving the terms of the agreement, invoices and receipts, working papers in respect of the calculation of the fees charged, bank records and employment contracts The firm may only deduct the management fee for qualifying services, which encompasses non-professional services which are required to provide the infrastructure in which the firm operates and to cater for its day-to-day operations; it does not extend to the provision of any services to a firm by its proprietor as employee of the service company For the management fee to be charged at an arm s length basis, the amount involved should reflect the costs of the service company which are directly attributable to the relevant services (e.g. salary paid to a typist) plus an appropriate mark-up to provide for the operating expenses (e.g. rent of premises occupied by the service company itself) and reasonable profit margin for the company A profit margin of not more than 12.5% of the cost element is generally accepted as being commercially realistic The firm and the service company should prepare their accounts to the same date 29

30 6. (b) Canyon Limited commenced business in Hong Kong in 1970 and currently prepares its accounts to 31 December annually. The company has been profitable. Recently it diversified its business and as a result, its peak season now falls in the period from November to January when the company needs to stock up substantial inventories. The management wants to change the accounting year-end date from 31 December to 31 March. Specifically, the company s next set of financial statements will cover the 15 months to 31 March The last set of accounts was prepared for the year ended 31 December REQUIRED: Advise the management of the profits tax implications arising from the change in the accounting date and how the profits in the years of assessment 2014/15 and 2015/16 will be assessed. State the relevant basis periods clearly in your answers. (8 marks) (Total: 20 marks) Ans (b) There will be a change in the accounting date in the year of assessment 2015/16 because the accounts will not be prepared to the corresponding day in the year, i.e. 31 December 2015 The Commissioner is empowered to compute the assessable profits for the year of change (year of assessment 2015/16), and to re-compute the assessable profits for the preceding year (year of assessment 2014/15) on such basis as he thinks fit (section 18E(1)) The practice of the IRD is to assess the year of change by adhering to the new accounting date as soon as possible Normally the basis period should be 12 months to the accounting date (section 18B(2)). Section 18E(2) only allows the Commissioner to use more than 12 months in case of business which commenced on or after 1 April Hence for an old business, like Canyon Limited, it is possible that there will be a drop-out period of three months. Because of the power under section 18E, the Commissioner can choose as the basis period either the 12 months ending 31 March 2016 or the 12 months ending 31 December 2015 In practice, the IRD usually allows a drop-out period of three months on the 30

31 basis that the period left out of assessment is not a high profits period In Yick Fung Estates Limited v CIR, it was held that the Commissioner was not entitled under section 18E to assess an old business for a basis period exceeding 12 months; however, if the change in accounting date was made for the sole and dominant purpose of obtaining a tax benefit, then section 61A could be invoked to counteract the tax benefit On the facts given, one can argue that the change of accounting date was triggered by the change in the company s peak season; this appears to be a possible genuine business reason and may be acceptable by the Commissioner Canyon Limited may seek advance ruling for the sake of certainty If the Commissioner accepts that the change in accounting date is not primarily for tax-avoidance purposes, the assessment will be made as follows: Year of assessment Basis period 2015/16 1 April March /15 1 January December 2014 (as originally assessed); or 1 April March 2015 (may be revised); depending on which basis gives a higher profits Otherwise, the basis period for the year of assessment 2015/16 would cover 15 months from 1 January 2015 to 31 March 2016 END 31