THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND ADMINISTRATORS International Qualifying Scheme Examination HONG KONG TAXATION DECEMBER 2011 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
SECTION A 1. Mr. A, a Hong Kong resident, has approached you, a tax consultant, for your advice in respect of the Hong Kong tax affairs of his wholly owned company, B Ltd, that was incorporated in Hong Kong. In a meeting with Mr. A, you obtained the following information from him: 1. Mr. A had a friend, Mr. C, who was the owner of a company in PRC, D Ltd. D Ltd operated a factory in Mainland China. Mr. C was a scientist. He saw a good business opportunity of importing a metal (X) from the US, processing it, and selling the processed metal (Y) to customers in Mainland China. 2. Because Mr. C did not have enough capital, he approached Mr. A for financial support. Instead of providing monetary support, Mr. A agreed to set up a wholly owned company, B Ltd, in Hong Kong to work with Mr C and D Ltd. Mr. A was the sole director and shareholder of B Ltd. B Ltd did not have an office outside Hong Kong. 3. B Ltd appointed Mr. C as agent for the operation of its business outside Hong Kong. Mr. C was given absolute authority to perform duties (including negotiating, concluding and executing contracts on behalf of B Ltd) outside Hong Kong. The agency agreement explicitly stated that Mr. C was not required to perform any services in Hong Kong. Mr. C was remunerated on a commission basis. 4. Mr. C negotiated and concluded contracts with buyers of metal Y in Mainland China on behalf of B Ltd. When a sales contract was signed by Mr. C on behalf of B Ltd, Mr. C would advise Mr. A to acquire the raw materials (metal X) by issuing a purchase order on B Ltd s letterhead from Hong Kong. Mr. A would sign the purchase order and fax it to the supplier in the US. Mr. A would also instruct his bank in Hong Kong to open the necessary letters of credit so that payments could be made to the supplier. The bank required Mr. A to provide security in order to open the letters of credit. 5. Negotiations on the price and the terms of the purchase with the supplier had been carried out in advance by Mr. C in the US. 6. After the supplier received B Ltd s purchase order, the supplier shipped metal X to D Ltd s factory in the Mainland China directly without passing through Hong Kong for processing. B Ltd paid a processing fee to D Ltd by transferring money from B Ltd s bank account in Hong Kong into D Ltd s bank account in Mainland China. 7. D Ltd sent the processed metal Y to the customers in Mainland China directly. Customers paid for the goods by transferring money into B Ltd s bank account in Hong Kong directly. 1
REQUIRED: 8. Mr. A considered that, apart from opening letters of credit, the role of B Ltd and himself was very passive since they did not have any knowledge or experience in the metals business. They had to rely on Mr. C to negotiate and conclude the contracts with suppliers and buyers. 9. Recently, Mr. A received a profits tax return in respect of B Ltd from the Inland Revenue Department (IRD). B Ltd s IRD file number is ABC-12345678. Ignore any implications under the Double Taxation Arrangement Between Mainland China and Hong Kong SAR. 1. (a) Discuss whether B Ltd s trading profits are subject to Hong Kong profits tax under section 14 of the Inland Revenue Ordinance. In your discussion, you should: - identify the conditions that must be satisfied before profits tax is charged under section 14; - set out the relevant principles (drawn from case law and the IRD s practice) that are necessary to address those conditions; and - apply the principles to the facts in the case to arrive at a reasonably drawn conclusion. Ans (a) Profits tax is charged on every person: carrying on a trade, profession or business in Hong Kong (first condition); and in respect of his assessable profits arising in or derived from Hong Kong from such trade, profession or business (second condition). First condition A company carries on business in the place where the central management and control of the company (i.e. the powers of the board of directors) is exercised (De Beers Consolidated Mines Ltd v Howe). The place of incorporation is irrelevant. Since B Ltd is a one-man company wholly owned and directed by Mr. A, who resides in Hong Kong, it would be difficult to argue that Mr. A exercised his powers as a director outside Hong Kong. Thus, the first condition is likely to have been satisfied. Second condition Principles: It has been recognised that ascertainment of the actual source of income is a practical hard matter of fact. No simple, single legal test is determinative. 2
The broad guiding principle is one looks to see what activity the taxpayer has done to earn the profits and where the activity is done. The activity could be carried out by the taxpayer or a third party under the instruction of the taxpayer. The IRD considers that, in general, the determining factor for the source of trading profits is the place where the contracts of purchase and sale are effected. Where both the contracts of purchase and sale are effected outside Hong Kong, no part of the profits are taxable. The IRD considers that effected cannot merely mean legally executed. It means actual steps leading to the existence of the contracts including the negotiation and, in substance, conclusion of the contracts. But there are other factors that the IRD could consider, because all relevant operations that produce the trading profits must be looked at to determine the locality of profits. For example: How were the goods procured and stored? How were the sales solicited? How were the orders processed? How were the goods shipped? How was the financing arranged? How was payment effected? Application: Candidates should analyse the transaction using the contract effected test by referring to the following matters: (i) sales and purchases were negotiated outside Hong Kong; (ii) all sales contracts were executed outside Hong Kong; and (iii) purchase orders were sent from Hong Kong. Candidates should also discuss the following matters: (i) the raw materials were delivered from the US to Mainland China without touching Hong Kong; (ii) the finished goods were delivered within Mainland China without touching Hong Kong; and (iii) letters of credit and payments were effected in Hong Kong. Based on their analysis, candidates should draw a conclusion as the source of the trading profits. 1. (b) Explain to Mr. A his obligations (if any) in respect of B Ltd s profits tax return, and the consequences and penalties for not fulfilling those obligations. Ans (b) The director of a corporation is liable for doing all such acts, matters and things as are required under the IRO by such corporation (section 57(1)). Accordingly, Mr. A has the obligation to complete B Ltd s profits tax return within the time limit specified by the Assessor, usually within 1 month. The return must be completed in full, and include a profits and loss account and a balance sheet (section 51(3) and BIR51). As B Ltd is 3
a corporation, an auditor s report is also required. The return must be signed on behalf of B Ltd. If the profits tax return has not been submitted, the Assessor may issue an estimated assessment on B Ltd (section 59(2)(b)). Mr. A and/or B Ltd may be prosecuted under section 80(2) for failing to submit returns within the time limit without reasonable excuse. A fine at level 3 ($10,000) plus treble the amount of tax undercharged may be imposed. As an alternative, the IRD may impose section 82A additional tax. The maximum amount of additional tax is treble the amount of tax undercharged. 1. (c) Mr. A promptly filed B Ltd s profits tax return, which includes a claim for profits tax exemption on the basis that the source of profits should be offshore. However, the Assessor did not agree and has issued a tax assessment in respect of B Ltd s profits. Mr. A has decided to engage you as B Ltd s tax representative and to object to the tax assessment. In addition, Mr. A does not wish to pay the tax demanded until the objection is settled. Prepare a short letter in a good format objecting to the tax assessment. You are NOT required to elaborate on the arguments that the profits should be offshore. Ans (c) The notice of objection must be addressed to the Commissioner of Inland Revenue (section 64(1)). The notice of objection must refer to the taxpayer s IRD file number for identification purposes. The notice of objection must state precisely the grounds of objection. The notice of objection should also include a statement asking the Commissioner to holdover the tax in dispute (Note: It is at the Commissioner s discretion whether to allow the holdover or not.) The notice of objection should be written in a good format. 4
SECTION B 2. (a) The following transactions took place during the year ended 31 March 2011: (i) On 1 April 2010, Mr. Au entered into a provisional sale and purchase agreement for the purchase of a residential property (Property A) for $6,500,000. On 14 April 2010, a formal agreement was executed in the solicitor s office. On 1 May 2010, Property A was conveyed in favour of Mr. Au s 100%-owned limited company. REQUIRED: (ii) On 1 June 2010, Mr. Au entered into a provisional lease agreement to rent Property B for three years. On 14 June 2010, a formal lease agreement was executed in the solicitor s office. The formal agreement was signed in duplicate. The monthly rent was $10,000. In addition, Mr. Au had to pay a non-refundable deposit equivalent to two months rent. (iii) On 1 July 2010, Mr. Au transferred 10,000 shares in a Hong Kong listed company to his daughter for her marriage for $1 per share; the market price at this time was $50 per share. Mr. Au purchased the shares two years ago for $10 per share. Compute the total stamp duty payable on the above transactions. Ans (a) (i) No stamp duty is payable on the provisional agreement because it was superseded by the formal agreement within 14 days. Stamp duty on the formal agreement = $180,000 + ($6,500,000 - $6,000,000) x 10% = $230,000. Full ad valorem stamp duty (i.e. $230,000) is payable on conveyance because Mr. Au s 100%-owned limited company is not considered to be the same person. (ii) Stamp duty on the monthly rent = ($10,000 x 12) x 0.5% = $600. Stamp duty on the non-refundable deposit = $20,000 x 4.25% = $850. Stamp duty on the formal lease agreement = $3. Stamp duty on the duplicate lease agreement = $5. (iii) Stamp duty on inter vivos transfer = ($1 x 10,000 x 0.2%) + $5 = $25. 5
2. (b) Section 45 of the Stamp Duty Ordinance exempts from stamp duty certain transactions between associated corporations, provided they do not cease to be associated within a certain period of time (the time condition). REQUIRED: In relation to section 45 of the Stamp Duty Ordinance, explain the following: (i) what transactions are exempt; (ii) the meaning of associated corporations; (iii) the time condition; and (iv) the consequence of the time condition being breached. Ans (b) The following transactions between associated corporations are exempt: Conveyance of immovable property; Transfer of beneficial interest in Hong Kong stock; and Agreement for sale of residential immovable property. Associated corporations means two corporations of which: One is the beneficial owner of not less than 90% of the issued share capital of the other; or A third corporation is owner of not less than 90% of the issued share capital of each corporation. If the transferor and transferee cease to be associated (except due to the transferor leaving the group) within two years of the execution of the instrument or the date on which the contract note was required to have been executed under section 19 and section 45 relief has been claimed: The transferor and transferee are required to notify the Collector of Stamp Duty within 30 days after the cessation (a failure to do so results in a penalty at level 2 ($5,000)); The section 45 relief will be withdrawn. 6
3. Mr. Chan is the Vice President (Accounting and Corporate Administration) of a large Hong Kong company. During the year ended 31 March 2011, Mr. Chan had the following income and expenditure: Income (i) (ii) (iii) (iv) Mr. Chan received a monthly basic salary of $100,000 from his employer. During the year, Mr. Chan lived in a flat on Hong Kong side. The flat was rented by Mr. Chan for a monthly rent of $20,000. Mr. Chan s employer reimbursed 50% of the rent and 100% of the utilities. The employer directly paid $150,000 to a private secondary school in Canada, being the tuition fees for Mr. Chan s younger child. Mr. Chan owned a flat on Kowloon side. On 1 April 2010, Mr. Chan rented this flat to a tenant for $15,000 per month. In addition, Mr. Chan received non-refundable rent of $30,000 up front. The rental period is for four years. Expenditure (v) (vi) (vii) (viii) In respect of Mr. Chan s residence, he incurred utilities totalling $50,000. All utilities were registered in Mr. Chan s name. In respect of Mr. Chan s Kowloon property, he incurred the following expenses during the year: - Government rates: $3,000 per quarter - Government rent: $2,000 per quarter - Management fees: $1,000 per month - Mortgage interest: $10,000 per month - Repairs and maintenances: $20,000 in total During the year, Mr. Chan was enrolled in the Doctor of Business Administration programme at a local university and paid tuition fees of $100,000. These were fully reimbursed by Mr. Chan s employer on the basis that the programme is relevant to Mr. Chan s employment. During the year, Mr. Chan was a full member of both the Hong Kong Institute of Certified Public Accountants and the Hong Kong Institute of Chartered Secretaries and paid membership fees of $2,000 and $1,000 respectively. 7
Other information (ix) (x) (xi) Mr. Chan s wife, his two children, and his father and mother lived in Canada during the year of assessment. Mrs. Chan works full-time in a Chinese restaurant in Chinatown. During the year ended 31 March 2011, her income was equivalent to HK$150,000. Mr. Chan s two children were aged 17 and 24 respectively. The younger child attended secondary school and the elder child attended university during the year of assessment. REQUIRED: Prepare Mr. Chan s salaries tax computation, property tax computation, and personal assessment computation for the year of assessment 2010/11. Based on your computations, advise Mr. Chan whether he should elect for personal assessment for the year of assessment 2010/11. (Note: Ignore provisional tax and any rebate announced in the 2011/12 Budget in your answers.) Ans (a) Mr. Chan Salaries tax computation Year of assessment 2010/11 $ Salary ($100,000 x 12) 1,200,000 Child education 150,000 Utilities reimbursement 50,000 Reimbursement of tuition 100,000 1,500,000 Less: Professional subscription (2,000) 1,498,000 Add: Rental value ($1,498,000 x 10%) 149,800 Less: Rent suffered ($10,000 x 12) (120,000) 29,800 Assessable income 1,527,800 Less: Self-education expenses (60,000) Net assessable income 1,467,800 Less: Married person s allowance (216,000) Child allowance (100,000) Net chargeable income 1,151,800 Tax at standard rate @15% 220,170 Tax at progressive rates 183,806 Tax payable 183,806 8
(b) Mr. Chan Property tax computation Year of assessment 2010/11 Premium ($30,000 x 12/36) 10,000 Rent ($15,000 x 12) 180,000 Assessable value 190,000 Less: Rates ($3,000 x 4) (12,000) 178,000 Less: Statutory deduction (20%) (35,600) Net assessable value 142,400 Property tax (15%) 21,360 (c) Mr. Chan Personal assessment computation Year of assessment 2010/11 Net assessable income (before deduction of 1,467,800 concessionary deductions) Net assessable value (NAV) 142,400 Total income 1,610,200 Less: Interest on rental property (120,000) Total income after deduction of interest 1,490,200 Less: Married person s allowance (216,000) Less: Child allowance (100,000) Reduced total income after personal allowance 1,174,200 Tax at standard rate @15% 223,530 Tax at progressive rates 187,614 Tax payable 187,614 Comparing the tax payable under personal assessment ($187,614) with separate assessments for different incomes ($183,806 + $21,360 = $205,166), it is more beneficial for Mr. Chan to elect for personal assessment. 9
4. For the year ended 31 December 2010, the profit and loss account of Dollar Limited is as follows: Notes $ $ Income Turnover 2,500,000 Less: Cost of goods sold (1,120,000) Gross profit 1,380,000 Interest income (i) 20,000 Rental income (ii) 500,000 1,900,000 Expenses Administrative expenses 30,000 Depreciation charges 40,000 Donations (iii) 500,000 Employee expenses (iv) 1,000,000 Entertainment expenses (v) 100,000 Legal and professional fees (vi) 75,000 Taxation expenses (vii) 350,000 Other expenses 20,000 (2,115,000) Net loss for the year (215,000) Dollar Limited also provides you with the following additional information: (i) Interest income: $ Derived from deposits placed in financial institutions in 15,000 Hong Kong Derived from deposits placed in financial institutions overseas 5,000 20,000 (ii) Rental income: $ Derived from property located in Hong Kong 200,000 Derived from property located overseas 300,000 500,000 (iii) The donations represent cash donations to an approved charitable institution. 10
(iv) Employee expenses: $ Salary 1,000,000 Annual contributions to Mandatory Provident Fund Scheme 200,000 1,200,000 (v) The entertainment expenses were incurred in connection with contract negotiations with potential clients. (vi) Legal and professional fees: $ Audit fee 10,000 Tax return preparation 5,000 Solicitors costs in setting up new lease agreements for 25,000 rental property in Hong Kong Solicitors costs in renewing existing lease agreements for rental property overseas 35,000 75,000 (vii) Taxation expenses: $ 2009/10 final tax + 2010/11 provisional tax 150,000 Penalties for late submission of 2009/10 employer s 200,000 returns 350,000 Additional information: On 1 July 2010, the company purchased two new (unused) buildings from a non-developer at bargain prices: an industrial building for its factory for $1,000,000 (cost of construction was $1,200,000) and a commercial building for its office for $1,400,000 (cost of construction was $1,600,000). The company has agreed with the IRD that its depreciation allowances on plant and machinery for the year of assessment 2010/11 are $120,000. REQUIRED: 4 (a) Prepare Dollar Limited s profits tax computation for the year of assessment 2010/11. (Ignore provisional tax.) 11
Ans (a) Dollar Limited Profits tax computation Year of assessment 2010/11 $ $ Net loss per accounts (215,000) Add: Depreciation charges 40,000 Donations 500,000 Employee expenses 50,000 Legal and professional fees 60,000 Taxation expenses 350,000 1,000,000 785,000 Less: Interest income 20,000 Rental income 300,000 Depreciation allowances (Note 1: 120,000 + 240,000 + 64,000) 424,000 (744,000) 41,000 Less: Donations (Limited to 35% of 41,000) (14,350) Assessable profits 26,650 @ 16.5% Profits tax payable for 2010/11 4,397 Note 1: Depreciation allowances P&M = $120,000 IBA = $1,000,000 x 20% + $1,000,000 x 4% = $240,000 CBA = $1,600,000 x 4% = $64,000 4. (b) Explain the tax treatment that you have applied to items (i), (ii), (v), (vi) and (vii). (i) Interest derived from deposits placed in financial institutions in Hong Kong is exempt from profits tax by virtue of the Exemption from Profit Tax (Interest Income) Order 1998. Interest derived from deposits placed in financial institutions outside Hong Kong is not taxable because it has a non-hong Kong source by virtue of the provision of credit test. (ii) Rental income derived from property located overseas is not taxable because rental income from the letting of real properties is considered to arise at the place where the property is located. 12
(v) Entertainment expenses can be allowed if they are predominantly incurred in connection with business transactions and the persons entertained are existing or potential clients. (vi) Solicitors costs in setting up new lease agreements are not deductible because legal expenses incurred in the acquisition of new rights or assets are not allowable. Solicitors costs in renewing lease agreements for rental property overseas are not deductible because they were not incurred in the production of profits chargeable to profits tax. (vii) Section 17 disallows any tax paid under the IRO except salaries tax paid in respect of employees. A fine or penalty for breaking the law is not allowable because the fine or penalty derives from the law itself, not from trading. 13
5. A Ltd, Mr. B and Mr. C have been in partnership for many years. They share profits/losses equally. The profit and loss account of the partnership for the year ended 31 March 2011 showed the following net loss: $ $ Gross receipts 700,000 Less: Salaries to Mr. B 450,000 Salaries to Mr. C 50,000 Interest on capital paid to A Ltd 475,000 Interest on capital paid to Mr. B 100,000 Interest on capital paid to Mr. C 50,000 Other expenses 250,000 (1,375,000) Net loss (675,000) REQUIRED: 5. (a) Prepare an allocation of profits for the partners, and compute the profits tax payable by the partnership. Ans (a) ABC Partnership Profits tax computation Year of assessment 2010/11 $ $ Net loss per account (675,000) Add: Salaries 500,000 Interest 625,000 1,125,000 Assessable profits 450,000 ABC Partnership Allocation of profit Year of assessment 2010/11 Salary Interest Residue (1:1:1) Re-allocation Assessable profits A Ltd Mr. B Mr. C Total $ $ $ $ - 450,000 50,000 500,000 475,000 100,000 50,000 625,000 475,000 550,000 100,000 1,125,000 (225,000) (225,000) (225,000) (675,000) 250,000 325,000 (125,000) 450,000 (54,348) (70,652) 125,000-195,652 254,348 0 450,000 Profits tax payable = $195,652 x 16.5% + $254,348 x 15% = $70,434 14
5. (b) Explain the taxation of interest income from loans derived by financial institutions according to the Inland Revenue Department s practice in the Departmental Interpretation and Practice Notes (DIPN) No. 21 (Locality of Profits). Ans (b) If initiation and funding of the loan are both ex-hong Kong, the interest income is 100% exempt. If initiation and funding of the loan are both in Hong Kong, the interest income is 100% taxable. If either initiation or funding of the loan is in Hong Kong and the other is ex-hong Kong, the interest income is 50% taxable. Initiation refers to the efforts exerted in obtaining the particular business including solicitation, negotiation and structuring of the loans. Funding refers to the provision of money for the loan. 5. (c) Explain the specific conditions in the Inland Revenue Ordinance in determining whether clubs and trade associations are chargeable to profits tax in Hong Kong. Clubs Section 24 (1) provides a test to determine whether a club is exempt from profits tax. The test is whether or not less than half of its gross receipts on revenue account (including entrance fees and subscriptions) are from members (section 24(1)). If not less than half of the gross receipts are from members, the club shall be deemed not to carry on business and is therefore not chargeable to profits tax. Otherwise the whole amount of the income shall be subject to profits tax. Trade associations Section 24 (2) provides a test to determine whether the income of a trade association is chargeable to profits tax. The test is whether more than half of the receipts by way of subscriptions are from persons who would claim a deduction of such payments under section 16 (section 24(2)). If more than half of the receipts by way of subscriptions are from such persons, the trade association is deemed to carry on a business and its income is therefore chargeable to profits tax. 15
6. (a) Mr. Wong is the sole shareholder of two companies: A Ltd, which carries out a restaurant business; and B Ltd, which carries out a garment retailing business. The restaurant sustains heavy losses and Mr. Wong wants to cease this business. The restaurant has a tax loss of $10 million to be carried forward. In order to utilise this tax loss, Mr. Wong plans to transfer his profitable garment retailing business to A Ltd. However, Mr. Wong is wondering whether the Inland Revenue Department could challenge the transaction and he wants to resolve any uncertainties prior to carrying out the transaction. REQUIRED: Advise Mr. Wong, making specific references to sections 61, 61A and 61B of the Inland Revenue Ordinance. Ans (a) In general, losses can be carried forward indefinitely to set off against future profits under section 19C. However, this is subject to section 61B. If section 61B applies, the CIR can refuse to allow set-off of the loss brought forward against any such future profits. In this case, section 61B is inapplicable because there is no change in shareholding in the corporation. However, the IRD may invoke section 61 which applies to any artificial or fictitious transaction. The commercial basis of a transaction is a test for artificiality (Cheung Wah Keung v. CIR (2003) 3 HKLRD 733). In this case, it seems the business transfer has no sound commercial basis. In addition, the IRD may also invoke section 61A, which applies to any transaction entered into for the sole or dominant purpose of enabling a person to obtain a tax benefit. According to the question, it seems the purpose of the business transfer is solely to utilise the tax loss. To conclude, it appears likely that the IRD can disregard the business transfer under section 61 or section 61A. In order to resolve any uncertainties prior to carrying out the transaction, Mr. Wong is advised to obtain an advance ruling. 6. (b) Mr. Yeung purchased a machine (30% pool) on 1 July 2009 at $300,000 for use in his sole proprietorship business. His accounts are prepared annually to 31 March. On 1 May 2010, he sold the machine to ABC Ltd for $400,000 and leased it back for $25,000 per month. 16
REQUIRED: Compute the depreciation allowances and balancing adjustments (if any) for Mr. Yeung for the years of assessment 2009/10 and 2010/11. Explain whether and how ABC Ltd can claim any depreciation allowances on the machine. Ans (b) Mr. Yeung s depreciation allowances 2009/10 30% pool Allowances Cost 300,000 IA: 60% on 300,000 (180,000) 180,000 120,000 AA: 20% on 120,000 (36,000) 36,000 WDV c/f 23,200 26,800 2010/11 Sale proceeds 400,000 Balancing charge (limited to 216,000 (216,000) depreciation allowances given) ABC Ltd s depreciation allowances No depreciation allowance can be claimed by virtue of section 39E because prior to the acquisition by ABC Ltd (the lessor), the machinery had been owned and used by the person who is now the lessee (Mr. Yeung). To enable ABC Ltd to claim depreciation allowances, the following conditions must be satisfied: Mr. Yeung sold the machine for or less than $300,000 to ABC Ltd. Mr. Yeung must not claim any depreciation. Because Mr. Yeung claimed depreciation, he can make a written disclaimer to withdraw the depreciation allowances. The disclaimer must be made within three months of the acquisition or such further time as the CIR allows. END 17