THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES Suggested Answers Level : Professional Subject : Hong Kong Taxation Diet : December 2006 The suggested answers are published for the purpose of assisting students in their understanding of what may be expected from a good candidate in the time allowed for each paper. They are in no way exhaustive nor model answer to the questions. They do not reflect the opinion of HKICS. 1
THE HONG KONG INSTITUTE OF CHATERED SECRETARIES HONG KONG TAXATION DECEMBER 2006 Suggested Answers SECTION A 1(a) The requirements for lodging a valid objection as laid down under section 64(1) of the Inland Revenue Ordinance are as follows: In writing addressed to the Commissioner. State precisely the grounds for the objection. Received by the Commissioner within one month after the date of the notice of assessment, unless the Commissioner grants an extension because of sickness, absence from Hong Kong or other reasonable excuse. Submit a tax return to validate the objection against an estimated assessment made in the absence of a return. (b) The Inland Revenue Department could impose penalties under section 82(1) in case of fraud and willful evasion: o If the taxpayer was prosecuted on summary conviction, a level three penalty plus treble amount of tax undercharged and imprisonment of six months. o If the taxpayer was prosecuted on indictment, a level five penalty plus treble amount of tax undercharged and imprisonment of three years. Alternatively if the Inland Revenue Department is of the opinion that a taxpayer failed to notify his or her chargeability without reasonable excuse, a level three penalty plus treble amount of tax undercharged could be imposed under section 80(2). If no prosecution has been instituted under section 82(1) or section 80(2), additional tax not exceeding treble amount of tax undercharged may be imposed by the Commissioner or a deputy commissioner personally, section 82A. (c) As War Limited does not carry on any other trade or business in Hong Kong, one single act of selling the nanometer technology to a Hong Kong company should not constitute a trade in Hong Kong. As such, the gain on disposal of technology would not be a taxable gain under section 14. 2
Alternatively if War Limited receives any payment in the form of a licensing fee, such a licensing fee would fall within the scope of section 15 (1)(b) as the technology will be used by Peace Limited in Hong Kong. Hence Peace Limited would be required to withhold tax of $10,500 ($200,000 x 30% x 17.5%), and make the payment to the Inland Revenue Department on behalf of War Limited. (d) Celia s case has to be considered in light of the six badges of trade as follows: The property has been used as Celia s residence since acquisition. Celia has already held the property for three years prior to disposal. This is the only property transaction that Celia has ever entered into. The disposal of property was owing to extenuating circumstances, i.e. the possible termination of Celia s employment contract. (e) Section 16G (6) defines prescribed fixed assets as: Machinery or plant used specifically and directly for any manufacturing process as specified in Inland Revenue Rule 2. Computer hardware other than that which is an integral part of any machinery or plant. Computer software and computer systems. Capital expenditure incurred in relation to prescribed fixed assets would be fully deductible from assessable profits in the year the expenditure was incurred. (f) Kowloon Chess Club Profits tax Year of assessment 2005/06 Members Non-members $ $ Subscriptions from members 800,000 Subscriptions from non members 600,000 Revenue from sales to non members 400,000 Rental revenue from a non member 200,000 800,000 (40%) 1,200,000 (60%) Since over 50% of the gross receipts came from non-members, Kowloon Chess Club would be deemed t business in Hong Kong according to section 24(1). 3
$ Total gross receipts 2,000,000 Less: Expenses associated with fund raising sales (200,000) Assessable profits 1,800,000 Profits tax payable @16% 288,000 (g) The following three factors should be considered in determining whether Fanny has a Hong Kong employment: Fanny is seconded by an American corporation to work for a Hong Kong subsidiary. It would be reasonable to expect that the Inland Revenue Department will consider her actual employer to be the Hong Kong subsidiary rather than the American corporation. Her contract of employment was negotiated outside Hong Kong but entered into in Hong Kong. Her remuneration is paid outside Hong Kong. As the Inland Revenue Department would place much weight on the first and second factors in practice, it is likely that Fanny would be considered as having a Hong Kong employment and therefore be fully chargeable to Hong Kong salaries tax. (h) Section 12(1)(a) allows the deduction from the assessable income of all outgoings and expenses wholly, exclusively and necessarily incurred in the production of assessable income: Wholly and exclusively means that the entire amount of expenses should be spent for the sole purpose of producing assessable income. Necessarily means that the expenses must be essential to the production of assessable income. Incurred implies an established liability or a definite commitment arising in the year concerned. In the production of assessable income refers to expenses incurred to enable the duties to be performed. 4
(i) George Goh Property Tax Year of assessment 2005/06 (Revised) $ Rental income (1 October 2005 to 31 March 2006) 36,000 Less: Unrelieved bad debt (Rental income for 2006/07 $6,000 Irrecoverable rent $18,000) (12,000) Assessable value 24,000 Less: 20% statutory deduction (4,800) Net assessable value 19,200 (j) The Collector of Stamp Duty may impose penalty in accordance with section 9 of the Stamp Duty Ordinance: Two times penalty if no more than one month late. Four times penalty if later than one month but not more than two months late. Ten times penalty if more than two months late. Furthermore any non-stamped instrument would not be admissible as evidence in any court proceedings in accordance with section 15 (1). 5
SECTION B 2(a) The Inland Revenue Department is authorised under the Inland Revenue Ordnance to scrutinise transactions that appear to have no commercial justification, especially those that have taken place between related parties. The relevant anti avoidance provisions here are section 61 and section 61A. Section 61 states that where an assessor is of opinion that any transaction which reduces the amount of tax payable by any person is artificial or fictitious, or that any disposition is not in fact given effect to, he may disregard any such transaction or disposition and the person concerned shall be assessable accordingly. If an assessor invokes section 61, he could choose to disregard the sale of property from Almighty Limited to Loser Limited. On the other hand, if an assistant commissioner considers that the sole or dominant purpose of the proposed arrangement is to enable any person to obtain a tax benefit, he might invoke section 61A by ignoring the arrangement or assessing the parties as he thinks fit. If so, the assistant commissioner would attempt to substitute the actual consideration of the transaction by the market value of the property at the date of transaction. As Section 61A would be applicable to transactions which are actually entered or effected, it is therefore more likely for the Inland Revenue Department to invoke Section 61A rather than Section 61. However if Almighty Limited can prove that there is commercial justification for carrying out the transaction in question and the tax benefit is merely obtained by incidence, Section 61A may not apply. Finally, the Inland Revenue Department may also contend that there is a change of shareholding of Loser Limited and that the sole or dominant purpose of such a change is to utilise its loss to avoid tax liability. As such, the Inland Revenue Department might invoke section 61B to prohibit the set off of losses brought forward against any future profits of Loser Limited. (b) The sale and purchase agreement between Almighty Limited and Loser Limited should not attract any stamp duty liability under Head 1(1A) of the Stamp Duty Ordinance, as Head 1(1A) only applies to residential buildings. 6
However the conveyance agreement would be chargeable under Head 1(1). The amount of stamp duty payable would be 3.75% (for property valued above $6.72 million) of the consideration or the market value of the property at the date when the agreement is signed, whichever is higher. In this case, the stamp duty payable would be based on the market value of $100 million rather than the actual consideration of $80 million. It is also likely that Almighty Limited would be eligible for the group relief exemption under section 45. As it will be holding more than 90% of Loser Limited s shareholding after the takeover, thus the two companies will qualify as associated bodies corporate for the purpose of section 45. Stamp duty adjudication is required for the aforementioned relief. But Alan should bear in mind if the associated body corporate status of Almighty Limited and Loser Limited ceased within two years time, the conveyance agreement would be chargeable to stamp duty within 30 days of such a cessation. Any person who fails to comply with such a reporting obligation is liable to a penalty of $5,000. 7
3(a) As Chris will be holding some stock of merchandise for the Japanese wholesaler in Hong Kong and regularly filling orders on their behalf, the Japanese wholesaler will be considered to have a permanent establishment in Hong Kong pursuant to Inland Revenue Rule 5. As an agent of the Japanese wholesaler, Chris has to furnish quarterly returns to the Commissioner showing the gross sales proceeds and pay a 1% consignment tax to the Commissioner according to section 20A. A lesser sum may be paid if the Commissioner agrees, and in practice only 0.5% is payable. (b) Chris & Co Profits tax computation Year of assessment 2005/06 Basis period: Year ended 31 March 2006 $ $ Net profit before tax 4,147,300 Add: Depreciation 500,000 Donations 500,000 Entertainment ($600,000 x 1/5) 120,000 Insurance expenses 41,700 Motor car expenses ($280,000 x 1/4) 70,000 Proprietor s salary 240,000 1,471,700 5,619,000 Less: Interest on Japanese yen deposits 400,000 Interest on private saving deposit 200,000 Depreciation allowance 492,000 (1,092,000) Assessable profit 4,527,000 Profits tax payable @16% 724,320 (c) Interest on foreign currency deposits placed with Oromo Bank in Tokyo is not taxable income, as the deposit was placed outside Hong Kong and the interest income was not derived from Hong Kong (section 15(1)(g)). Interest on Chris private saving deposit in Hong Kong is also not taxable income, as the deposit did not come from the funds of the business (section 15(1)(g)). 8
4. (a) Francis Fung Salaries tax computation Year of assessment 2005/06 $ $ Salaries ($60,000 x 12) 720,000 Utilities bills 50,000 Education allowance 30,000 800,000 Add: Rental value ($800,000 x 10%) 80,000 Less: Rental suffered ($720,000 x 5%) (36,000) 44,000 844,000 Share option gain (10,000 x ($4-$1)) 30,000 Assessable income 874,000 Less: Approved charitable donation (874,000 x 25%) 218,500 Mandatory Provident Fund contribution 12,000 Elderly residential care 60,000 (290,500) Net assessable income 583,500 Less: Single person allowance 100,000 Single parent allowance 100,000 Child allowance 60,000 (260,000) Net chargeable income 323,500 Tax at standard rate @16% 93,360 Tax at progressive rates 53,900 Tax payable 53,900 9
(b) (iii) The share option gain is ascertained in accordance with section 9(1)(d) and s.9 (4). The gain is crystallised at the date of exercise, and the date of grant and ultimate sale of the shares acquired are irrelevant. (iv) School fees are specifically taxed under section 9(2A)(b). (v) The premium paid by Friendly Limited to AAA is not assessable to Francis, because it appears that Friendly Limited was discharging its sole liability to AAA (section 9(1)(a)(iv)). Similarly, the reimbursement by AAA to Francis should not be taxable on the basis that it is not derived from the contract of employment (Hochstrasser v Mayes). (vii) The deduction of elderly residential care expenses under section 26D is restricted to $60,000. No dependant parent allowance is available for Francis mother, as a deduction was already granted for elderly residential care expenses. (viii) A child allowance is available for both children, because they are both aged below 25 and in full-time education at an educational establishment. The mere fact that the eldest has a part-time job does not indicate that he is not being maintained by Francis. 10
5. GMS & Co Profit or loss allocation Year of assessment 2004/05 Gold Ltd Mr Ma Ms See Total $ $ $ $ Salaries 300,000 150,000 ---- 450,000 Interest on capital 100,000 ---- ---- 100,000 Residue (3:2:1) (150,000) (100,000) (50,000) (300,000) 250,000 50,000 (50,000) 250,000 Reallocation (250:50) (41,667) (8,333) 50,000 ---- 208,333 41,667 ---- 250,000 Add: Loss b/f ---- ---- (20,000) (20,000) 208,333 41,667 (20,000) (230,000) Less: Loss set-off ---- (10,000) ---- (10,000) Transfer to personal assessment ---- (31,667) ---- (31,667) Net assessable profit 208,333 ---- (20,000) 188,333 Year of assessment 2005/06 $ Period I: 1 April 2005 31 December 2005 (800,000) x 9/12 (600,000) Period II: 1 January 2006 31 March 2006 (800,000) x 3/12 (200,000) Agreed loss (800,000) Gold Ltd Mr Ma Ms See Total Period I $ $ $ $ Salaries 300,000 150,000 ---- 450,000 Interest on capital 112,500 ---- ---- 112,500 Residue (3:2:1) (581,250) (387,500) (193,750) (1,162,500) (168,750) (237,500) (193,750) (600,000) Period II Salaries 100,000 50,000 ---- 150,000 Interest on capital 37,500 ---- ---- 37,500 Residue (1:1) (193,750) (193,750) ---- (387,500) (56,250) (143,750) ---- (200,000) 11
Total Period I (168,750) (237,500) (193,750) (600,000) Period II (56,250) (143,750) ---- (200,000) (225,000) (381,250) (193,750) (800,000) Add: Loss b/f ---- ---- (20,000) (20,000) (225,000) (381,250) (213,750) (820,000) Less: Loss set-off against corporation 225,000 ---- ---- 225,000 Loss lapsed ---- ---- 20,000 20,000 Transfer to personal assessment ---- ---- 193,750 193,750 Loss c/f ---- (381,250) ---- (381,250) 12
6(a) Under the current arrangement, Holly Limited is engaged in the manufacturing of jeanswear. The Inland Revenue Department has provided examples of the different tax treatment of manufacturing profits derived from processing arrangements under Departmental Interpretation and Practice Note 21. One pertinent example concerning processing arrangements is as follows: Under a processing or assembling arrangement, the Mainland entity is responsible for processing, manufacturing or assembling goods that are required to be exported to places outside the Mainland. The Mainland entity provides the factory premises, land and labor. For this, it charges a processing fee and exports the completed goods to the Hong Kong manufacturing business. The Hong Kong manufacturing business normally provides the raw materials. It may also provide technical know how, management, production skills, design, skilled labor, training and supervision for the locally recruited labor and the manufacturing plant and machinery. The design and technical know how development is usually carried out in Hong Kong. With regard to the involvement of Holly s staff in the manufacturing process carried on in the Shenzhen factory, it is likely that Holly Limited could claim the 50:50 apportionment basis with regard to Departmental Interpretation Practice Note 21. That is to say, only 50% of Holly Limited s profits from the sale of the jeanswear manufactured in the Mainland would be chargeable to Hong Kong profits tax. (b) Under the proposed arrangement, the role of Grand Limited is not a manufacturer but a trader in Hong Kong. Trading profits are generally regarded as sourced in the place where the contracts of sales and purchases are effected. The tax implications of the proposed arrangement very much depend on the places where the relevant contracts are negotiated and concluded. The general principle laid down in the Departmental and Interpretation Practice Note 21 is that if either the contract of purchase or the contract of sales is effected in Hong Kong, the whole trading profits are regarded as derived from Hong Kong, and there is no apportionment of profits for trading transactions. 13
It is therefore most likely that the Inland Revenue Department will claim that all the profits of Grand Limited have a Hong Kong source, despite the fact the jeanswear will be sold to US customers. (c) Transfer pricing is broadly used to describe a cross border transaction between parties who are not at arm s length. Transfer pricing strategy is usually used to reduce the profits retained by companies in a high tax jurisdiction and to increase the profits retained by companies in a low tax jurisdiction so as to reduce the overall tax burden of the group as a whole. The Inland Revenue Department is empowered to invoke section 20 if it is satisfied that: Transactions have been carried out between a Hong Kong resident and a closely connected non-resident. The result is that the Hong Kong resident will earn no or less than the ordinary taxable profits in Hong Kong. Closely connected here means that both the Hong Kong resident and non-resident have substantially identical owners, or that there is the same beneficial owners of their shares. Alternatively if the Inland Revenue Department considers that the sole or dominant purpose of the sale transaction between the Zhongshan enterprise and Grand Limited is to enable any person to obtain a tax benefit, the Assistant Commissioner might invoke Section 61A by ignoring the arrangement or assessing the parties as he thinks fit. 14