THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND ADMINISTRATORS International Qualifying Scheme Examination HONG KONG TAXATION JUNE 2011 Time allowed 3 hours Section A Compulsory case study Section B 5 long questions (attempt any 3) DO NOT OPEN THIS PAPER UNTIL INSTRUCTED TO DO SO BY THE INVIGILATOR Important Note: Candidates are allowed 15 minutes reading time to read through the question paper before the commencement of the examination between 1:45p.m.- 2:00p.m. During the reading time, all candidates must be silent and must not write or mark anything on their question papers or answer books. Candidates must close all their reference books, notes or other unauthorised materials and put these under their chairs. If any candidates write or make any marks during the reading time, or if they speak or in any other way communicate with anyone either in or outside the examination hall during this period or read any unauthorised materials, they will be disqualified from continuing this examination paper. Once candidates have opened the question paper, they are not allowed to leave the examination hall until 2:30p.m. Page 1 of 14
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SUBJECT NO 16M HONG KONG TAXATION JUNE 2011 The examination paper is divided into TWO sections. Section A is a case study with compulsory questions which carries 40 marks. Candidates should attempt THREE questions from Section B, all of which carry 20 marks each. You should allow yourself approximately 70 minutes in total to answer the questions in Section A, and 35 minutes for each of the questions attempted in Section B. $ denotes Hong Kong dollars. Tuesday afternoon 31 May 2011 Time allowed: 3 hours SECTION A (Compulsory answer ALL parts of this question) 1. Mr. Lee has approached you, a tax consultant, for your advice in respect of his Hong Kong tax affairs. In a meeting on 30 May 2011 with Mr. Lee, you obtained the following information from him: 1. Mr. Lee was born and raised in Hong Kong. During the 1990s, Mr. Lee emigrated to the (US) and has subsequently become a US citizen. Meanwhile, he still retains his Hong Kong permanent resident identity card, his bank accounts and driver s license in Hong Kong. 2. In the US, Mr. Lee was employed by Golden Gate Electronics (US) Limited, a large multinational company based in the US, as an engineer. Golden Gate has subsidiaries in Hong Kong and Mainland China. In order to develop the engineering capability in Mainland China, Golden Gate Electronics (US) Limited decided to transfer Mr. Lee to oversee the Shenzhen factory, which is Golden Gate Electronics (US) Limited s subsidiary in Mainland China. 3. For administrative convenience, Mr. Lee was attached to Golden Gate Electronics (HK) Limited, the Hong Kong subsidiary of Golden Gate Electronics (US) Limited, because it has an experienced team of accounting and human resources professionals. 4. The Hong Kong subsidiary issued, under its own letterhead, a Letter of Transfer to Mr. Lee. The letter documents that Mr. Lee is to transfer to the Shenzhen factory for the period from 1 April 2010 to 31 March 2011. The letter also set out Mr. Lee s salary and benefits in detail. In particular, he is entitled to a monthly salary of HK$60,000 and a monthly overseas allowance of HK$40,000. After Page 3 of 14
deducting for the relevant PRC Individual Income Tax (IIT), the net amount is to be paid into Mr. Lee s bank account in Hong Kong. 5. Due to an agreement with the Shenzhen Local Tax Bureau, Mr. Lee s overseas allowance is not subject to IIT. 6. Mr. Lee arrived in Shenzhen on 1 April 2010 to carry out his employment duties. Because of the proximity between Shenzhen and Hong Kong, Mr. Lee occasionally crosses the border and spends the weekend in Hong Kong. During the year ended 31 March 2011, he spent 305 days in Shenzhen and 60 days in Hong Kong. Sometimes, he brings documents and samples from the Shenzhen office to the Hong Kong office and vice versa in order to save time and shipping expenses. 7. While in Shenzhen, Mr. Lee felt in love with his assistant, who also came from Hong Kong. As a result, Mr. Lee decided that he would not go back to US at the end of the transfer period. In February 2011, Mr. Lee tendered his resignation and his last working day was 31 March 2011. 8. At the end of the working day on 31 March 2011, Mr. Lee came back to Hong Kong and has been living in his girlfriend s apartment since then. 9. In addition, Mr. Lee made some investments in Hong Kong as follows: (a) He purchased 2,000 shares in a public company listed on the Hong Kong stock market for $40,000 in December 2010. In January 2011, he gave all these Hong Kong shares to a Hong Kong charitable institution. The market value of the shares at the date of gift was $25 per share. (b) He acquired a flat in Hong Kong for $7 million in January 2011. The provisional and final agreements for sale were signed 21 days apart. On 1 February 2011, Mr. Lee leased the apartment to a tenant on the following terms: (i) Lease period: 1 February 2011 to 31 January 2014. (ii) Monthly rent of $10,000, payable on the first day of each month starting February 2011. (iii) Rent deposit of $20,000 payable at the start of the lease. (iv) Premium of $20,000 payable at the start of the lease. 10. In April 2011, Mr. Lee received a letter from Golden Gate Electronics (HK) Limited. The letter enclosed a copy of the Employer s Return form IR56F in which Golden Gate (HK) reported Mr. Lee s salary and benefits to the Hong Kong Inland Revenue Department for the year ended 31 March 2011. 11. In early May 2011, Mr. Lee received a green envelope from the Inland Revenue Department which contained his Individual Composite Tax Return form BIR60. Mr. Lee believes that he can ignore his tax return because he did not work in Hong Kong during the year ended 31 March 2011, and he has come to you for advice. Page 4 of 14
REQUIRED: (a) Advise Mr. Lee whether, and if so to what extent, he will be subject to Hong Kong salaries tax for the year ended 31 March 2011. Specifically, you should advise Mr. Lee about his source of employment and his entitlement to all possible reliefs, including exemptions, under the Inland Revenue Ordinance. You should also advise Mr. Lee how much of his income would be subject to Hong Kong salaries tax under the various scenarios; however, you are not required to perform any salaries tax computations. Note: Even if you consider that Mr. Lee is not entitled to a particular relief, do not skip it. You should also identify the relief and discuss why Mr. Lee may not be entitled to claim it. (24 marks) (b) (c) Other than possible penalties for non-compliance, advise Mr. Lee the consequences if he chooses to ignore his tax return and refuses to pay any tax subsequently demanded by the Inland Revenue Department. (Note: You are not required to discuss the penalty provisions under the Inland Revenue Ordinance.) (6 marks) Advise Mr. Lee whether, and if so to what extent, the documents executed for the transactions in item 9 above attract Hong Kong stamp duty. (10 marks) (Total: 40 marks) Page 5 of 14
SECTION B (Answer THREE questions from this section) 2. In the 2010/2011 Budget, the Financial Secretary said (at paragraph 30): The Inland Revenue Department (IRD) has established procedures to track property transactions involving speculation and will follow up each case closely. If it is found that such transactions constitute a [trade or] business, the IRD will levy profits tax on the persons or companies concerned for profits arising from such transactions. REQUIRED: (a) (b) (c) Explain, critically, the definition of a trade and a business with reference to the Inland Revenue Ordinance. (6 marks) Analyse when profits arising from property transactions will be subject to profits tax, with reference to the six badges of trade. (9 marks) If profits arising from a property transaction are subject to profits tax but the seller fails to notify the IRD of his chargeability to tax without reasonable excuse, explain the potential consequences and penalties under the Inland Revenue Ordinance. (5 marks) (Total: 20 marks) Page 6 of 14
3. Consider the following employment benefits and expenditures: (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix) Amount paid by an employer in connection with the education of a child of an employee. Company car made available by an employer for the private use of an employee with an option to receive transportation allowance (in cash) in lieu of using the car. Payment of an employee s utilities by the employer. Loans provided to employees at less than market interest rates either from the employer s own funds or from money borrowed from the bank at market rates by the employer. Benefits from the use of corporate credit cards for private purposes by an employee. Travelling expenses of an employee. Subscriptions to professional associations by employees. As specified in the employment contract, a sum equivalent to one month salary is required to paid by an employee to the employer in lieu of proper notice of resignation." Depreciation of the cost of a computer purchased by an employee for employment purposes. REQUIRED: For items (i) to (v) above, fully explain, with reasons, whether they are assessable under Hong Kong salaries tax. For items (vi) to (ix) above, fully explain, with reasons, whether they are deductible under Hong Kong salaries tax. Consider all possibilities and make any necessary assumptions. (Total: 20 marks) Page 7 of 14
4. Dolly Limited was incorporated in Hong Kong. It carries on a business as a stationery trader in Hong Kong. For the year ended 31 December 2010, its profit and loss account is as follows: Notes $ $ Income Turnover 6,000,000 Less: Cost of goods sold (4,200,000) Gross profit 1,800,000 Unrealised exchange gain (i) 200,000 Compensation income (ii) 250,000 2,250,000 Expenses Administrative expenses 20,000 Bad debt expenses (iii) 40,000 Depreciation charges 80,000 Donations (iv) 1,000,000 Employee expenses (v) 400,000 Legal and professional fees (vi) 30,000 Other expenses 50,000 (1,620,000) Net profit for the year 630,000 Dolly Limited also provides you with the following additional information: (i) The unrealised exchange gain arises from the conversion of accounts receivable in foreign currency to local currency at the end of the accounting period. (ii) Compensation income represents insurance compensation for the total loss of a company car (original cost: $400,000; 30% pool) that was involved in a traffic accident. (iii) Bad debt expenses: $ Write-off of a loan made to a director 60,000 Less: Recovery of bad debt previously allowed (20,000) 40,000 (iv) Donations: $ Cash donations to Community Chest, Hong Kong 800,000 Donations in kind to Community Chest, Hong Kong 200,000 1,000,000 (v) Employee expenses: $ Salary 250,000 Payments to a retiring director for agreeing not to compete with the company 150,000 400,000 Page 8 of 14
(vi) Legal and professional fees: $ Audit fees 10,000 Tax return preparation 5,000 Objection against 2008/09 Notice of Assessment 15,000 30,000 Additional information: As at 1 January 2010, the tax written down values of the plant and machinery used in the business to produce assessable profits were as follows: 20% pool: $200,000 30% pool: $550,000 On 1 July 2010, the company purchased two identical pieces of office furniture (20% pool). The purchase price of furniture item #1 of $50,000 was settled in full in cash. Due to cash flow problems, furniture item #2 was financed by instalments with a $20,000 upfront payment and 12 instalments of $3,000 each. On 31 December 31, 2010, furniture item #1 was sold for $60,000. On 1 September 2010, the company purchased a computer (30% pool) for $30,000. REQUIRED: (a) (b) Prepare Dolly Limited s profits tax computation for the year of assessment 2010/11. (Ignore provisional tax.) (14 marks) Explain the tax treatment that you have applied to items (i), (ii), (iv) and (v). (6 marks) (Total: 20 marks) Page 9 of 14
5. The following information pertains to Eric for the year ended 31 March 2011: (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) Eric received a monthly basic salary of $45,000 from his employer, which is a Hong Kong company. During the first half of the year, Eric lived in a flat provided by his employer. During the second half of the year, Eric lived in his newly purchased apartment in Tai Koo Shing and received a monthly housing allowance of $6,000 from his employer. Eric owned a flat in Ma On Shan. On 1 April 2009, Eric rented this flat to a tenant for $9,000 per month. In addition, Eric received non-refundable rent of $18,000 up front. The rental period is for two years. During the year, Eric earned $80,000 teaching guitar on a private basis. Eric paid $100,000 and $120,000 to a bank: this represents the mortgage interest payments in respect of the Ma On Shan property and the Tai Koo Shing property respectively. Eric paid $2,500 per quarter and $3,000 per quarter to the government for rates in respect of the Ma On Shan property and the Tai Koo Shing property respectively. During the year, Eric made various charitable donations totalling $250,000 to approved charitable organisations. Eric is single with no dependents. REQUIRED: (a) (b) Show whether or not it is more beneficial for Eric to elect for personal assessment for the year of assessment 2010/11. Support your answer with detailed computations. (17 marks) Explain why it is/is not more beneficial for Eric to elect for personal assessment for the year of assessment 2010/11. (3 marks) (Note: Ignore provisional tax and any rebate announced in the 2011/12 Budget in your answers.) (Total: 20 marks) Page 10 of 14
6. Taxpayers may set up service company arrangements to minimise their Hong Kong tax liabilities. Two types of arrangements have been identified as causing particular concern. The Inland Revenue Department (IRD) has classified these two types of service companies as Type I and Type II. Section 9A of the Inland Revenue Ordinance (IRO) was enacted to deal with Type I cases, while Type II cases are dealt with in Department Interpretation and Practice Notes (DIPN) No. 24. (a) (b) Explain how and why taxpayers structure Type I service companies. Explain how section 9A of the IRO deals with Type I service company arrangements. (12 marks) Explain how and why taxpayers structure Type II service companies. Explain how DIPN No. 24 deals with Type II service company arrangements. (8 marks) (Total: 20 marks) End of Examination Paper Page 11 of 14
Tax Rates and Allowances Personal Allowances 2010/11 $ Basic 108,000 Married Person 216,000 Child 1 st and 9 th (each) year of birth 100,000 other years 50,000 Dependent Brother or Dependent Sister Allowance 30,000 Dependent Parent Aged 60 or more 30,000 Aged between 55 and 59 15,000 Additional Dependent Parent Aged 60 or more 30,000 Aged between 55 and 59 15,000 Dependent Grandparent Aged 60 or more 30,000 Aged between 55 and 59 15,000 Additional Dependent Aged 60 or more 30,000 Grandparent Aged between 55 and 59 15,000 Single Parent Allowance 108,000 Disabled Dependant Allowance 60,000 Salaries Tax and Personal Assessment Tax Rates 2010/11 Progressive Rates: First $40,000 2% Next $40,000 7% Next $40,000 12% Remainder 17% Standard Rate 15% Profits Tax Rates (2008/09 onwards) Unincorporated Business 15.0% Corporation 16.5% Property Tax Rates (2008/09 onwards) 15.0% Depreciation Allowances (2004/05 onwards) Plant and Machinery Initial Allowance 60% Annual Allowance 10%, 20% or 30% (as specified in question) Industrial Building Initial Allowance 20% Annual Allowance 4% Commercial Building 4% Page 12 of 14
Stamp Duty Payable (2010/11 onwards) Head 1(1) $1 - $2,000,000 $100 & $2,000,001 - $2,351,760 $100 + 10% of value above $2,000,000 Head 1(1A) $2,351,760 - $3,000,000 1.5% of consideration $3,000,001 - $3,290,320 $45,000 + 10% of value above $3,000,000 $3,290,321 - $4,000,000 2.25% of consideration $4,000,001 - $4,428,570 $90,000 + 10% of value above $4,000,000 $4,428,571 - $6,000,000 3% of consideration $6,000,001 - $6,720,000 $180,000 + 10% of value above $6,000,000 $6,720,001 - $20,000,000 3.75% of consideration $20,000,000 - $21,739,120 $750,000 + 10% of value above $20,000,000 Above $21,739,120 4.25% of consideration Head 1(2) Premium Same as under Head 1(1) Rent: Uncertain term 0.25% of annual rent Term of less than a year 0.25% of total rent Term of 1 year to 3 years 0.5% of annual rent Term of more than 3 years 1% of annual rent Head 2(1) 0.1% of the consideration Head 2(2) $5 Head 2(3) $5 + 0.2% of value Head 2(4) $5 Head 3(1) 3% of market value Head 3(2) $5 Page 13 of 14
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