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THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES

THE INSTITUTE OF CHARTERED SECRETARIES AND

ADMINISTRATORS

International Qualifying Scheme Examination

HONG KONG TAXATION

DECEMBER 2012

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

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SECTION A

1.

Lifestyle Limited carries on a manufacturing and trading business in Hong Kong. The

company’s income statement for the year ended 31 March 2012 showed net income of

$7,200,000 which is after taking into account the following items:

Income: Note $

Dividend from a Hong Kong listed company 16,000

Interest income 1 85,000

Proceeds from assignment of rental income 2 900,000

Profit on disposal of patent 3 140,000

Expenses:

Bad debts 4 208,000

Contribution to retirement scheme 5 1,543,000

Depreciation 473,000

Donation 6 50,000

Exchange differences 7 41,000

Interest expenses 8 142,000

Legal and professional fees 9 100,000

Profits tax 785,000

Notes to the accounts:

1. Interest income: $

Interest on deposits placed with Hang Seng Bank in Hong Kong 32,000

Interest on deposits placed with HSBC in Singapore 48,000

Interest on tax reserve certificate 5,000

85,000

2. The company let a commercial unit in Kwun Tong to a tenant at $30,000 per month from April 2011 onwards for a fixed term of three years, and assigned the right to receive rental income under the lease to a finance company for $900,000. This amount was immediately recognised in the income statement.

3. The company acquired a patent 10 years ago for use in the production process at a cost of $300,000. The patent was disposed during the year for $440,000 and a gain of $140,000 was recognised in the accounts.

4. Bad debts expenses: Increase in allowance for doubtful trade accounts for which recovery action has been taken in vain

70,000 Increase in allowance for doubtful accounts based on 2% of the trade debts outstanding

26,000

Trade debts written off 112,000

208,000

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5. Contribution to recognised retirement scheme:

Contribution for employees (at 10% of salaries) 1,260,000

Contribution for directors (at 20% of directors’ fees) 300,000

Refund from the scheme for employees who have left the

company

(17,000)

1,543,000

6. The company has donated products with book value of $50,000 to an elderly care

home which is an approved charity in Hong Kong.

7. Exchange differences:

Exchange loss on conversion of foreign currency time deposits 22,000

Exchange loss on collecting trade debts 19,000

41,000

8. Interest expenses:

Bank interest paid to HSBC in Hong Kong* 97,000

Loan interest paid to a shareholder (unsecured) 45,000

142,000

* The borrowing was secured by the deposits placed with the same bank in Singapore

(see note 1 above) and personal guarantees given by the shareholders. At all material

times, the borrowing was greater than the amount of deposits.

9. Legal and professional fees:

Fees for annual audit and tax filing 60,000

Legal fees for new lease (see note 2 above) 3,000

Other (allowable) 37,000

100,000

Additional note:

Total depreciation allowances agreed with the Assessor for the year are $330,000.

Additional information:

The company plans to set up a branch in Mainland China to sell its products in the

Mainland. While the solicitation and negotiation of contracts will be conducted in the

Mainland, the production will continue be carried out in Hong Kong. The board of directors

would like to know if the profits from such sales could be claimed as offshore income. The

board understands that setting up a branch in the Mainland will create tax exposure under

the Corporate Income Tax Law in the Mainland. However, protection or relief is available

to a Hong Kong company under The Arrangement between the Mainland of China and the

Hong Kong SAR for the Avoidance of Double Taxation and the Prevention of Fiscal

Evasion with respect to Taxes on Income (Mainland/HK CDTA).

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REQUIRED:

1. (a) Prepare the Hong Kong profits tax computation for Lifestyle Limited for the

year of assessment 2011/12. Ignore provisional tax.

Ans (a) Lifestyle Limited

Profits tax computation

Year of assessment 2011/12

Basis period: Year ended 31 March 2012 (Section 18B(1))

$ $

Profit per accounts 7,200,000

Add: Depreciation 473,000

Donation in kind 50,000

Profits tax 785,000

Sales proceeds of patent 300,000

Increase in general allowance for doubtful

debts

26,000

Excess contribution for directors ($300,000 x

5%/20%)

75,000

Exchange loss on converting time deposits 22,000

Bank interest to HSBC 48,000

Loan interest to a shareholder 45,000

Legal fee for new lease 3,000 1,827,000

9,027,000

Less: Dividends (16,000)

Interest on deposits - Hang Seng Bank (32,000)

Interest on deposits - HSBC (48,000)

Interest on tax reserve certificate (5,000)

Profits on sale of patent (140,000) (241,000)

8,786,000

Less: Depreciation allowances (330,000)

Assessable profit 8,456,000

Profits tax payable at 16.5% 1,395,240

Less: Tax reduction (75%, max $12,000) (12,000)

Final profits tax payable 1,383,240

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1. (b) Analyse the proper tax treatments for all items given in notes 1 to 9 above.

Ans (b) Interest income

Interest income received 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 is arising from Hong Kong

Lifestyle Limited carries on business in Hong Kong

Interest on deposit placed with Hang Seng Bank is sourced in Hong Kong

and chargeable to profits tax

However, interest can be exempt because the deposits were placed with a

financial institution in Hong Kong and they were not used to secure any bank

borrowing

Interest on deposits placed with HSBC in Singapore was sourced outside

Hong Kong and is not taxable

Interest on tax reserve certificates is exempt under section 26A(a)

Assignment of rental income

Sum received by a person as consideration in respect of the transfer of a

right to receive taxable rental income is deemed to be a taxable trading

receipt under sections 15(1)(m) and 15A unless the ownership of the

property is also transferred

$900,000 received by Lifestyle Limited is taxable

Disposal of patent

The cost of purchasing the patent should have been deducted under section

16E(1) when it was acquired 10 years ago

The sale proceeds are deemed to be a taxable receipt under section 16E(3)

Effective 2011/12, the taxable receipt is restricted to the deduction previously

claimed, i.e. $300,000 only

Bad debts expenses

Trade debts written off are deductible under section 16(1)(d) if they are

proved to have become bad and were included as taxable trading receipts

Allowance based on 2% of trade debts outstanding is not regarded as

“incurred” and cannot be deducted

Where recovery action has been taken on trade debts in vain, it can be

estimated to the satisfaction of the assessor that they have become bad and

are deductible

Contribution to retirement scheme

Annual contribution to recognised retirement scheme can be deducted up to

15% of the total emolument of the employee by virtue of section 17(1)(h)

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Contribution for the employees is not excessive and can be deducted in full

Contribution for the directors has to be reduced to the 15% limit

Refund from recognised retirement scheme is deemed to be taxable receipts

under section 15(1)(h) to the extent that the relevant contribution has been

allowed as a deduction

Donation

Donation to approved institution must be in money, not in kind

Donation of products is not “money” and cannot be deducted under section

16D

Exchange differences

Time deposits are capital investment of a company (CIR v Li & Fung);

exchange loss on conversion of foreign currency deposits is capital in nature

and not deductible

Exchange loss on collecting trade debts is revenue loss and deductible

Interest expenses

To be deductible, interest expenses must be incurred in the production of

chargeable profits under section 16(1)(a)

Bank interest paid to HSBC is interest on money borrowed from a financial

institution and satisfies the condition under section 16(2)(d)

Under the secured loan test, the borrowing was secured by deposits placed

in Singapore generating non-taxable interest income

Deduction has to be reduced by the amount of tax-free interest income by

virtue of section 16(2A); only $49,000 ($97,000 - $48,000) can be deducted

The shareholder loan was borrowed from a person other than a financial

institution and section 16(2)(c) has to be considered

Since the shareholder is likely not to be liable to profits tax for the interest

income received, the condition under section 16(2)(c) cannot be fulfilled and

no deduction is allowed

Legal and professional fees

Fees for annual audit and submission of tax return were incurred in the

normal course of business to discharge normal legal obligations of a taxpayer

and with a view to earn profit; they are deductible expenses

Fee for preparing new tenancy agreement is of a capital nature and

non-deductible

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1. (c) Advise the board on the Hong Kong issues relating to the plan of setting up

a branch in the Mainland and the protection or relief available under the

Mainland/HK CDTA .

Ans (c) Under section 14(1), a person is chargeable to profits tax if he carries on a

business in Hong Kong and the profits arise in or are derived from Hong

Kong

Only operations which directly produce the profits are relevant; one should

focus on the effective causes for earning the profits, activities that are

antecedent or incidental can be ignored

Although the sales contracts are effected outside Hong Kong, it is likely that

the IRD would regard the production process in Hong Kong to be the

profit-making activities

All the profits from selling the goods to customers in the Mainland would likely

be chargeable to Hong Kong profits tax

Under Article 7 of the Arrangement between the Mainland of China and the

Hong Kong SAR for the Avoidance of Double Taxation and the Prevention of

Fiscal Evasion with respect to Taxes on Income, the profits of a Hong Kong

enterprise shall be taxable only in Hong Kong unless the enterprise carries

on business in the Mainland through a permanent establishment situated

therein

However, in such a case only the profits attributable to that permanent

establishment may also be taxed in the Mainland

The term “permanent establishment” is provided in Article 5 to mean a fixed

place of business through which the business of an enterprise is wholly or

partly carried on

It also includes especially a place of management; a branch; an office; a

factory; a workshop; a mine, an oil or gas well, a quarry or any other place of

extraction of natural resources

If Lifestyle Limited sets up a branch in the Mainland selling its products, this

likely constitutes a permanent establishment and the profits attributable to the

branch will be subject to corporate income tax in the Mainland

To eliminate any double taxation, tax paid in the Mainland by a Hong Kong

resident shall be allowed as a credit against Hong Kong profits tax under

Article 21 if the profit is subject to Hong Kong profits tax.

However, the amount of the tax credit shall not exceed the amount of Hong

Kong tax on such profits computed in accordance with the tax laws and

regulations in Hong Kong

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SECTION B

2.

Henry Bao is the Vice-president - Engineering of Sapphire Limited (Sapphire), a company

carrying on business in Hong Kong. He provides you with the following information relating

to the year ended 31 March 2012:

1. He received a monthly salary of $50,000 for the year, and a discretionary bonus of

$85,000.

2. He was provided with company quarters at a nominal rent of $3,000 per month. He

also paid the management fee of $13,200 for the year.

3. He received a holiday package for his home trip to Taiwan, which was purchased by

Sapphire from Wing On Travel Agency for $10,000. The package can be redeemed for

cash after deducting a handling charge of $2,000.

4. He engaged a domestic helper at a monthly salary of $5,000 which was paid by

Sapphire on his behalf.

5. He was enrolled in Sapphire’s MPF-exempt retirement scheme. During the year, he

has made contribution at 5% of his monthly salary to the retirement scheme.

6. He was also enrolled in Sapphire’s group medical insurance scheme. During the

year, he obtained a medical refund of $8,000 from the insurance company, and

another $3,000 which was not covered by the insurance from Sapphire pursuant to the

terms of his employment.

7. On 1 April 2011, he was awarded 50,000 shares in Sapphire. The shares were vested

on him immediately with a sales restriction period of one year from the date of the

award. On 10 December 2011, he received dividend income of $5,000 from these

shares. He sold all these shares in the market on 15 May 2012.

8. On 2 February 2012, he was granted an option to subscribe for 100,000 shares in

Sapphire at a $3 per share. This share option was granted without condition. He sold

one half of the option on 9 March 2012 and received $180,000.

9. During the year, Henry paid a membership subscription of $1,900 to the Hong Kong

Institution of Engineers. He also paid $3,000 to attend continuing professional

development seminars organised by the Institution.

10. Henry is married and his wife, Annie, is a housewife. They have a son, aged 20,

attending university in the US. Annie’s parents, aged 57 and 63, reside in Hong Kong.

Annie paid them $6,000 per month in support of their living.

In September 2012, Henry was approached by a head-hunter and was offered a three-year

contract to work in a company based in Singapore. Henry resigned from Sapphire effective

from 1 December 2012 and will permanently leave Hong Kong by early January 2013. He

has not yet exercised the remaining share option mentioned in note 8 above.

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Sapphire’s shares were quoted on the stock exchange at the following prices on the

following dates:

1 April 2011 $6.00

2 February 2012 $8.00

9 March 2012 $7.00

1 April 2012 $7.50

15 May 2012 $7.20

30 November 2012 $6.50

REQUIRED:

2. (a) Prepare the Hong Kong salaries tax computation for Henry Bao for the

year of assessment 2011/12. Ignore provisional tax.

Ans (a) Henry Bao

Salaries tax computation

Year of assessment 2011/12 $ $

Salary ($50,000 x 12) 600,000

Bonus 85,000

Holiday journey 10,000

Salary of domestic helper ($5,000 x 12) 60,000

Medical refund 3,000

Share award (50,000 x $6 x 0.95) 285,000

1,043,000

Rental value [($1,043,000 - $1,900) x 0.1] 104,110

Less: Rent suffered ($3,000 x 12 + $13,200) (49,200) 54,910

Share option gain - Assignment 180,000

1,277,910

Less: Membership subscription (1,900)

Self-education expenses (3,000) (4,900)

1,273,010

Less: Contribution to retirement scheme (12,000)

1,261,010

Less: Personal allowances

Married person's allowance (216,000)

Child allowance (60,000)

Dependent parent allowance - aged 63 (36,000)

Dependent parent allowance - aged 57 (18,000) (330,000)

Net chargeable income 931,010

Salaries tax payable at progressive rates

146,271

Less: Tax reduction (75%, max $12,000) (12,000)

Final salaries tax payable

134,271

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2. (b) Advise Henry on the Hong Kong salaries tax treatment of the share-based

benefits received by him (notes 7 and 8), including the possible treatment

of dividends received during the sales restriction period and the share

option which has not yet been exercised, by reference to the assessing

practice of the Inland Revenue Department.

Ans (b) Shares obtained through share-based remuneration are taxable perquisites

under section 9(1)(a) forming part of a taxpayer’s employment income

According to DIPN No. 38, the 50,000 shares awarded to Henry will be

assessed to tax at the time of grant by the employer because the shares

were immediately vested in him (the upfront approach)

Market value at the time of grant will be used for valuation purposes

A 5% discount in valuation generally will be allowed as there is a one-year

sale restriction period

Dividends received during the restriction period are regarded as investment

income and are not taxable

For the share option, any gain realised on its exercise, assignment or

release will be subject to salaries tax under section 9(1)(d)

For the assignment of one half of the option on 9 March 2012, the taxable

amount is the consideration received; the market value is irrelevant

With a view to finalising the salaries tax liability of a person who is departing

permanently from Hong Kong, the IRD will, as a concession, allow him to

elect to have the liability ascertained on the basis of a notional exercise of

the option

Any tax liability can be finalised on the basis of the gain that would have

been realised if the option had been exercised on a day within seven days

before the date of submission of the person’s tax return for the final

assessment applicable to the year of assessment in which he permanently

departs from Hong Kong

As a further concession, the IRD will accept an election made within three

months from the date of permanent departure from Hong Kong if it has not

been made before departure; the date of departure will be taken as the date

of the notional exercise for calculating the gain in such case

No further liability will arise when the option is actually exercised, assigned

or released after his departure from Hong Kong

However, if it transpires that the gain in respect of the actual exercise, etc.

is less than the amount assessed in respect of the notional exercise, the

IRD will favourably consider any application for appropriate amendment

and re-assessment

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3.

Benson Wong is the sole beneficial owner of Ocean Limited, which in turn wholly owns

Reef Limited and partly owns Coral Limited. All companies are incorporated in Hong Kong.

The group structure is as follows:

REQUIRED:

Analyse the Hong Kong stamp duty implications arising from the following transactions

which have taken place during the year ended 31 December 2012. You should compute

the stamp duty payable where applicable and clearly identify the relevant charging heads.

3. (a) On 1 February 2012, Ocean Limited sold Property A, a shopping unit in

Causeway Bay, to Reef Limited for a consideration of HK$20 million. Reef

Limited financed the purchase consideration by borrowing $10 million from the

Bank of East Asia.

On 1 March 2012, Reef Limited let out Property A for a term of two years at a

fixed monthly rent of $50,000 plus a variable rent computed at 1% of the

turnover of the shop. The total monthly rent is not to exceed $70,000. The lease

was executed in duplicate.

Ans (a) The conveyance of immovable property in Hong Kong is chargeable to

stamp duty under Head 1(1)

Reef Limited is wholly owned by Ocean Limited and they fall within the

definition of associated bodies corporate; exemption from stamp duty can

be sought under section 45 for the transfer between associated bodies

corporate

100% 80%

Benson Wong

Reef Limited Coral Limited

100%

Ocean Limited

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Corporations are associated if one is the beneficial owner of not less than

90% of the issued share capital of the other

Section 45(5A) provides that exemption shall not apply if the instruments

are executed in connection with an arrangement under which part of the

consideration is provided by a person other than an associated body

corporate of the transferor or transferee

Although the consideration was partly provided by the bank, the Collector of

Stamp Revenue accepts that exemption will not be denied if the loan is

made in the ordinary course of the bank’s business and the bank does not

obtain any rights over the property other than as security

An agreement for the lease of immovable property in Hong Kong is subject

to stamp duty under Head 1(2)

Based on the contingency principle, if the consideration payable under an

instrument is uncertain at the time of its execution, stamp duty is chargeable

on the maximum of any specified amount

Rate for a lease of more than one year but less than three years is 0.5%

Stamp duty payable is: $70,000 (maximum) x 12 x 0.5% = $4,200

The duplicate copy is stampable at $5 under Head 4

3. (b) On 5 April 2012, Reef Limited executed a deed to transfer Property B, a

residential property in Quarry Bay which has been held by Reef Limited for five

years, to Coral Limited at a consideration of $7 million. The market value of the

property was $7.5 million on that date.

On 20 October 2012, Coral Limited signed a provisional sale and purchase

agreement to sell Property B to a third party at the fair market value of $9

million. The formal sale and purchase agreement was signed on 1 November

2012 and the assignment deed was executed on 1 December 2012.

Ans (b) Reef Limited and Carol Limited are not associated bodies corporate and no

exemption is available

As the stated consideration is below market value, the transaction is treated

as a voluntary deposition inter vivos and stamp duty is charged at the full

market value

Stamp duty payable under Head 1(1) is: $7.5 million x 3.75% = $281,250

The provisional sale and purchase agreement of residential property would

be subject to stamp duty under Head 1(1A)

However, it was superseded by the formal sale and purchase agreement

within 14 days and the later became the dutiable instrument

Stamp duty payable is: $9 million x 3.75% = $337,500

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If the sale and purchase agreement is duly stamped, the deed of

assignment will be subject to stamp duty of $100 only under Head 1(1)

Since the property was acquired by Coral Limited on or after 20 November

2010 and was disposed of with 24 months of the date of acquisition, special

stamp duty is payable under Head 1(1B)

The rate is 10% as the property has been held for six months or more but

less than 12 months

Special stamp duty is: $9 million x 10% = $900,000

3. (c) On 3 December 2012, Ocean Limited sold 15% of its shareholding in Reef

Limited to a third party at a consideration of $15 million.

Ans (c) Transfer of shares in a Hong Kong company must be registered in Hong

Kong and hence chargeable to stamp duty under Head 2(1)

Stamp duty payable is: $15 million x 0.2% = $30,000

A fixed duty of $5 is payable for the instrument of transfer under Head 2(4)

After the disposal of the 15% interest in Reef Limited, Ocean Limited and

Reef Limited ceased to be associated bodies corporate

Section 45(4)(a) provides that a stamp duty exemption will be withdrawn if

the transferor and the transferee cease to be associated due to a change in

shareholding in the transferee within two years following the date of transfer

Hence, stamp duty must be paid for the conveyance of Property A from

Ocean Limited to Reef Limited

Stamp duty is: $20 million x 3.75% = $750,000

The Collector shall be notified within 30 days of such cessation

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4.

Barry Tong received a notice of estimated profits tax assessment in respect of his sole

proprietorship business, Barry & Co., in which profits of $1,000,000 was assessed for the

year of assessment 2011/12. The notice was dated 20 November 2012. Barry has not

submitted a tax return for the year and he noted that the estimated profit was more than his

actual profit earned. Therefore, he came to your office for advice.

After meeting Barry, you have ascertained the following information:

1. The accounting profits of Barry & Co. for the year ended 31 March 2012 was

$550,000. This figure was arrived at after charging the following items:

(i) salary paid to Barry of $360,000;

(ii) mandatory contribution to MPF scheme for Barry of $18,000; and

(iii) donation of moon cake costing $8,000 to an elderly centre operated by Tung

Wah Group of Hospitals, an approved charitable institution.

2. Barry also carries on a partnership business (named “Leung Tong Kee”) with

Fanny Leung, sharing profits or losses equally. During the year ended 31

December 2011, the agreed tax loss of the partnership is $340,000.

3. Barry solely-owned a property in Lam Tin which was acquired in January 2011 and

let out for rental income from 1 March 2011 onwards for a term of two years at a

monthly rent of $12,000. A lease premium of $50,000 was received from the

tenant. Barry paid Government rent and mortgage loan interest of $4,300 and

$97,000 respectively for the year ended 31 March 2012 in respect of this property.

He also spent $7,000 to replace the window damaged by typhoon in September

2011.

4. Barry is single and ordinarily resides in Hong Kong. His mother, aged 70, resides

in a registered elderly care home. During the year, her residential fee of $80,000

was paid by Barry.

REQUIRED:

4. (a) (i) Without any computation, explain whether it is advantageous for

Barry Tong to elect for personal assessment for the year of assessment

2011/12.

Ans (a) (i) Because there is a share of partnership loss and unrelieved mortgage

interest expense on the rental property, it is clear that Barry Tong will be better

off in electing for personal assessment.

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4. (a) (ii) Calculate the Hong Kong tax liability for Barry Tong under personal

assessment for the year of assessment 2011/12.

Ans (a) (ii)

Barry Tong

Personal assessment

Year of assessment 2011/12

$

Net assessable value (see note 1) 135,200

Assessable profit (see note 2) 924,000

Total income 1,059,200

Less: Interest expense (97,000)

Elderly residential care expense (72,000)

890,200

Less: Share of partnership loss (170,000)

720,200

Less: Basic allowance (108,000)

Net chargeable income 612,200

Tax at progressive rates 92,074

Less: Tax reduction (12,000)

Final tax charged under personal assessment 80,074

Note 1: Net assessable value

Rent ($12,000 x 12) 144,000

Lease premium ($50,000 x 12/24) 25,000

Assessable value 169,000

Less: 20% statutory deduction (33,800)

135,200

Note 2: Assessable profit

Accounting profit 550,000

Add: Barry’s salary 360,000

MPF contribution 6,000

Donation 8,000

924,000

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4. (b) Advise Barry any penalties applicable to him and what he should do with

the notice of assessment received.

Ans (b) As Barry has not submitted a tax return, he failed to comply with the

requirement under section 51(1) and is guilty of an offence under section

80(2)

He will be subject to a fine at level 3 ($10,000) and a further fine of treble

the amount of tax which has been or would have been undercharged in

consequence of such non-compliance

However, the Commissioner may compound the offence

If no prosecution has been instituted under section 80(2), the Commissioner

may seek to impose additional tax under section 82A to an amount not

exceeding three times of the tax undercharged

Barry should note that the assessable profit of his sole-proprietorship

business is in fact greater than (instead of lower than) the estimated profits

as certain expenses are not deductible under profits tax

He should be advised to lodge an objection immediately, and in any event

not later than one month after the date of notice of assessment (section

64(1)), i.e. 20 December 2012

In this case where the estimated assessment was issued due to the

absence of a tax return, the objection will not be valid unless the duly

completed tax return is also submitted

The objection should contain the ground of objection, i.e. that the estimated

assessment is not in accordance with the amount disclosed in the tax return

submitted

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5.

Cambridge Trading Limited (Cambridge) carries on a trading business in Hong Kong and

its trading profits are chargeable to Hong Kong profits tax. In addition to trading, it has

entered into a number of agency contracts with overseas customers by providing sourcing

and other services in return for commission income. All these contracts were concluded by

the staff in Hong Kong.

Under these contracts, Cambridge is responsible for locating suppliers to manufacture the

goods for the clients, monitoring the production, maintaining quality control and arranging

the shipment of goods. Cambridge has in turn engaged agents in Mainland China and

Thailand to perform these services outside Hong Kong. Cambridge’s major roles are to

negotiate and enter into contract with the customers, liaise with the overseas agents and

monitor the status of these projects.

Upon delivery of the finished goods to the overseas customers, Cambridge is paid a

commission equal to 7% of the value of the export sales. Cambridge remunerates the

overseas agents at 5% of the value of the goods in consideration for their services.

The management of Cambridge is of the view that the commission income received from

these agency contracts should not be subject to profits tax in Hong Kong as the relevant

services which earned the income were performed by the agents outside Hong Kong.

As a separate issue, Cambridge is considering the purchase of certain designs to be used

in some of the products in trading to enhance their competitiveness in the market. The

management understands that acquisition of intellectual property right currently receives

favourable tax treatment, but is also subject to certain constraints. With a view of getting

the maximum tax relief, they wish to know more about the relevant provisions before

proceeding with the purchase.

REQUIRED:

5. (a) Advise the management on how the source of the commission income is

to be determined and evaluate if the income will be chargeable to Hong

Kong profits tax.

Ans (a) Section 14(1) imposes three conditions for a profit to be chargeable to

Hong Kong profits tax, namely:

- a person must carry on a trade, profession or business in Hong Kong;

- a profit is derived from that trade, profession or business; and

- the profit is arising in or derived from Hong Kong

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Cambridge carries on a business in Hong Kong and has earned

commission income from the business carried on in Hong Kong; the income

will be taxable if it is sourced in Hong Kong

In determining the locality of profits, the board guiding principle laid down in

CIR v Hang Seng Bank is that “one looks to see what the taxpayer has

done to earn the profit in question and where he has done it”

In ING Baring Securities (Hong Kong) Limited v CIR, the court emphasised

the need to grasp the reality of each case, focusing on effective causes

without being distracted by antecedent or incidental matters; the focus is on

establishing the geographical location of the taxpayer’s profit-producing

transactions as distinct from activities antecedent or incidental to those

transactions

Cambridge provided buying services to its overseas customers in return for

the commission income; for service income, the source is the place where

the services are performed which give rise to the service fees (paragraph

45(e) of DIPN No. 21)

The overseas agents were responsible for locating suppliers to

manufacture the goods, monitoring the production, maintaining quality

control and arranging shipment of goods; all these activities were

performed outside Hong Kong and without them Cambridge would not be

able to earn the commission income

Cambridge negotiated and entered into agency contracts with its customers

in Hong Kong, liaising with the overseas agents and monitoring the status

of the projects

There is an important distinction between the taxpayer managing its

business in Hong Kong and performing its profit-producing activities outside

Hong Kong; only the latter is relevant in determining the source of income

The activities performed by Cambridge in Hong Kong, although

commercially essential to the operations and profitability of the company,

could be regarded as antecedent or incidental to and not the profit-making

activities

On this basis, the 7% commission earned by Cambridge should be sourced

outside Hong Kong and non-taxable

The facts in this question resemble those in the Li & Fung (Trading) Limited

case in which the Court of Appeal has decided that the commission income

was not taxable

However, the IRD has indicated that the courts did not have the opportunity

to consider the entire facts of the case, and therefore the judgment does

not have wider application to other source cases

The Court of Final Appeal in Ngai Lik Electronics Co Ltd v CIR clearly

stated that sourcing and agency activities in Hong Kong might give rise to

assessable profits

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The IRD may contend that the relevant profit-producing activities were

Cambridge entering into the contractual arrangements in Hong Kong with

its customers and agents; furthermore, without its supervision and

management, Cambridge would not be able to carry out the buying

contracts and earn the commission income

It is therefore open for the IRD to argue that the overseas agents earned

the 5% commission income for their operations performed outside Hong

Kong, whereas Cambridge earned the remaining 2% commission for the

supervision and management services performed by the staff in Hong Kong

5. (b) Advise the management on the new legislation relating to the purchase

and disposal of registered design, including the related anti-avoidance

provisions.

Ans (b) Effective from the year of assessment 2011/12, expenditure incurred in the

purchase of copyright, registered design and registered trademarks for use

in the production of chargeable profits can be deducted under section

16EA

The design must be registered, which could be made either in Hong Kong

or overseas

The design must be used in Hong Kong by the taxpayer. In this case as the

trading activities are carried out in Hong Kong, the design is likely to be

used in Hong Kong.

Deduction is by five equal amounts over five years of assessment, starting

from the year in which the expenditure is incurred, provided that the

registered design is owned at the end of the basis period for that year

If the registered design has an expiry period of less than five years, the

purchase cost can be deducted in equal amount over the number of

remaining years of protection

A proportionate part of the expenditure is deductible if it is used partly for

producing chargeable profits

The deduction also includes legal and valuation fees incurred on the

acquisition of the design

Upon disposal, the proceeds are treated as trading receipts and the

difference is deductible if the sales proceeds are less than the unallowed

expenditure, and taxable if the sales proceeds are greater than the

unallowed expenditure (but restricted to amount already deducted)

No deduction is allowed if the design is acquired wholly or partly from an

associate; is under sale and license back arrangement; is licensed for use

wholly or principally outside Hong Kong by a person other than the

taxpayer; or where the whole or predominant part of the consideration was

financed directly or indirectly by a non-recourse debt

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6.

River Limited commenced business in Hong Kong ten years ago. Initially it prepared its

accounts to 31 December annually. In 2010, it changed its accounting date to 30 June. On

30 April 2012, the company ceased business. The adjusted profits before depreciation

allowance for the relevant years are as follows:

Year ended 31 December 2009 $2,300,000

6 months ended 30 June 2010 $1,500,000

Year ended 30 June 2011 $870,000

10 months ended 30 April 2012 $120,000

As at 30 June 2011, the reducing values of the pooling system are as follows:

20% pool $230,000

30% pool $170,000

The following information is extracted from the company’s records:

1. On 10 July 2011, the company acquired an electric car for $300,000. It was

subsequently sold on 5 March 2012 for $210,000.

2. On 15 August 2011, the company acquired a second-hand photocopier for $30,000

(asset ranking for depreciation allowance at 20%).

3. On 30 April 2012, the company sold all the assets under the 20% pool to Lake

Limited, a fellow subsidiary, for a consideration of $280,000.

4. The motor vehicles under the 30% pool were not sold at the time of cessation. The

market value of the vehicles was $120,000 as of 30 April 2012.

REQUIRED:

6. (a) Analyse the adjusted profits before depreciation allowance of River

Limited for the years of assessment from 2009/10 to 2012/13, showing

clearly the basis period for each year of assessment. Identify the year of

change and explain the basis of assessment for this year. Would your

answer be different if the change in accounting date in 2010 was due to

the alignment of the accounting date of River Limited with that of the

holding company?

Ans (a) Year of assessment 2009/10

Basis period: 1 January 2009 to 31 December 2009

Adjusted profits: $2,300,000

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Year of assessment 2010/11 (Year of change)

Basis period: 1 July 2009 to 30 June 2010

Adjusted profits: $2,300,000 x 6/12 + $1,500,000

= $2,650,000

Year of assessment 2011/12

Basis period: 1 July 2010 to 30 June 2011

Adjusted profits: $870,000

Year of assessment 2012/13

Basis period: 1 July 2011 to 30 April 2012

Adjusted profits: $120,000

The year of change is the year of assessment 2010/11, where the

company fails to make up an account to the corresponding day in the

following year of assessment – section 18E(1)(a)

The Commissioner is empowered to compute the profits for the year of

change and the preceding year on such basis as he think fit

Assessment is normally based on a 12-month period; for the year of

assessment 2010/11, profit for six months from 1 July 2009 to 31

December 2009 would be included and hence assessed twice

As a concession, the IRD may limit the basis period to a period of less than

12 months if the change of accounting date is for “compelling reasons” and

is not tax-motivated

If the change of the accounting date in 2010 was due to the alignment of

the accounting date with that of the holding company, it is possible that the

IRD may accept a basis period of six months from 1 January 2010 to 30

June 2010, and the adjusted profit will be $1,500,000 only

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6. (b) Calculate the tax reliefs or charges for River Limited for the year of

assessment 2012/13 based on the information given. Advise if any

aspects of your computation may need to be adjusted if (i) the assets

sold to the fellow subsidiary are found to be appreciably below the

market value of the relevant assets; and (ii) the motor vehicles in the 30%

pool were sold for $100,000 in November 2012.

Ans (b) Depreciation allowances on plant and machinery

20% Pool 30% Pool

$ $

W.D.V. b/f 230,000 170,000

Add: Photocopier 30,000

Less: Initial allowance (60%) (18,000) -

242,000

170,000

Less: Sale proceeds (280,000)

Market value of vehicles - (120,000)*

Balancing charge (38,000)

Balancing allowance 50,000*

* see explanation below

The electric car qualified as environmentally-friendly vehicle and the

purchase cost of $300,000 can be deducted under section 16I(2)

On subsequent disposal, the sale proceeds of $210,000 is taxable under

section 16I(2A)

Where assets qualifying for depreciation allowance are sold and both the

buyer and seller are persons over both of whom some other person has

control, the Commissioner shall determine the true market value for the

sale price of such assets for the purposes of calculating the balancing

allowance or charge, if the sale price does not represent the true market

value (section 38B); the assets sold to Lake Limited (which is a fellow

subsidiary of River Limited) at an under-value may need to be adjusted

upwards to the true market value

When the business has ceased and there is no sale, the Commissioner will

estimate the open market value of the vehicles and deem the amount to be

received immediately prior to the cessation (section 39D(4))

If the sale is made within 12 months of the cessation, the taxpayer may

claim adjustment of any balance allowance or charge (section 39D(5));

hence, balancing allowance for River Limited would be adjusted to $70,000

when the vehicles were sold in November 2012

END