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

ADMINISTRATORS

International Qualifying Scheme Examination

HONG KONG TAXATIONDECEMBER 2015

Suggested Answer

The suggested answers are published for the purpose of assisting students in theirunderstanding of the possible principles, analysis or arguments that may be identifiedin each question

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SECTION A

1.

Ruby Limited (RL) carries on a business of trading in household appliances in HongKong. Its profits are returned as assessable in Hong Kong. Its accounting profit aftertax for the year ended 31 March 2015 is $3,100,000, which is arrived at after takingthe following items into account:

Note $Income:Commission 1 25,000Dividends 24,600Interest income 2 85,800Unrealised gain on securities 3 56,000

Expenses:Amortisation of trademark 4 140,000Bad debts 5 112,570Contributions to MPF scheme 6 695,000Depreciation 274,000Exchange differences 7 17,000Interest expenses 8 322,000Profits tax 317,000Repairs and maintenance 9 103,650

Notes to the accounts:

1. During the year, RL was appointed by Creative Limited (CL), a company carryingon business in Taiwan, to be its sole agent selling a new vacuum cleaner in HongKong on consignment basis. The sales were not promising and RL terminated theagency agreement on 31 March 2015. The total sales made on behalf of CLduring the period were $200,000. RL has remitted the net sales (after deductingcommission income of $25,000) to CL.

$

2. Interest income:

Interest on deposits placed with DBS Bank in Singapore

(Principal of $4,000,000) 53,500

Interest on i-bonds issued by the Hong Kong Government

(Principal of $4,000,000) 25,000

Interest on short-term qualifying debt instruments (issued in 2013) 7,300

85,800

3. RL invested part of its surplus fund in securities which are listed on the StockExchange of Hong Kong. It was agreed that profits from the trading in these

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securities are chargeable to profits tax. In the preparation of the financialstatements, the securities held by the company were measured at fair value at theaccounting date and the unrealised gain was recognised in the income statement.

4. During the year, RL acquired a trademark which was registered both in HongKong and the Mainland at a total cost of $2,000,000. Legal expenses of $100,000were incurred. The values of the trademark registered in Hong Kong and in theMainland were $1,000,000 each. RL entered into a contract with an independentmanufacturer in the Mainland to produce a specific product bearing thattrademark. The products were sold in the Hong Kong market. The total acquisitioncosts of the trademark were amortised over 15 years for accounting purposes.

5. Bad debts:

Increase in allowance for doubtful accounts computed at specified

percentages of trade debts according to their age 33,000

Write-off of trade debt due from a customer in liquidation 79,570

112,570

6. Contributions to Mandatory Provident Fund (MPF) scheme:

Ordinary contribution at 10% of employees’ remuneration 595,000

One-off contribution to mark the company’s 20th anniversary 100,000

695,000

7. Exchange differences:

Unrealised loss on revaluation of time deposits 48,500

Gains on settlement of trade debts (31,500)

17,000

8. Interest expenses:

Bank interest paid on a loan of $8,000,000 from DBS Bank

in Hong Kong 217,000

Interest paid on a shareholder’s loan 105,000

322,000

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The general banking facilities with DBS Bank were secured by the depositsplaced with the bank in Singapore and the i-bonds (see note 2 above).

Interest on the shareholder’s loan was charged at 3% on the amount due to KeithChan when the company acquired a factory unit from him in 2013 and used it as awarehouse.

9. Repairs and maintenance: $

Replacement of carpet 37,000

Renovation to convert a meeting room into a showroom 50,000

General repairs and maintenance for office equipment 16,650

103,650

Additional information:

The depreciation allowance (other than that arising from the information given in thenotes above) agreed with the assessor for the year of assessment 2014/15 is$746,000.

On 20 November 2015, RL received a notice dated 18 November 2015 issued by theCommissioner alleging that he proposed to issue additional tax under section 82A ofthe Inland Revenue Ordinance because the company had failed to submit the profitstax return for the year of assessment 2013/14 by the specified date. RL submitted theprofits tax return two months after the deadline due to the pregnancy of theaccounting manager. RL has not objected to the assessment and the profits tax wasduly paid.

REQUIRED:

1. (a) Calculate the Hong Kong profits tax liability of Ruby Limited for the year ofassessment 2014/15. Ignore provisional tax.

(14 marks)

Ans (a) Ruby LimitedProfits tax computation

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Year of assessment 2014/15

Basis period: Year ended 31 March 2015 (section 18B(1))$ $

Profit per accounts 3,100,000Add: Amortisation of trademark 140,000

Depreciation 274,000Profits tax 317,000Increase in allowance for doubtful trade debts 33,000Special contribution to MPF scheme

($100,000 x 4/5) 80,000Unrealised loss on time deposits 48,500Interest paid to DBS Bank 53,500Interest paid on a shareholder's loan 105,000Renovation expense 50,000 1,101,000

4,201,000Less: Dividends (24,600)

Interest on deposits with DBS Bank (53,500)Interest on i-bonds (25,000)Unrealised gain on securities* (56,000)Trademark [($1,000,000 + $50,000) / 5] (210,000) (369,100)

3,831,900Less: Depreciation allowance (746,000)

Commercial building allowance ($50,000 x4%) (2,000) (748,000)

Assessable profits 3,083,900

Profits tax at 16.5% on ordinary receipts (3,076,600 =3,083,900 – 7,300) 507,639Concessionary rate on QDI receipts ($7,300 x 8.25%) 602

508,241Less: One-off tax reduction (20,000)Profits tax payable 488,241

* Alternate treatment of offering the gain as assessable in accordance with IRD’sinterim administrative measure is acceptable if this treatment is properly justified inpart (b) of the answer.

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1. (b) Advise the profits tax implications arising from the information given in note 1,including any obligations of Ruby Limited under the Inland Revenue Ordinanceand the consequence of it failing to meet these obligations.

(5 marks)

Ans (b) For RL, commission income was earned for the agency services it hasprovided in Hong Kong and is taxable

CL will be considered to be carrying on a business in Hong Kong through theagent it has appointed in Hong Kong, RL, which has a stock of merchandise inHong Kong from which RL regularly fills orders on CL’s behalf

Section 20A(3) requires an agent who makes consignment sales to submit aquarterly return to the Commissioner showing gross proceeds of such salesand at the same time to remit a sum equal to 1% of the gross proceeds orsuch lesser sum as the Commissioner may agree

In practice, only 0.5% of gross proceeds is demanded

CL’s profits tax liability in Hong Kong is $200,000 x 0.5% = $1,000

Alternatively, CL’s tax liability may also be ascertained in accordance withInland Revenue Rule 5 and it is open to CL to produce accounts to show thatits liability is in fact less than 0.5% of the gross sales proceeds

RL shall retain out of any assets in its possession or control a sufficientamount to meet the tax liability under section 20A(2)

The tax chargeable is recoverable by all means out of the assets of thenon-resident or from the agents (section 20A(1)); hence RL may be liable tosettle the consignment tax as it has failed to withhold and pay the tax beforeremitting the proceeds to CL

1. (c) Analyse the proper tax treatments for the items given in note 2 to 9 above.

(16 marks)

Ans (c) Interest income (note 2)

Interest income received by or accrued to a corporation is taxable undersection 15(1)(f) if the person carries on a business in Hong Kong and theinterest income arises from Hong Kong

While RL carries on a business in Hong Kong, interest on deposits placed withDBS Bank in Singapore is sourced outside Hong Kong as the provision ofcredit is outside Hong Kong; such interest is not chargeable to profits tax

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Interest income from i-bonds issued by the Government under the LoansOrdinance is exempt from profits tax under section 26A(1)(b)

Interest income on short-term qualifying debt instruments issued on or after 25March 2011 is subject to a reduction of tax rate by 50% under section 14A

Unrealised gain on securities (note 3)

RL held the securities for trading purposes and the unrealised gain is ofrevenue nature

Per DIPN No. 42, the IRD took the view that in determining the assessableprofits, it would follow the accounting treatment stipulated in HKAS 39 and anyunrealised gain recognised in the income statement is taxable

The Court of Final Appeal in CIR v Nice Cheer Investment Ltd (2013) ruledthat the word ‘profits’ connotes actual or realised and not potential oranticipated profits; furthermore, neither profits nor losses may be anticipated;hence, unrealised gains were held as not taxable

The IRD announced that, as an interim measure, it would accept the tax returnfor the years of assessment 2013/14 and 2014/15 filed on the fair value basis,but these could be re-computed if the taxpayer subsequently adopts therealisation basis

It would be beneficial for RL to exclude the unrealised gain from profits tax onthe basis of the court decision

Trademark (note 4)

The cost of acquisition of the registered trademark for use in the production ofchargeable profits is deductible under section 16EA(2) effective from the yearof assessment 2011/12; this cost includes the legal expenses incurred on theacquisition

The deduction is allowed by five equal instalments

Section 16EC(4)(b) stipulates that that no deduction is allowable if, at any timewhen the trademark is owned by a taxpayer, another person holds rights as alicensee, and the trademark is used wholly or principally outside Hong Kongby a person other than the taxpayer

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The Hong Kong registered trademark was used by RL itself for selling thefinished goods to produce profits chargeable to tax in Hong Kong; section16EC(4)(b) is therefore not applicable and RL can deduct one-fifth of thepurchase costs in the year of assessment 2014/15

The Mainland registered trademark was used by the contractor for theproduction of goods in the Mainland; as such, section 16EC(4)(b) is applicableand the purchase price for the Mainland registered trademark is not deductible

Bad debts (note 5)

Bad debts incurred are deductible under section 16(1)(d) if the trade debts areproved to have become bad, or are estimated to the satisfaction of theassessor to have become bad during the basis period, and they have beenincluded as taxable trading receipts

Actual write-off of trade debts for a customer in liquidation is thereforedeductible

However, a general allowance for doubtful accounts which is roughlyestimated (specified percentages of the amounts outstanding) is not regardedas ‘incurred’ and cannot be deducted

Contributions to MPF scheme (note 6)

Any ordinary contribution to a recognised retirement scheme for employees isdeductible up to an amount of 15% of the employee’s remuneration undersection 17(1)(h); the contribution of 10% is not excessive

Payment of a special contribution can be deducted over five years ofassessment under section 16A

Exchange differences (note 7)

An exchange gain arising from trade debts is revenue in nature and is taxable

However, an exchange loss on revaluation of foreign currency time deposits iscapital in nature and therefore not deductible under section 17(1)(c)

Interest expenses (note 8)

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To be deductible, under section 16(1)(a) interest expenses must be incurred inthe production of chargeable profits

Interest paid to DBS Bank is on money borrowed from a financial institutionand satisfies the condition under section 16(2)(d)

The borrowings were secured by the deposits placed with the bank inSingapore earning non-taxable interest income; hence, the deduction is to berestricted under section 16(2A)

The amount of interest related to the loan secured by the deposit with DBSBank in Singapore that is deductible is $217,000/2 - $53,500 = $55,500; theamount of interest related to the loan secured by the i-bond is fully deductible

For the interest on the shareholder’s loan, the condition under section 16(2)(c)is relevant because the lender is a person other than a financial institution

Since interest received by the lender is not taxable under section 15(1)(g),assuming Keith does not carrying on business in Hong Kong himself, thecondition under section 16(2)(c) cannot be fulfilled and the interest paid to himcannot be deducted

Repairs and maintenance (note 9)

Carpet falls under the category of ‘implement, utensil and article’; expenditureincurred on its replacement can be deducted under section 16(1)(f)

Capital expenditure on the refurbishment of non-domestic buildings can bededucted over five years under section 16F; however, this does not apply toexpenditure incurred to enable the building to be used for a purpose differentfrom that it was used for immediately before the expenditure was incurred

Instead, a commercial building allowance at 4% of the expenditure can beclaimed

1. (d) Advise Ruby Limited of the applicable penalties under the Inland RevenueOrdinance and the rights it has in respect of an assessment of additional taxunder section 82A.

(5 marks)

(Total: 40 marks)

Ans (d) Under section 51(1), an assessor may give notice to any person requiring himwithin a reasonable time stated in such notice to furnish a tax return

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Failing to comply with section 51(1) without reasonable excuse is an offenceunder section 80(2)

A taxpayer is liable on conviction to a fine at level 3 and a further fine of treblethe amount of tax undercharged or would have been undercharged

In D13/85, the Board of Review described the concept of ‘reasonable excuse’as ‘… what one would expect a reasonable person to do in all of thecircumstances’; the lack of accounting staff or the fact that the staff areincompetent were not accepted as reasonable excuses (e.g. D26/99 andD26/89)

In this case, the pregnancy of the accounting manager is not a reasonableexcuse for non-compliance with section 51(1)

Instead of instituting prosecution under section 80(2), the Commissioner mayimpose additional tax for an amount not exceeding treble the amount of taxwhich has been or would have been undercharged under section 82A

Before making an assessment of additional tax, the Commissioner or a deputycommissioner shall give notice to the taxpayer informing him of the allegedfailure, and the taxpayer has the right to submit written representations by adate not earlier than 21 days from the date of service of the notice

The Commissioner or deputy commissioner shall consider and take intoaccount the submitted representations before making the assessment

A person who has been assessed to additional tax under section 82A(1) shallnot be liable to be charged on the same facts with an offence under section80(2) or 82(1)

The taxpayer has the right to lodge an appeal to the Board of Review withinone month after the notice of assessment is given to him on the followinggrounds:

- he is not liable to additional tax, for example, he can prove that the return wassubmitted on time or there was a reasonable excuse for late submission;

- the amount of additional tax assessed on him exceeds the amount for whichhe is liable; or

- the amount of additional tax is excessive having regard to the circumstances

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SECTION B

2. Phillip Wein is an Australian resident. He is employed by an Australian-basedcompany, Brilliant Corporation (BC), as a regional manager. He is required tooversee the operations of various group companies in East Asia. The InlandRevenue Department has agreed that Phillip has a non-Hong Kong sourcedemployment.

Phillip’s travel record during the year ended 31 March 2015 was as follows:

Hong Kong 123 daysChinese mainland 95 daysJapan 30 daysAustralia 92 days (including 30 days’ annual leave)Other countries 25 days

Phillip has provided you with the following information for the year ended 31 March2015:

1. He received an annual salary of $730,000.

2. He also received a travel allowance of $50,000 which he used fully for airtickets for his home leave.

3. Phillip was provided with a hotel room during his stay in Hong Kong. Totalhotel charges of $123,000 were paid by BC. It was agreed that 5% of thehotel charges would be deducted from his payroll.

4. Phillip joined a social club which he used to entertain clients while he was inHong Kong. He paid an annual subscription fee of $7,000 and obtained a fullrefund for this from BC.

5. He was also provided with a corporate credit card on which he could chargeall business entertainment expenses. During the year, a total amount of$156,000 was charged to the credit card, including $12,000 for a diamondring which he bought for his wife as a souvenir. All the credit card bills werepaid by BC.

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6. He was enrolled in the company’s medical insurance scheme. His medicalbills for Chinese medicines of $5,000 were not accepted by the insurancecompany. After negotiation, he claimed a refund from BC.

7. During the year, BC paid the following tax bills on Phillip’s behalf:

Hong Kong salaries tax $31,000Chinese income tax $43,000

8. On 1 July 2014, Phillip was unconditionally granted an option to acquire100,000 shares in BC at $5 each. On 1 August 2014, he sold one-half of theoption and received $250,000. On 2 March 2015, he exercised the option forthe remaining shares and sold the shares two days afterwards. The marketvalues per share were as follows:

1 July 2014 $81 August 2014 $112 March 2015 $94 March 2015 $10

9. Phillip is enrolled in BC’s retirement scheme in Australia and has contributed$73,000 to the retirement scheme during the year.

10. Phillip is married and his wife is a nurse working in Australia. They have ason, aged 17 during the year, who attends school in Australia.

REQUIRED:

2. (a) Based on the information provided, advise Phillip Wein of his Hong Kongsalaries tax position, including the basis of assessment and how hisassessable income is to be determined.

(8 marks)

Ans (a) The IRD has agreed that Phillip has a non-Hong Kong sourcedemployment; his salary will be chargeable to Hong Kong salaries tax undersection 8(1A)(a) in respect of income derived from his services rendered inHong Kong

Since he has spent more than 60 days in Hong Kong in the year ofassessment, the exemption under section 8(1A)(b) and 8(1B) does notapply even though he may be regarded as a visitor for tax purposes

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Phillip’s assessable income will be computed on a time-apportionmentbasis; this applies to all income and benefits derived from his employment

However, since Hong Kong only imposes salaries tax on Phillip’s incomederived from services rendered in Hong Kong, his Hong Kong salaries taxpaid by the employer (a discharge of his personal liability) is fully taxablewithout apportionment

On the other hand, it is likely that his Chinese income tax paid by theemployer is for his services rendered outside Hong Kong and is wholly nottaxable

Under section 8(1A)(a), leave pay attributable to services rendered in HongKong is also taxable; although Phillip took his annual leave in Australia, thenumber of days of leave which is attributable to Hong Kong services will betaken into account in apportioning his assessable income

Since Phillip was provided with a room in a hotel in Hong Kong, the rentalvalue of 4% on his assessable income (after time-apportionment) will betaxable, but the rental value can be reduced by his contribution to hisemployer

His travel allowance is used for his home leave (holiday journey) and istaxable

Although Phillip entertained clients at the club, joining a social club is notessential to his performance of duties; the club subscription fee is notwholly, exclusively and necessarily incurred for the purpose of producingchargeable income and is not deductible under section 12(1)(a); the refundrepresents a cash allowance and is taxable

The purchase of a diamond ring which Phillip has charged to the corporatecredit card which was settled by the employer is taxable; in ordinary usage,the cardholder has a liability to pay for the goods received which have beeneffectively discharged by the employer

The refund of the medical bills of $5,000 from the employer is also taxablebecause the sum is derived from his employment and for services rendered

For the share options, any gain realised upon the exercise, assignment orrelease of the option will be subject to salaries tax under section 9(1)(d)

2. (b) Calculate Phillip’s Hong Kong salaries tax liability for the year ofassessment 2014/15. Ignore provisional tax. Round the number of days to

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the nearest integer in your calculation.

(12 marks)

(Total: 20 marks)

Ans (b) Phillip WeinSalaries tax computation

Year of assessment 2014/15$ $

Annual salary 730,000Travel allowance 50,000Refund of club subscription 7,000Personal expense charged to credit card 2,000Refund of medical bills 5,000

804,000

Assessable income under time-apportionment*($804,000 x 134 / 365) 295,167

Hong Kong salaries tax paid by employer 31,000326,167

Rental value ($326,167 x 4%) 13,047Less: Rent suffered ($123,000 x 5%) (6,150) 6,897Share option gain:

- assignment 250,000- exercise [50,000 x ($9 – $5)] 200,000

450,000Apportioned on the number of days ($450,000 x 134/365) 165,205Total assessable income 498,269Less: Concessionary deductions

Contribution to retirement scheme -498,269

Less: Personal allowancesMarried person's allowance (240,000)Child allowance (70,000) (310,000)

Net chargeable income 188,269

Tax at progressive rates 20,005

Tax at standard rate (15%) 74,740

Salaries tax payable at progressive rate 20,005

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Less: One-off tax reduction (75%) (15,004)5,001

* No. of days chargeable to salaries taxNo. of days in Hong Kong 123Leave days attributed to Hong Kong services

(30 days x 123 / 335) 11134

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3. As of 1 July 2015, Wonderful Limited wholly-owned Beautiful Limited and PeacefulLimited. Beautiful Limited in turn wholly owned Graceful Limited. All thesecompanies are incorporated in Hong Kong. The group chart is shown below:

Due to business re-structuring, the following transactions have been carried out:

REQUIRED:

Analyse the Hong Kong stamp duty implications arising from the above transactions. Inyour analysis, you are required to:

- discuss whether stamp duty is payable,

- calculate any stamp duty payable,

- indicate the time within which the stamp duty should be paid, and

- address the consequence of failing to pay the duty within that time.

(Total: 20 marks)

3. (a) On 2 July 2015, BL sold all its shareholding in GL to PL for a consideration of$20,000,000.

Upon receiving the sale proceeds from PL on 16 July 2015, BL distributed$10,000,000 as dividends to WL.

On 3 August 2015, WL sold 15% of its interest in PL to a third party, JumboLimited, for a cash consideration of $5,000,000. Jumbo Limited also took up abank loan of $2,000,000 borrowed by PL and due to HSBC.

(13 marks)

Wonderful Limited(WL)

Beautiful Limited(BL)

100%

Graceful Limited(GL)

100%

Peaceful Limited(PL)

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Ans (a) Disposal of shares in GL by BL to PL (2 July 2015)

For the transfer of Hong Kong stock, stamp duty is payable at 0.1% on boththe bought note and sold note under Head 2(1)

However, an exemption can be sought under section 45 of the Stamp DutyOrdinance for the transfer between associated bodies corporate

BL and PL were associated bodies corporate because a third bodycorporate, WL, was the beneficial owner of not less than 90% of the issuedshare capital of BL and PL

Section 45(4)(a) provides that an exemption shall not apply if theinstruments are executed in connection with an arrangement under whichpart of the consideration is provided or received, directly or indirectly, by aperson other than an associated body corporate of the transferor ortransferee

Upon receiving the sale proceeds, BL distributed $10 million as dividend toits shareholder, WL; as WL wholly owns BL, this may not affect theexemption

However, if WL in turn distributes the dividend to its shareholders as part ofthe arrangement, the section 45 exemption would be lost

Disposal of 15% interest in PL by WL to Jumbo (3 August 2015)

Implications of the transaction on 2 July 2015

Section 45(4)(c) further provides that no exemption is available if, as part ofthe arrangement, the transferor and transferee were to cease to beassociated by reason of a change in the percentage of the issued sharecapital of the transferee held by the transferor or a third body corporate

WL has sold 15% of its interest in PL to Jumbo Limited, a third party; PLtherefore ceased to be an associate after the share transfer and hence theexemption for the transfer of the shares on 2 July 2015 would be lost

BL and PL must notify the Collector of Stamp Revenue that they haveceased to be associated within 30 days after the date of the cessation(section 45(5A)) if prior exemption has been sought

On the assumption that the purchase consideration represents the fair

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market value of the shares transferred, stamp duty payable is:

$20,000,000 x 0.2% = $40,000

The instrument of transfer is stampable at $5 under Head 2(4)

Disposal of 15% interest in PL by WL to Jumbo (3 August 2015)

Stamp duty on the transaction

Under section 24(3), where there is a transfer of shares in a body corporateand the transferee assumes a liability of that body corporate, the amount ofliability so assumed is taken as part of the consideration chargeable withstamp duty

Jumbo Limited took up the bank loan of $2 million due to HBSC; this shouldbe included in the consideration chargeable with stamp duty

Stamp duty payable is:

$7,000,000 x 0.2% + $5 = $14,005

Consequence of late stamping

For the transfer of Hong Kong stock, all bought and sold notes should bestamped within two days if the sale and purchase is effected in Hong Kong,while the instrument of transfer should be stamped before execution

Since stamp duty has not been paid in respect of all the transactions, apenalty for late stamping will apply to the transfer of the shares between BLand PL, and that between WL and Jumbo Limited

Since the delay is more than two months, under section 9 the penalty is 10times the amount of stamp duty

However, the Collector may partly or wholly remit the penalty payabledepending on individual circumstances of each case

In a voluntary disclosure case, if the delay was not deliberate, the followingformula is adopted in calculating the reduced penalty, subject to a minimumsum of $500:

14% x stamp duty payable x (No. of days delayed / 365 days)

3. (b) On 16 November 2015, BL entered into an agreement to acquire a commercialunit in Wong Chuk Hang for $9,000,000 from a property developer. The

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conveyance on sale was executed on 30 November 2015. On the same day, BLleased the unit to PL for a term of five years. The monthly rent is $50,000 with arent-free period of two months. In addition, a lease premium and a refundabledeposit of $120,000 and $100,000 respectively were paid upon the signing of theagreement.

(7 marks)

No stamp duty has yet been paid in respect of all these transactions. Today is 1December 2015.

Ans (b) Acquisition of Wong Chuk Hang Property by BL (16 November 2015)

Effective from 23 February 2013, an agreement for sale of anynon-residential property is also chargeable to stamp duty under Head 1(1A)

Stamp duty on the agreement for sale is:

$9,000,000 x 7.5% = $675,000

If the agreement for sale is duly stamped, the conveyance on sale ischargeable at $100 under Head 1(1)

Buyer’s stamp duty and special stamp duty do not apply in this casebecause the property involved is a non-residential property

Stamp duty on the agreement for sale and conveyance on the sale ofimmovable property should be paid within 30 days after the execution of theinstruments (i.e. not later than 16 December 2015 and 30 December 2015respectively)

Lease agreement between BL and PL on 30 November 2015

The lease of immovable property is subject to stamp duty under Head 1(2)

The rate of stamp duty is 1% on the average yearly rent as the lease termexceeds three years

Stamp duty payable is:

Rent portion: ($50,000 x 58 / 60) x 12 x 1% = $5,800

Premium: $120,000 x 4.25% = $5,100

The duplicate copy is stampable at $5 under Head 4

The lease of immovable property must be stamped within 30 days (i.e. notlater than 30 December 2015)

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4. Brian Lee owns a residential property in Central which he inherited from his fathera few years ago. The property was let to Tony Chan in January 2013 for two yearsat a monthly rent of $20,000. Tony moved out from the property in June 2014leaving a note to Brian indicating that he decided to terminate the lease on 31 May2014 and he was sorry that he had not paid the rent for the period from 1 February2014 to 31 May 2014. He also failed to pay the building management fee of $5,000which was then settled by Brian. The Inland Revenue Department has agreed thatthe unpaid rent debt had become bad in June 2014. Brian held two months’ rentaldeposit from Tony.

Brian engaged an agent to secure a new tenant on the following terms:

Duration of lease: Two years from 1 August 2014

Monthly rent: $24,000 (inclusive of rates and management fee)

Rental deposit: $48,000

Lease premium: $60,000

During the year ended 31 March 2015, Brian paid the following expenses inrelation to this property:

Agency fees: $20,000

Building management fees: $15,000

Rates and Government rent: $11,400 and $8,640 respectively

Brian owns another property, in Wanchai, which was purchased in 2013 and whichhe has occupied as his place of residence since then. He financed the purchasewith a loan from Bank of East Asia which was secured by a charge over hisproperty in Central. During the year ended 31 March 2015, he paid interest of$132,500 on this loan.

Brian carries on a partnership business with Victor Fung in Hong Kong. For theyear of assessment 2014/15, the partnership loss as agreed with the IRD was$150,000. Brian and Victor shared profits and losses in the business equally. Eachof them drew an annual salary of $100,000 from the partnership.

Brian also provides consultancy services as a self-employed person. The

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assessable profits from this consultancy business were $260,000 for the year ofassessment 2014/15. He has donated $150,000 to a university, an approvedcharitable institution, to set up a scholarship and has deducted the maximumamount of donation in computing the assessable profits.

Brian is single and he has no dependants.

REQUIRED:

4. (a) Calculate the Hong Kong property tax payable in respect of the Centralproperty for the year of assessment 2014/15. Ignore provisional tax.

(6 marks)

Ans (a) Property tax computationYear of assessment 2014/15

$Rent ($20,000 x 2) + ($24,000 x 8) 232,000Lease premium ($60,000 x 8/24) 20,000

252,000Less: Irrecoverable rent ($80,000 - $40,000) (40,000)Assessable value 212,000Less: Rates paid by owner (11,400)

200,600Less: 20% statutory deduction (40,120)Net assessable value 160,480

Tax payable at 15% 24,072

4. (b) Determine Brian’s tax liability under personal assessment for the year ofassessment 2014/15 and advise if it is advantageous for him to do theelection. Show all your workings.

(8 marks)

Ans (b) Brian LeePersonal assessmentYear of assessment 2014/15

$Net assessable value 160,480Net assessable income -Assessable profits 260,000Total income 420,480

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Less: Concessionary deductionsApproved charitable donation

($150,000 - $140,000) (10,000)Home loan interest (100,000)

310,480Less: Share of partnership loss ($150,000 x ½) (75,000)

235,480Less: Personal allowance

Basic allowance (120,000)Net chargeable income 115,480

Tax at progressive rates 7,857Less: Tax reduction (75%, maximum $20,000) (5,893)Tax payable under personal assessment 1,964

Tax payable without personal assessment: $

Property tax [see part (a)] 24,072

Profits tax of sole-proprietorship business:

($260,000 x 15% - $20,000) 19,000

43,072

Tax saving with personal assessment:

($43,072 - $1,964) 41,108

The tax saving is due to the deduction of more approved donations under personalassessment, the utilisation of the share of partnership loss, and the deduction ofhome loan interest and personal allowance, which are available under personalassessment.

4. (c) Advise Brian on the following:

(i) the requirements for the election of personal assessment; and

(ii) the conditions for the deductibility of the interest paid to Bank of EastAsia.

(6 marks)

(Total: 20 marks)

Ans (c) To be eligible for personal assessment, an individual must be of or above the

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age of 18, or under the age of 18 with both parents dead; and who, or whosespouse, is either a permanent resident or a temporary resident

‘Permanent resident’ means an individual who ordinarily resides in HongKong

It appears that Brian is ordinarily resident in Hong Kong (he has maintained aplace of abode and with businesses carrying on in Hong Kong) and he will beeligible to be assessed under personal assessment

The election must be made in writing and lodged with the Commissioner ofInland Revenue not later than two years after the end of the year ofassessment concerned or one month after an assessment forming part of thetotal income for the year of assessment is final and conclusive; or furtherperiod as the Commissioner may allow; whichever is the later

Under section 26E, home loan interest paid can be deducted from aperson’s income up to a maximum of $100,000 under personal assessment

Brian is the owner of the property in Wanchai, which is situated in Hong Kongand which is for residential use

It was used by Brian as his place of residence

The lender is a financial institution

The loan is secured by a charge over another property which is situated inHong Kong

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5. Bravery Limited carries on a food processing business in Hong Kong. In August2014, it acquired a new three-storey building in Kowloon Bay and put it into thefollowing use:

Ground floor Leased to a motor car company, one half of the floor wasused as a showroom and the rest was used as a workshopwhere the cars were tuned and repaired if necessary beforethey were placed in the showroom.

First floor Leased to a computer distributor for storing goods.

Second floor Used by Bravery Limited for food production, except for15% of the area which was used for a small office.

Bravery Limited entered into the following transactions during the year ended 31March 2015:

1. $200,000 was incurred on leasehold improvements to the second floor of thenew building. Another $50,000 was spent on installing environmentally-friendlylighting.

2. Machines used in the production processes were acquired for $167,000.

3. A hybrid electric car (powered by fuel and battery) was acquired for $330,000.An old diesel motor car was sold for $67,000.

4. A food processing machine (depreciation rate: 20%) was acquired underhire-purchase on the following terms:

Cash price: $145,000

Down payment: $45,000 (paid on 1 September 2014)

Monthly installment: $10,000 for 12 months (starting from 1 October 2014)

5. Office equipment was transferred from the Macau branch office. It had beeninitially acquired for $40,000 and used by the Macau office for two years beforebeing transferred and used in the Hong Kong business. Its market value on thedate of transfer was $9,300.

6. New furniture and office equipment were acquired for $80,000.

The tax written down values of the pooling system as of 31 March 2014 are:

20% (comprising furniture and equipment) $323,000

30% (comprising motor vehicles) $117,000

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REQUIRED:

5. (a) Analyse the type of allowances available to Bravery Limited under profitstax in respect of the Kowloon Bay property. No calculation is required in thispart.

(8 marks)

Ans (a) An industrial building is defined in section 40(1) as building or structure usedfor a qualifying trade, which includes, inter alia, the following:

- a trade consisting of the subjection of goods or materials to any process;

- a trade consisting of the storage of goods or materials which are to beused in the manufacturing of other goods or materials, or on their arrivalinto Hong Kong

An industrial building excludes an office and showroom

If the non-qualifying use amounts to not more than 10% of the total capitalexpenditure, such non-qualifying use can be ignored

It is not necessary for the building to be used by the owner; he could claimthe relevant allowance if the building is put into qualifying use by the tenant

The ground floor was used by the tenant selling motor cars; the portion usedas a showroom does not qualify as an industrial building; the part used as aworkshop also does not qualify because the repairing activities are onlyincidental to the car selling business

A commercial building is a building other than an industrial building

Hence, Bravery Limited should be able to claim commercial buildingsallowance in respect of the ground floor

The tenant on the first floor carries on a computer distribution business; thetrade is not one of storage; the storage of goods is only incidental to itsdistribution business

Hence, Bravery Limited should be able to claim commercial buildingsallowance in respect of the first floor

Bravery Limited used 85% of the second floor for food production, which isone of the qualifying uses; the portion used as office is more than 10% andhence cannot be ignored for the purpose of calculating the industrialbuildings allowance

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It should be able to claim industrial buildings allowance on 85% of theexpenditure in respect of the second floor, and commercial buildingsallowance on the remaining 15% of the expenditure

5. (b) Discuss and compute the depreciation allowances under profits tax basedon the information given for transactions 1 to 6 above. Show your workings.

(12 marks)

(Total: 20 marks)

Ans (b) Bravery Limited may claim industrial buildings allowance for the leaseholdimprovement carried out in the second floor, but only up to 85% of the cost:

Initial allowance: $200,000 x 85% x 20% = $34,000

Annual allowance: $200,000 x 85% x 4% = $6,800

For the portion used as office, commercial buildings allowance is available:

Annual allowance: $200,000 x 15% x 4% = $1,200

Environmentally-friendly lighting qualifies for a deduction over five yearsunder section 16I(3), i.e. the deduction is $10,000 for the year ofassessment 2014/15

Machines used directly and specifically in the production processes qualifyfor a deduction as prescribed fixed assets under section 16G(1); the full costof $167,000 is deductible in the year

A hybrid electric car is an environmentally-friendly vehicle and the purchasecost can fully be deducted under section 16I(2)

Although the food processing machine may be used directly or specifically infood processing, it was acquired under hire-purchase and therefore does notqualify for a deduction under section 16G; instead depreciation allowancescan be claimed under the non-pooling system

For office equipment which was not previously used for producingchargeable profits now brought into the business, the capital expenditureincurred shall be computed by deducting notional annual allowances fromthe original cost (section 39B(6)); its market value is irrelevant

Depreciation allowances on plant and machinery20% Pool 30% Pool

$ $

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W.D.V. b/f 323,000 117,000Equipment bought into use

($40,000 x 0.8 x 0.8) 25,600Additions 80,000Less: Initial allowance (60%) (48,000) -

380,600 117,000Less: Disposal - (67,000)

380,600 50,000Less: Annual allowance (76,120) (15,000)W.D.V. c/f 304,480 35,000

Food processing machine under hire-purchaseCost 145,000Less: Initial allowance

($45,000 + $100,000 x 6/12) x 60% (57,000)88,000

Less: Annual allowance (20%) (17,600)W.D.V. c/f 70,400

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6. (a) Dr Wilfred Wong is an ear, nose and throat specialist. He is going to start his ownprivate practice in form of a sole-proprietorship business. He has heard from hisfriend that using a service company may help him reduce his profits tax liability.Specifically, he has been told that he should set up a limited company whichwould provide services to his clinic in return for a management fee. He wonders ifthis is feasible and has approached you, as a tax consultant, for advice.

REQUIRED:

Advise Wilfred on the following:

(i) How the service company arrangement could help reduce his profitstax payable.

(6 marks)

(ii) The minimum requirements that must be satisfied for the arrangementto be acceptable to the Inland Revenue Department.

(6 marks)

Ans (a) (i)

The profits earned by the clinic will be subject to profits tax at 15%; anydeduction is limited to those expenses which are incurred in theproduction of chargeable profits; Wilfred’s personal expenses cannot bededucted

With a service company, it is possible for that company to enter into anagreement with the firm (the clinic) under which the service company mayprovide premises, staff, plant and equipment, miscellaneous supplies (e.g.medical, stationery, etc.) or other services to the clinic in return for amanagement fee

If the management fee paid is allowed as a deduction and exceeds thecost that would have otherwise been incurred by the firm, the assessableprofits of the firm will be reduced

The service company will in turn seek to minimise its exposure to tax onthe excess payment by claiming deductions for tax efficient remunerationprovided to the proprietor of the firm as employee or director of the servicecompany, such as housing accommodation and other fringe benefits

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which are not convertible into cash and hence not assessable undersalaries tax (e.g. the use of a motor car and running costs charged to thecompany’s account)

By deducting certain private expenses of the proprietor which otherwiseare not deductible by the firm, a tax saving is achieved through the servicecompany despite the fact that any of its residual profits will be subject to ahigher profits tax rate of 16.5% plus other necessary costs, such asauditing, for having a service company

(ii)

DIPN No. 24 sets out the minimum requirements which must be satisfiedto support a claim for the deduction of a management fee

The service company has to function as a separate business operating onan arm’s length basis in its dealing with the firm

The respective rights and obligations and dealings with each other shouldbe properly documented

The service agreement should specify the relevant services and the basison which fees are to be paid

Other documents to be kept include minutes of meetings approving theterms of the agreement, invoices and receipts, working papers in respectof the calculation of the fees charged, bank records and employmentcontracts

The firm may only deduct the management fee for ‘qualifying services’,which encompasses non-professional services which are required toprovide the infrastructure in which the firm operates and to cater for itsday-to-day operations; it does not extend to the provision of any servicesto a firm by its proprietor as employee of the service company

For the management fee to be charged at an arm’s length basis, theamount involved should reflect the costs of the service company whichare directly attributable to the relevant services (e.g. salary paid to atypist) plus an appropriate mark-up to provide for the operating expenses(e.g. rent of premises occupied by the service company itself) andreasonable profit margin for the company

A profit margin of not more than 12.5% of the cost element is generallyaccepted as being commercially realistic

The firm and the service company should prepare their accounts to thesame date

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6. (b) Canyon Limited commenced business in Hong Kong in 1970 and currentlyprepares its accounts to 31 December annually. The company has beenprofitable. Recently it diversified its business and as a result, its peak season nowfalls in the period from November to January when the company needs to stockup substantial inventories. The management wants to change the accountingyear-end date from 31 December to 31 March. Specifically, the company’s nextset of financial statements will cover the 15 months to 31 March 2016. The lastset of accounts was prepared for the year ended 31 December 2014.

REQUIRED:

Advise the management of the profits tax implications arising from thechange in the accounting date and how the profits in the years ofassessment 2014/15 and 2015/16 will be assessed. State the relevantbasis periods clearly in your answers.

(8 marks)

(Total: 20 marks)

Ans (b) There will be a change in the accounting date in the year of assessment2015/16 because the accounts will not be prepared to the correspondingday in the year, i.e. 31 December 2015

The Commissioner is empowered to compute the assessable profits for theyear of change (year of assessment 2015/16), and to re-compute theassessable profits for the preceding year (year of assessment 2014/15) onsuch basis as he thinks fit (section 18E(1))

The practice of the IRD is to assess the year of change by adhering to thenew accounting date as soon as possible

Normally the basis period should be 12 months to the accounting date(section 18B(2)). Section 18E(2) only allows the Commissioner to usemore than 12 months in case of business which commenced on or after 1April 1974. Hence for an old business, like Canyon Limited, it is possiblethat there will be a drop-out period of three months. Because of the powerunder section 18E, the Commissioner can choose as the basis periodeither the 12 months ending 31 March 2016 or the 12 months ending 31December 2015

In practice, the IRD usually allows a drop-out period of three months on the

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basis that the period left out of assessment is not a high profits period

In Yick Fung Estates Limited v CIR, it was held that the Commissioner wasnot entitled under section 18E to assess an old business for a basis periodexceeding 12 months; however, if the change in accounting date wasmade for the sole and dominant purpose of obtaining a tax benefit, thensection 61A could be invoked to counteract the tax benefit

On the facts given, one can argue that the change of accounting date wastriggered by the change in the company’s peak season; this appears to bea possible genuine business reason and may be acceptable by theCommissioner

Canyon Limited may seek advance ruling for the sake of certainty

If the Commissioner accepts that the change in accounting date is notprimarily for tax-avoidance purposes, the assessment will be made asfollows:

Year of assessment Basis period

2015/16 1 April 2015 – 31 March 2016

2014/15 1 January 2014 – 31 December 2014

(as originally assessed); or

1 April 2014 – 31 March 2015 (may be revised);

depending on which basis gives a higher profits

Otherwise, the basis period for the year of assessment 2015/16 wouldcover 15 months from 1 January 2015 to 31 March 2016

END