THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES. Suggested Answers

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1 THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES Suggested Answers Level : Professional Subject : Hong Kong Taxation Diet : June 2006 The suggested answers are published for the purpose of assisting students in their understanding of what may be expected from a good candidate in the time allowed for each paper. They are in no way exhaustive nor model answer to the questions. They do not reflect the opinion of HKICS. 1

2 THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES HONG KONG TAXATION JUNE 2006 Suggested Answers SECTION A 1.(a) Obligation to notify the Commissioner of his chargeability to tax within four months from the end of the relevant year of assessment. (section 51 (2)) Obligation to notify cessation of source of income within one month of cessation. (section 51 (6)) Obligation to notify the Commissioner if about to leave Hong Kong one month before the date of departure. (section 51 (7)) Obligation to notify any change of address within one month of change. (section 51 (8)) (b) Net chargeable income or net assessable profit or net assessable value is likely to be less than 90% of that estimated. Cessation of source of income. Valid objection has been lodged against the preceding year s assessment. Election of personal assessment made which will reduce the overall tax liability. Loss brought forward has been omitted in computing the amount of assessable profit in the current year. Entitlement to new personal allowances under salaries tax. 2

3 (c) M & J Partnership Profits tax computation Year of assessment 2004/05 Mary Joseph Total $ $ $ Salaries 300, , ,000 Residual 100, , ,000 Assessable profit 400, ,000 1,000,000 Assessable profit transferred to personal assessment (400,000) Assessable profit of the partnership 600,000 Profits 16% 96,000 (d) Gordon Limited Depreciation allowance schedule Year of assessment 2003/04 Industrial building allowance Commercial building allowance $ $ Additions 3,600,000 (60%) 2,400,000 (40%) Less: IA (20%) (720,000) - W.D.V. c/f 2,880,000 2,400,000 Year of assessment 2004/05 Industrial building allowance Commercial building allowance $ $ W.D.V. b/f 2,880,000 2,400,000 Less: AA (4%) (144,000) (96,000) W.D.V. c/f 2,736,000 2,304,000 3

4 (e) Florence Chan Salaries tax Year of assessment 2004/2005 $ Market value at the time of exercise (5,000 x 4) 20,000 Days rendering services in Hong Kong during the vesting period 350 Total amount of days in the vesting period 730 Taxable gain attributable to services rendered during the vesting period (20,000 x 350/730) 9,589 (f) Peter Wong Salaries tax Year of assessment 2004/05 $ $ Salaries 30,000 x ,000 Add: Rental value 360,000 x 10% 36,000 Rent suffered (16, ,000 15,000) x 12 (30,000) 6,000 Gratuity 60,000 Assessable income 426,000 (g) Rental income from land and buildings is subject to profits tax if the rental income is a receipt from a trade or business carried on by the recipient in Hong Kong, such as: Letting or subletting of a property by a corporation is deemed to be a business under section 2 (1). Sub-letting by any other person (not a corporation) of any premises held under a lease or tenancy other than from the HKSAR Government. Letting and related activities carried out by any other person (not a corporation) amount to carrying on a trade or business as a matter of fact under section 14(1). (h) Permanent resident means an individual who ordinarily resides in Hong Kong. Temporary resident means an individual who is in Hong Kong: for a period amounting to more than 180 days during the tax year, or more than 360 days over two consecutive years of assessment, one of which is the year for which an election is sought. The time limit for making an election for personal assessment is the later of: 4

5 two years after the end of the year of assessment in respect of which the election is to be made; or one month after the notice of assessment on income which will fall into the total income has become final and conclusive. (i) (j) It would be possible to apply transfer pricing arrangements with a subsidiary. A Hong Kong subsidiary will be able to delay the declaration of dividends to its overseas holding company, so that the holding company can defer the tax on dividend income to a later period. A subsidiary will only be required to submit its own audited accounts to the Inland Revenue Department, avoiding any need to submit the overseas holding company s accounts in Hong Kong. A subsidiary will be assessed to tax in accordance with its actual profit sourced in Hong Kong, whereas a branch could be assessed based on one of the arbitrary methods as provided under Inland Revenue Rules 5. Gift of immovable property or Hong Kong shares to a charity. Transfer of immovable property or Hong Kong shares between associated companies. Conveyance of immovable property or Hong Kong shares involving a debt that is greater than the market value of the property. Transfer of immovable property or Hong Kong shares which is/are a life time gift. Foreclosure order. 5

6 SECTION B 2. (a) Circumstances when an assessment becomes final and conclusive under section 70 are: where no valid objection nor appeal has been lodged. where an objection or appeal has been withdrawn or an appeal has been dismissed. where an assessment under objection has been settled by agreement or determination without further appeal. (b) Under section 70A of the Inland Revenue Ordinance, if it can be established that the assessment is excessive by the reason of error or omission, the taxpayer may apply for the assessment to be reopened within six years after the end of that year of assessment or six months after the issue of the notice of assessment. If however the taxpayer has deliberately made an error in order to achieve certain purposes or advantages and he subsequently changed his mind, section 70A claim will not be accepted (Extramoney Limited v CIR). Hence it would be very unlikely that the Inland Revenue Department will agree that there is an error or omission in the tax returns submitted by Julian for the years of assessment from 2003/04 to 2004/05. (c) Julian should report the understated profits to the Inland Revenue Department as soon as possible, as the Inland Revenue Department is authorised under the Inland Revenue Ordinance to take actions against any person known to be making an incorrect return or statement without reasonable excuse. There is no statutory definition for reasonable excuse, but various Board of Review decisions have stated that if a reasonable person acted in good faith and honestly believed what he did was legal then this amounts to a reasonable excuse. As Julian has been misstating the assessable profit intentionally, it will be very difficult for him to establish that he has a reasonable excuse. 6

7 (d) Section 82(1) provides that any person who, willfully with intent to evade tax, omits from any return made under the Inland Revenue Ordinance any sum which should be included, or signs any statement or return furnished without reasonable grounds for believing the same to be true, shall be guilty of an offence. On summary conviction, the penalty is at level 3 ($10,000) plus a fine of treble the amount of tax that has been undercharged as well as imprisonment for a maximum term of six months. On indictment, the penalty is at level 5 ($50,000) plus a fine of treble the amount of tax that is undercharged as well as imprisonment for a maximum term of three years. Section 80 (2) provides that any person who, without reasonable excuse, makes an incorrect return by omitting or understating anything in respect of which he is required by the Inland Revenue Ordinance to make a return, may be charged a penalty at level 3 plus a further fine of treble the amount of tax which has been undercharged in consequence of the incorrect return. If no prosecution has been instituted under section 80 (2) or section 82 (1) in respect of the offence concerning the incorrect return or statement, additional tax (not exceeding treble the amount of tax that has been undercharged) might be imposed personally by the Commissioner or a Deputy Commissioner under section 82A. 7

8 3. Reality Limited Profits tax computation Year of assessment 2004/05 (a) $ $ Net profit before tax 4,539,300 Add: Contribution to mandatory provident fund (30, ,000 x 15%) 45,000 Depreciation 70,000 Increase in general provision 270,000 Specific provision on loan advanced to employees 200,000 Replacement of water basins (12,000 x 4/5) 9,600 Installation of new shower facilities 20, ,600 5,153,900 Less: Dividend income 100,000 Fire compensation received 800,000 Interest income 22,000 Depreciation allowance 82,000 CBA on new shower facilities (20,000 x 4%) 800 (1,004,800) Assessable profits 4,149,100 Profits tax 726,092 (b) (iv) Interest income from the bank in Hong Kong will be exempt from tax under the Exemption from Profits Tax (Interest Income) Order 1998 (subject to comments stated in (v) below). Interest from the US bank is offshore in nature and is not subject to Hong Kong profits tax. (v) Interest expenses would be deductible under section 16(1)(a) and section 16(2)(e), as the loan has been used for the purchase of trading stock and the advance of loan has not come from any connected person. However, as the US$ deposit stated in (iv) above has been used for securing a loan whose interest expenses will be deductible under section 16(2)(e), the corresponding interest income will not be eligible for exemption under the 8

9 Interest Exemption Order 1998 in accordance with DIPN 34 (Revised). (vii) In order to be eligible for a deduction under section 16(1)(d), positive action must have been taken to enforce collection and the amount claimed must be a specific provision and not a general provision. Hence the increase in general provision of $270,000 must be added back in the tax computation. In addition, the debt must have been originally included as a trading receipt or money lent in the ordinary course of a lending business. As a result, the specific provision relating to loans advanced to employees would not be eligible for a deduction under profits tax. (viii) Reality Limited should be able to claim the replacement of water basins as building refurbishment under section 16F, as the expenditure is used for the renovation of a non-domestic building. Hence Reality Limited would be entitled to claim a deduction for 20% of the expenditure incurred on replacement of water basins in the year of assessment 2004/05. New shower facilities are not refurbishment, and Reality Limited would be entitled to the 4% commercial building allowance rather than the 20% refurbishment allowance under section 16F in respect of this expenditure. 9

10 4. (a) Ronald Kung Salaries tax computation Year of assessment 2003/04 $ $ Salaries 50,000 x ,000 Car allowance 8,000 x 12 96,000 Personal credit card expenses 12, ,000 Less: Petrol costs and parking fees 42,000 x 40% 16,800 Initial allowance 100,000 x 60% x 40% 24,000 Annual allowance 40,000 x 30% x 40% 4,800 (45,600) 662,400 Add: Rental value 662,400 x 10% 66,240 Assessable income 728,640 Less: Approved charitable donation (80,000) Net assessable income 648,640 Less: Single personal allowance 100,000 Single parent allowance 100,000 Child allowance 30,000 (230,000) Net chargeable income 418,640 Tax at standard 100,539 Tax at progressive rates 66,723 Tax payable 66,723 (b) Section 9A is used by the Inland Revenue Department to challenge the use of a service company to disguise an employer-employee relationship. Section 9A applies if the fees are paid to a service company for services provided by an individual who controls the company. Section 9A could be applied to the BVI company, as the company is controlled by Ronald and is providing the personal services to ECL similar to those provided when Ronald was employed by ECL. However, it is further provided that section 9A will not be applied if all the six criteria listed in section 9A (3) are satisfied. These criteria characterise the contract for service. Based on the information provided, it appears that the relationship between Ronald and ECL will probably meet these criteria and section 9A will probably not apply. If section 9A does not apply, income that the BVI company receives from ECL 10

11 will not be assessable under profits tax but assessable under salaries tax as Ronald s income. ECL will be required to fulfill the obligations as an employer as if Ronald is its employee. Moreover the income that Ronald derives from the BVI company will not be taxable. 5. (a) John Leung Property tax computation 2004/05 $ 2005/06 $ Property A Rent 12,000 x 9 108,000 12,000 x ,000 Premium 300,000 x 9/30 90, ,000 x 12/30 120,000 Less: Rates 3,200 x 3 (9,600) 3,900 x 4 (15,600) Assessable value 188, ,400 Less: Statutory deduction (20%) (37,680) (49,680) Net assessable value 150, ,720 Property tax 16% 24,115 31,795 Property B Rent 18,000 x ,000 18,000 x , ,000 x 7 Additional charge 2,500 x 7 17, , ,500 Less: Rates 3,000 x 4 (12,000) 4,000 x 4 (16,000) Irrecoverable rent 18,000 x 2 27,000 (9,000) Assessable value 204, ,500 Less: Statutory deduction (20%) (40,800) (45,100) Net assessable value 163, ,400 Property tax 16% 26,112 28,864 11

12 (b) Personal allowances are available and progressive rates are used (but limited to the standard rate). Allow deduction of mortgage interest expenses that are not available under property tax. Allow deduction of approved charitable donations that are not available under property tax. (c) The initial premium of $150,000 will be deemed to be payable during the period to which it relates, i.e. 2004/05 to 2006/07, under property tax. However, the whole amount would be fully taxable in the year in which it is accrued under profits tax, i.e. 2004/05. Legal costs are not deductible under property tax, but will be allowable expenses under section 16(1) for profits tax purposes. If the irrecoverable rent exceeds the assessed consideration, the excess will be carried back and deducted from the assessable value of the relevant land and/ or buildings for the next most recent year of assessment under property tax. In contrast, any excess irrecoverable rent not allowable in the current year will be carried forward to set off against assessable profits in future years under profits tax. 12

13 6.(a) Under the existing arrangement, the Hong Kong customers should be able to claim a tax deduction under section 16(1) in respect of the licensing fee paid to Naive Limited, as the licensing fee is revenue in nature and is incurred in the production of income assessable to Hong Kong profits tax. With regard to DIPN 21, the locality of any licensing fee other than that deemed chargeable under section 15(1)(a) or (b) would be determined on the same basis as trading profits. As the licensing contract is effected in Hong Kong and the software is used in Hong Kong, the royalty fee receivable by Naive Limited should be taxable under section 14. The fact that the customers may be using the software outside Hong Kong is not a relevant factor to be considered here. (b) The Hong Kong customers should have no problems in claiming a deduction in respect of the licensing fee paid under section 16(1), even if the software licensing fee were paid to an overseas entity. On the other hand, the royalty income received by the Indian joint venture would fall within the deeming section under section 15(1)(b), as sum, not otherwise chargeable to profits tax received by or accrued to a person for the use of or right to use in Hong Kong any patent, design, trademark, copyright materials, secret process or formula or other property of a similar nature, or for imparting an undertaking to impact knowledge directly or indirectly connected with the use in Hong Kong of any such patent, design, trademark, copyright, secret process or formula or other property. Furthermore, section 15(1)(ba) provides that any cost associated with the use or right to use outside Hong Kong any patent, design, trademark, copyright material, secret process or formula, or other similar property for imparting know-how which is deductible in ascertaining the assessable profits of a Hong Kong company should be treated as deeming trading receipts, provided that the sum is received or accrued after 25 June Since it is most likely that the Hong Kong customers will claim a deduction for the software licensing fee, the receipt of the licensing fee by the Indian joint venture would be taxable in Hong Kong. Section 21A provides that the assessable profit of a person s income chargeable under 13

14 section 15(1)(b) should be taken as 30% of the sum, except for any sum derived from an associate in respect of rights that were previously owned by a person carrying on a trade, profession or business in Hong Kong, which is deemed at 100%. As the software license was originally owned by Naive Limited and the Indian joint venture will be considered as an associate of Naive Limited, the customer will be required to pay 17.5% (100% x profits tax rate of 17.5%) of the total licensing fee to the Inland Revenue Department. (c) The issue of shares by the Indian joint venture to Naive Limited is unlikely to attract any stamp duty liability, as stamp duty is only imposed on share transfers and not on an initial share allotment. It is also unlikely that any future transfer of shares will have to be registered in Hong Kong and therefore subject to Hong Kong stamp duty, as the Indian joint venture should keep its own share register in India, and not in Hong Kong 14