THE TAXATION INSTITUTE OF HONG KONG CTA QUALIFYING EXAMINATION PILOT PAPER PAPER 5 ADVANCED TAXATION PRACTICE

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1 THE TAXATION INSTITUTE OF HONG KONG CTA QUALIFYING EXAMINATION PILOT PAPER PAPER 5 ADVANCED TAXATION PRACTICE Advance Tax- pilot_1007_q&a_jy R28/3/2013 1

2 QUESTIONS Section A Case Answer Question 1 in this Section (60 marks) Austco Ltd is an Australian company. It has carried on a business consultancy development service since It has offices in major cities in Australia and South East Asia (except Hong Kong and Macau). It provides consultancy services to foreign companies setting up business in Australia, and Australian companies setting up business in South East Asia. Mr Toby, the General Manager of Austco Ltd, wishes to explore opportunities in the Mainland of China and Hong Kong by providing the following services: i. introduction of the company s expertise in management efficiency and effectiveness to Mainland enterprises, ii. introduction of Australian companies to enter the market in the Mainland and Hong Kong, and iii. introduction of Mainland enterprises to enter the Australian market. The company has to decide whether it will set up a company in Hong Kong or in the Mainland of China. There are two alternatives open to the company: i. set up a branch or a company in Hong Kong to make use of the infrastructure of the Hong Kong business environment as a stepping stone to the Mainland market ii. set up a branch or a company in the Mainland and run the business directly from the Mainland. Question 1 Write a letter to Mr Toby advising him of the following: (a) A comparison of the Mainland s enterprise income tax system with Hong Kong s profits tax system explaining their similarities and differences in the charge to tax with particular reference to the tax incentives generally available to a business in the Mainland and Hong Kong. (30 marks) Advance Tax- pilot_1007_q&a_jy R28/3/2013 2

3 (b) Based on your answer on (a), give your opinion whether it is better to set up a business entity in the Mainland or in Hong Kong. (17 marks) (c) Your firm is approached by Austco Ltd to carry out a feasibility study on the tax implications of setting up a business in the Mainland. Explain the ethical issues you have to consider before accepting the appointment. (10 marks) Format (3 marks) (Total 60 marks) Section B Answer TWO questions out of three (20 marks each question) Question 2 Austco Ltd, mentioned in Section A, wishes to set up a branch in the Mainland, and send staff from Australia to work in the Mainland. Required: Explain the rules that Austco Ltd is required to observe for employees working in the Mainland in respect of their Australian staff and how their income is chargeable to individual income tax in the Mainland? (20 marks) Question 3 Austco Ltd, mentioned in Section A, wishes to set up a branch in Hong Kong, and send staff from Australia to work in Hong Kong. Required: Explain the rules that Austco Ltd is required to observe for employees working in Hong Kong in respect of their Australian staff and how their income is chargeable to Hong Kong salaries tax? (20 marks) Advance Tax- pilot_1007_q&a_jy R28/3/2013 3

4 Question 4 Whykwokyan Limited, a foreign company, wishes to set up a business in both the Mainland of China and Hong Kong. It decides to invest A$1,000,000 in each business. Initially, the company will inject share capital of A$100,000 into each company and finance the balance with a loan of A$900,000. Required: Explain the tax rules governing the payment of interest expenses and dividends by a Hong Kong company and a Mainland company. (20 marks) END OF QUESTION PAPER Advance Tax- pilot_1007_q&a_jy R28/3/2013 4

5 SUGGESTED ANSWERS Answer 1(a) The answer will cover the following points: Basis of charge Hong Kong territorial basis Mainland world-wide basis of taxation. Tax rates Hong Kong s low tax rate of 16.5% Mainland tax rate of 25%. Establishment of an enterprise no approval required in Hong Kong approval required in Mainland. Capital gains tax none in Hong Kong included as part of the income of an enterprise in the Mainland. Dividends not taxed in Hong Kong taxed in the Mainland. Interest income exempt from profits tax in Hong Kong if the deposit is not used to secure a loan taxed in the Mainland. Withholding tax only applicable in Hong Kong to royalties paid to non-residents, fees paid to overseas entertainers and sportsmen and consignment tax Mainland imposes withholding tax on payments of income made to non-residents. Depreciation allowances Hong Kong has generous depreciation allowance on purchases of plant and machinery (initial allowance of 60%) the Mainland has less generous depreciation allowances. Hong Kong promotes the acquisition of high-tech machinery and gives a 100% deduction for the cost of purchase of machinery for research and development, prescribed fixed assets, such as computer hardware and software and machinery of manufacturing and environmental protection machinery. Hong Kong promotes the acquisition of know-how and intellectual property by the allowance of a 100% deduction for the cost of acquisition of patents for the purpose of know-how and industrial processes used in Hong Kong provided the patent is not Advance Tax- pilot_1007_q&a_jy R28/3/2013 5

6 acquired from associates the Mainland does not provide ant such concessions to enterprises. Hong Kong attracts overseas intellectual property owners to sell trademark, copyright and patent to Hong Kong businesses by providing a beneficial tax rate of 4.95% (16.5% x 30%) on royalty income paid by Hong Kong businesses to overseas enterprises. In other words, only 30% of the royalty income is chargeable to Hong Kong profits tax. Hong Kong does not provide any tax incentives for a particular industry or business. the Mainland provides tax incentives for certain industries or business in special economic zones wherein the enterprise income tax rate may be reduced to 15% or 20% as the case may be. The Mainland has more than 30 double tax treaties with other jurisdictions while Hong Kong has 5 double tax treaties in force with other jurisdiction (although more double tax treaties have recently been signed). If the company does not come from a jurisdiction that has signed a double tax arrangement with Hong Kong, there will not be any tax credit for income tax in the home country (subject to any unilateral measures that the home country may have for allowing a tax credit). Answer 1(b) The different taxation factors for determining whether to set up a business in the Mainland or Hong Kong include the following: Tax rates and tax incentives It may not be beneficial to set up a business in the Mainland as the enterprise income tax rate is 25% whilst Hong Kong s profits tax rate of 16.5% is lower. However, the Mainland tax rate may be reduced to 15% or 20% for certain industries in certain economic zones. If so, the benefit of Hong Kong s lower income tax may not be so attractive. Capital gains Hong Kong is more attractive as capital gains are not taxed whilst the Mainland taxes profit on sale of a capital asset as a part of taxable income. The tax liability becomes more burdensome at times of high rises in property prices. Advance Tax- pilot_1007_q&a_jy R28/3/2013 6

7 Dividend tax Hong Kong is more attractive as income is not taxed on two tiers, first on the enterprise and second on shareholders upon their receipt of dividends. Full deduction on high-tech machinery and generous depreciation allowance Hong Kong is attractive in that a very large proportion of the cost of purchase is a tax-deductible expense in the year of acquisition. This is specifically beneficial if a Hong Kong company acquires machinery just before the end of the accounting year as the company can claim a large deduction. In this way, the company may greatly reduce its profits tax liability. Beneficial treatment for royalty income paid to non-resident associated companies Transfers of intellectual property from a parent company are beneficial in Hong Kong as it only deems 30% of the royalty income as chargeable income. The whole amount of the royalty is chargeable in the Mainland. Double tax arrangement The number of double tax arrangements in force in Hong Kong is much less than the Mainland. The country of residence may therefore not allow double tax relief for profits tax paid in Hong Kong. From this perspective the Mainland is a better place for setting up a business than Hong Kong. Answer 1(c) Before accepting the appointment as Austco Ltd s tax advisor for the preparation of a feasibility study on the tax implications of setting up a business in the Mainland, the following ethical issues have to be considered: i. The firm s level of technical competence in providing the service and advice, for example, has the firm carried out similar services to other clients; ii. Any issues on independence or conflict of interest of your firm and staff for the provision of service to Austco Ltd; iii. Any issues of Austco Ltd that may threaten compliance with fundamental principles such as illegal or dishonest activities carried out by Austco Ltd; Advance Tax- pilot_1007_q&a_jy R28/3/2013 7

8 iv. Potential threats to the integrity of your firm that may be created from issues associated with Austco Ltd; v. Evaluation of the significance of any threats identified, and whether there are sufficient safeguard against such threats, and whether these are covered by professional indemnity insurance. Answer 2 The charge of individual income tax in the Mainland depends on whether the employee is a resident or a non-resident. If the employee is a resident, all his worldwide income derived from the employment is chargeable to individual income tax (IIT) in the Mainland. Based on the facts of the question, the staff working in the Mainland are likely to be non-residents and accordingly will be chargeable to IIT based on the number of days spent in the Mainland. Time apportionment is allowed. However, if the branch is considered to be a permanent establishment in the Mainland, or the remuneration of the staff is fully charged to the branch in the Mainland, the whole of the yearly income of the staff is taxable notwithstanding that the remuneration is paid to the staff outside of the Mainland. If the remuneration is paid by the branch in the Mainland, the payment is subject to withholding tax. The tax so withheld has to be remitted to the Chinese tax authority for record at the beginning of the next month. At the end of each calendar year, the employee has to personally file his own income tax return in respect of his taxable income for the whole year to the Chinese tax authority. If the staff are not resident in a jurisdiction which has a double tax arrangement with the Mainland, and their remuneration is not paid by the branch in the Mainland, they may get exemption of IIT on the condition that they do not stay in the Mainland for more than 90 days in a year. If they stay in the Mainland for more than 90 days, they are chargeable with IIT on a time apportionment basis. For the purpose of counting 90 days, a part of a day is counted as a full day. However, for the purpose of calculating time apportioned income, the day of arrival and the day of departure are counted as one day. If the staff are Australian, and they are not paid by the branch in the Mainland, they may get exemption of IIT on the condition that they do not stay in the Mainland for more than 183 days in a year. Similarly, for the purpose of counting 183 days, a part of a day is counted as a full day. Advance Tax- pilot_1007_q&a_jy R28/3/2013 8

9 If the staff are also chargeable with Australian income tax on income received from the Mainland, they may get tax relief in the form of a tax credit against Australian tax payable under the double tax arrangement between the Mainland and Australia. People earning income from the Mainland who are chargeable with IIT have to register with the tax authority. Answer 3 Hong Kong salaries tax system is different from that of IIT in the Mainland in that the basis of charge does not depend on whether the employee is a resident or non-resident of Hong Kong. The charge is based on whether there is a Hong Kong employment or a non-hong Kong employment. If there is a Hong Kong employment, all the remuneration is chargeable to Hong Kong salaries tax. If there is a non-hong Kong employment, only a part of the remuneration is chargeable to salaries tax. If the employees remuneration is not paid by the Hong Kong branch or is not charged back to the Hong Kong branch, it is likely to be a non-hong Kong employment. The income is chargeable on a time-apportionment basis depending on the number of days the employee stays in Hong Kong in each year of assessment. Similar to the Mainland, for the purpose of calculating time-apportioned income, the arrival day and the departure day are counted as one day. If the employee is a visitor to Hong Kong, and stays in Hong Kong for 60 days or less in a year of assessment, the income is fully exempt from Hong Kong salaries tax. Again, similar to the Mainland, in counting 60 days, a part of a day is counted as a full day. If the employee is employed by the Hong Kong branch, or the employees remuneration is charged back to Hong Kong branch, it is likely to be a Hong Kong source employment. In this situation, the full income is chargeable to salaries tax even though the remuneration may be paid to the staff outside of Hong Kong. If the staff are chargeable to overseas income tax similar to Hong Kong salaries tax on his Hong Kong employment income, the income so taxed overseas may be excluded from the charge to Hong Kong salaries tax. Advance Tax- pilot_1007_q&a_jy R28/3/2013 9

10 If the individual does not elect to exclude the income, he may get tax relief through a tax credit for Hong Kong salaries tax against the overseas tax paid on his Hong Kong employment income. If the staff is a resident of a jurisdiction which has a double tax arrangement with Hong Kong, and his remuneration is not paid by the branch in Hong Kong, he may get exemption from Hong Kong salaries tax when he does not stay in Hong Kong for more than 183 days in a continuous period of 12 months. If the staff is an Australian, he will not get any benefit from the 183 days as Hong Kong and Australia have not signed a double tax arrangement. Answer 4 Payment of Interest For the enterprise set up in the Mainland, the interest expense paid by the Mainland enterprise to Whykwokyan Limited (WKK), a foreign company, is deductible from the taxable income of the Mainland enterprise so long as it is incurred in the production of its taxable income. When interest is paid to WKK, PRC income tax at the rate of 10% is withheld. For the enterprise set up in Hong Kong, the interest paid by Hong Kong enterprise to WKK is not deductible from the taxable income of the Hong Kong enterprise, even though it is incurred in the production of Hong Kong taxable income. The reason is that WKK is a non-resident, and its income is not chargeable to Hong Kong profits tax. From a tax saving perspective, interest paid in the Mainland has a greater benefit than interest paid in Hong Kong. For example, if $100 of interest is paid, the Mainland company will get a tax saving of $25 (i.e. tax rate of 25% on $100); when the interest is remitted to WKK, withholding tax of $10 is deducted, and the tax saving is reduced by $10. The overall tax saving is $15 (i.e. $25 $10) out of each $100 of interest paid. For Hong Kong profits tax, as the interest is not a deductible expense, there is no tax saving for the interest paid. In view of the above, the payment of interest by a Mainland enterprise has a greater benefit than the payment of interest by a Hong Kong enterprise. Payment of Dividend For the enterprise set up in the Mainland, WKK is chargeable to income tax at the rate of 10% on the dividend received from the Mainland enterprise, and the tax is withheld by the Mainland enterprise. Advance Tax- pilot_1007_q&a_jy R28/3/

11 If WKK comes from a jurisdiction which has a double tax arrangement with China, the withholding tax rate on dividends may be reduced; alternatively the withholding tax paid in China may be treated as a tax credit and set off against WKK s home income tax. This depends on the terms of the double tax arrangement. If WKK is not a resident of a jurisdiction with a double tax arrangement with China, the withholding rate will remain at 10%. For the enterprise set up in Hong Kong, Hong Kong does not tax dividends and dividends paid by the Hong Kong enterprise to WKK are not chargeable to Hong Kong profits tax. On this basis it is more favourable for WKK to set up an enterprise in Hong Kong END Advance Tax- pilot_1007_q&a_jy R28/3/