Professional Level Options Module, Paper P6 (HKG)

Answers

Professional Level Options Module, Paper P6 (HKG) Advanced Taxation (Hong Kong) June 2012 Answers Cases are given in the answers for educational purposes. Unless specifically requested, candidates were not required to quote specific case names to obtain the marks but were required only to provide the general principles involved. The suggested answers are of the nature of general comment only. They are not offered as advice on any particular matter and should not be taken as such. No reader should rely on the suggested answers as the basis for any decision. The examiners expressly disclaim all liability to any person in respect of any direct, indirect, incidental, consequential or any other damages relating to the use of the suggested answers. 1 Report to Acquirer Group To: The Directors of the Acquirer Group ( A-Group ) From: Tax Advisor Date: 15 June 2012 Subject: Tax due diligence review of Smart HK Ltd ( Smart-HK ) We refer to the proposed acquisition by the A-Group of the Smart-Group which includes, inter alia, the subsidiaries in Hong Kong ( Smart-HK ), the PRC ( Smart-PRC ) and Singapore ( Smart-Singapore ). As part of the due diligence exercise conducted on the Smart-Group, you have requested us to conduct a Hong Kong tax due diligence review of Smart-HK with the aim to assess the Hong Kong tax position of Smart-HK, and whether there is any potential tax risk that may lead to unexpected additional tax liabilities to the A-Group after acquisition. Based on the information provided, we have the following observations which may require your further consideration and attention: (i) Hong Kong profits tax implications of the profits arising from the PRC Contracts Based on s.14 of the Inland Revenue Ordinance (IRO), profits tax is charged on every person carrying on a trade, profession or business in Hong Kong in respect of his assessable profits arising in or derived from Hong Kong from such trade, profession or business. As Smart-HK is carrying on business in Hong Kong, the first test of the two limbs is satisfied. However, whether an amount of profit derived by Smart-HK is taxable in Hong Kong depends on whether the profit is sourced in Hong Kong, i.e. the second test which in turn depends on the nature of the profit. According to the Departmental Interpretation and Practice Note (DIPN) 21 (revised 2009), the broad guiding principle is one looks to see what the taxpayer has done to earn the profits in question and where he has done it (basing on CIR v Hang Seng Bank Ltd and CIR v HK-TVB International Ltd). This is the so-called operations test. However, how to identify the activities that produced the relevant profits in order to ascertain where those activities took place is a contentious issue. Various approaches have been derived from different court cases, although it has been the view of the Inland Revenue Department (IRD) that the totality of facts be looked at, that is, all the activities of a business leading to the earning of the profit. However, this approach has been criticised (in cases such as ING Baring Securities (HK) Ltd v CIR and CIR v Li & Fung (Trading) Ltd) and the courts have suggested that weighting should only be given to those profit-generating activities that directly give rise to the profits earned, and all other activities antecedent or incidental to the profit-generating activities should be ignored. Moreover, that the activities of any person abroad who undertakes the relevant profit generating transactions on behalf of, and on the instructions of the taxpayer, even if that person is not an agent of the taxpayer should also be taken into account (ING Baring). Given the contentious development of the source rule as mentioned above, it would not be straightforward to conclude that the profits of Smart-HK earned from the training services sub-contracted to Smart-PRC are offshore and non-taxable. Below is a list of arguments that may possibly be used to challenge or defend against the offshore claim: Arguments for the offshore claim (1) The nature of profits derived by Smart-HK from the provision of training services is service income. Based on DIPN 21, the source of profits from the provision of a service is determined by the place where the service is performed. Since the training services are conducted in the PRC via Smart-PRC, the profits from the provision of such services should be sourced in the PRC and thus not taxable in Hong Kong. (2) Based on ING Baring, the activities giving rise to the relevant gross profit earned by Smart-HK are the performing of training services in discharge of its obligations under the PRC contracts, and these obligations are primarily the provision of training sessions in the PRC for the customers staff in the PRC. All these obligations are then sub-contracted to Smart-PRC which agrees to fulfil these obligations on behalf of Smart-HK. Smart-PRC is effectively acting on behalf of Smart-HK and is an agent of Smart-HK, even if there is no legal agency agreement in writing. Pursuant to the ING Baring case, because the training services by Smart-PRC are provided on behalf of Smart-HK, they should be taken into account in identifying the activities carried out by Smart-HK in deriving the profits and where such activities were carried out. (3) We assume Smart-HK has minimal involvement in the provision of the services in earning the PRC training fee revenue except that it sends experienced trainers to assist Smart-PRC. However, no charge is made to Smart-PRC, indicating that Smart-HK is prepared to take the responsibility to assure the quality performance of the PRC training sessions. All other supporting activities conducted by Smart-HK in Hong Kong, including liaison with customers, arranging itinerary, etc, are antecedent as well as incidental to the training services in the PRC. Based on ING Baring and Li & Fung, these antecedent and incidental activities should be ignored, and thus all profits arising from the PRC contracts are sourced offshore and should not be assessable to profits tax in Hong Kong. 15

(4) The role played by Smart-PRC is fundamental and crucial to the earning of the training fee by Smart-HK. In the absence of the services provided by Smart-PRC in the PRC, Smart-HK would not have been able to earn the training fee. (5) Since the training fees under the PRC contracts are totally offshore and non-taxable, the sub-contract fee paid to Smart-PRC is not incurred in the production of assessable profits, and thus not tax deductible. As a result, the net income of $200,000 is not taxable. Arguments against the offshore claim (1) Smart-HK is making profits out of contracting and sub-contracting activities. It is effectively earning a spread between the training fee from the customer and the sub-contract fee paid to Smart-PRC, rather than earning a service-type of profit from the provision of a service. The source of the spread should not be determined by the place where the service is performed, but by the place where the contract is effected. Since the PRC contracts are negotiated and signed in Hong Kong, the income from the contracts would therefore be sourced in Hong Kong and taxable. (2) Depending on the terms in the sub-contract, the obligations under the PRC contracts were sub-contracted out to Smart-PRC, suggesting that Smart-PRC is the sub-contractor engaged by Smart-HK, not an agent of Smart-HK. Smart-PRC has its own business established in the PRC, and it takes on its own business and contract risk under the sub-contract agreement. The sub-contracting fee paid to Smart-PRC should represent the value of the services provided by Smart-PRC, which is 80% of the gross contract fee from the customers. This indicates that the difference, being 20%, should represent the value or reward for the activities performed by Smart-HK in Hong Kong, including its decision and management, liaison work and supporting activities. As a result, the difference of 20%, or $200,000, should be onshore and thus, taxable in Hong Kong. (3) It would seem that the obligations required under the PRC contracts are partly done in Hong Kong and partly in the PRC. The total income should be apportioned based on each party s contribution. Taking the above into account, on balance, we are inclined to opine that Smart-HK is likely to be challenged by the IRD on the offshore claim. This is not only based on the current IRD practice that all relevant facts be examined as per DIPN 21, but also because the extent to which the Court of First Instance s decision in Li & Fung will be affirmed by the more senior courts upon appeal is still uncertain. We would recommend that the potential tax liabilities and penalty thereon should be reflected in the acquisition price of the Smart-Group. (ii) Hong Kong profits tax implications to Smart-HK of the sub-contract fee paid to Smart-PRC Under the arrangement, Smart-HK sub-contracts the obligations under the PRC contracts to Smart-PRC, at a fee equivalent to 80% of the gross contract fee received from the customer by Smart-HK. Assuming that the gross contract fee is taxable pursuant to the IRO, a tax deduction can be claimed for the 80% sub-contract fee paid to Smart-PRC. Based on s.16(1) of the IRO, expenses or outgoings will be allowed to the extent they are incurred in the production of assessable profits. Therefore, if evidence is adequate to prove that the sub-contract fee was paid for the services provided by Smart-PRC to enable Smart-HK to earn the gross contract fee, the sub-contract fee is prima facie tax deductible. By virtue of DIPN 46 (issued in December 2009), the IRD has expressed its views on how, and to what extent, a transaction between associated enterprises should be conducted. When two associated enterprises are carrying on business with each other, the transfer price charged for the transfer of goods, services and intangible property is expected to be at arm s length. Two enterprises are regarded as associated if one enterprise participates directly or indirectly in the management, control or capital of the other enterprise, or the same persons participate directly or indirectly in the management, control or capital of both enterprises. However, DIPN 46 makes no reference to the shareholding threshold or residency. In the context of Smart-HK, as Smart-PRC is wholly owned by Smart-HK, they would be regarded as associated enterprises in the context of transfer pricing. The basis and quantum for the sub-contract fee payable by Smart-HK to Smart-PRC would be expected to be at arm s length. A price is regarded as at arm s length if the price transacted between the associated enterprises is comparable to the price transacted by independent enterprises dealing with each other in similar transactions. If any deviation is found from the arm s length basis, a tax adjustment may be made by the IRD to bring the income or expense, as the case may be, back to the arm s length level. In the case of Smart-HK, it would be important to ascertain and justify with proper documentation that the 80% sub-contract fee is commensurate with the value of services provided by Smart-PRC. The most common methodologies, comparable uncontrolled price and cost-plus pricing, may be used to ascertain what the arm s length price should be. The Smart-Group should be asked to provide any information that may be available to enable a transfer pricing review to be conducted. Should a transfer pricing review be done, efforts should be made to ensure that proper documentation is maintained. In the event that the 80% basis is found to be excessive, it is likely that the IRD would apply s.16(1) to restrict the amount of tax deduction for the sub-contract fee to the amount determined as arm s length. Although the authority to restrict the amount of tax deduction under s.16(1) has been challenged by the court (Ngai Lik Electronics Co Ltd v CIR), it is still believed that the IRD would follow this approach as mentioned in DIPN 46. Alternatively, the IRD may choose to rely on Article 9 (Associated Enterprises Article) of the Double Taxation Arrangement between Hong Kong and the PRC, to adjust upwards the profits of Smart-HK according to the market price benchmarked to an independent transaction. In a situation where the IRD considers that Smart-HK and Smart-PRC are engaged in a tax avoidance arrangement in order to obtain a tax benefit, the IRD may impose s.61 and/or s.61a and/or s.20 to counteract the tax benefit obtained/otherwise obtainable. In the case of Smart-HK, it is in doubt whether the sub-contract fee is deliberately overstated so as to provide 16

sufficient funds for Smart-PRC to finance its investment activities in the PRC, in return for which Smart-HK shares the return of the investment activities by way of an excessive dividend which is non-taxable in Hong Kong. Further investigation is recommended in order to form an opinion as to whether a potential risk of s.61 and/or s.61a and/or s.20 being invoked by the IRD exists. (iii) (iv) Hong Kong profits tax implication of the royalty income received by Smart-PRC The taxability of the royalty received by Smart-PRC from Smart-HK for the use of copyright in Hong Kong and Singapore is governed by s.15 of the IRO. As Smart-PRC is not carrying on business in Hong Kong, the royalty it receives will not fall within the scope of s.14, but s.15. Under s.15(1)(b), any payments received for the use of, or right to use, in Hong Kong a patent, design, trademark, copyright material, secret process or formula or any similar property or for imparting know-how in connection with the use of any of those properties are deemed to be receipts arising in Hong Kong from a trade, profession or business carried on in Hong Kong. In the case where the right to use is offshore Hong Kong, s.15(1)(ba) taxes a royalty payment for use outside Hong Kong if the royalty payment is claimed as tax deductible in Hong Kong. In the case of Smart-PRC, the royalty received for the use of the copyright in Hong Kong in the training sessions conducted by Smart-HK in Hong Kong would fall within s.15(1)(b) and thus be taxable. 30% of the gross royalty received is deemed to be assessable profits of Smart-PRC. Based on the figures provided, the estimated tax is $445 ($9,000 x 30% x 16 5%). Smart-HK is deemed to be acting as the agent of Smart-PRC and is obliged to file the appropriate tax return on behalf of Smart-PRC, withhold the tax amount from the payment before it is made to Smart-PRC, and pay the tax amount to the IRD on behalf of Smart-PRC. Failure to do so would trigger a penalty. It is recommended that Smart-HK be requested to provide evidence that these reporting and withholding obligations have been duly complied with. In respect of the royalty paid for the use of the copyright in Singapore by Smart-Singapore, since Smart-HK has sought to claim the royalty from Smart-Singapore as offshore and non-taxable and thus has not claimed the related royalty payment to Smart-PRC as tax deductible in Hong Kong, Smart-PRC would not be liable to Hong Kong profits tax in respect of the Singapore-sourced royalty income unless Smart-HK s aforesaid claim fails. No compliance obligation is required. Other tax compliance obligations in Hong Kong Other than the above-mentioned technical risks which may potentially expose Smart-HK to additional tax risks, it is also important to assess the tax compliance level of Smart-HK itself. In the absence of a satisfactory level of tax compliance or reporting, Smart-HK is potentially subject to challenge by the IRD, leading to tax payable on additional assessments and possibly a penalty. The following is a list of information required for further review, together with relevant explanations: (1) All Hong Kong profits tax returns, computations, notices of assessments (including revised, additional assessments and notices for provisional payment of taxes), and copies of all correspondence between the IRD and Smart-HK for the past seven years. This information would enable us to obtain the overall tax position of the company and the level to which such tax positions have been accepted by the IRD. Seven years records are required because the IRD has the authority to re-open the assessment for any year within six years. Therefore, any assessment within this statutory time limit carries the same risk. Moreover, Smart-HK is also obliged under the tax law to maintain a good record of its business for not less than seven years. (2) By reviewing the tax computations and assessments issued, the nature of tax adjustments made by the IRD would give an indication of the extent of the tax aggressiveness of Smart-HK in dealing with the IRD. More importantly, it would help assess the level of adequacy of the company s tax provisions made to date. Excessive understatement (and/or overstatement) of tax provisions may have significant implications for the acquisition value of the company. (3) The records of correspondence with the IRD would indicate whether there is any outstanding dispute or objection with the IRD, or appeal to the Board of Review or even the courts. If so, the issue in dispute and the possible outcome would need to be further assessed. Moreover, details of prior years legal and professional fees would help reveal whether there are any undisclosed tax disputes. (4) Copies of correspondence with all tax consultants engaged by Smart-HK may help to explain the mode of operation of Smart-HK, especially the role played by Smart-PRC. This is required in order to provide a defence against any future challenge from the IRD on the offshore claim for the fee under the PRC contracts. (5) Copies of contracts, licence agreements and documentation supporting the basis of charge between Smart-HK and other associates. These are important documents to substantiate the inter-company transactions in the case of challenge by the IRD. (6) Any other reporting documents and tax payment proof, if any, filed with or issued by the local tax authorities in both the PRC and Singapore for transactions between Smart-HK and its associates. These documents may relate to, amongst others, the PRC withholding tax paid, if any, on the dividend paid from Smart-PRC, Singapore withholding tax paid, if any, on the royalty from Smart-Singapore, foreign exchange clearance of funds remitted into and out of the PRC or Singapore, etc. These are required to assess whether, and to what extent, Smart-HK is in compliance with the foreign tax requirements. (7) Any records and information, including employers returns filed with the IRD, to prove that Smart-HK has fully complied with the employer s reporting obligations in respect of its employees. If reporting has been made to the PRC tax authority in respect of the trainers sent to support Smart-PRC, all related information should also be reviewed. 17

The above observations are drawn based on the information provided, but it is considered that other relevant information is required to enable us to assess the tax position of Smart-HK in further detail. Please help collate the information as mentioned above for our further review. Should there be any questions regarding the above, we are pleased to meet with you and explain in greater detail. End of Report 2 Mr Chan (a) (b) Taxability of the termination payments The Hong Kong salaries tax implications arising from the termination of Mr Chan s employment are as follows: (1) The terminal payment representing final salary is taxable as it is income from his employment by World Ltd (the Company). (2) Compensation for leave is also taxable on the basis that it is income from his employment by the Company. (3) Compensation for loss of office may be argued as not taxable on the ground that it is a payment for breach of contract rather than a payment for services rendered. For this ground to be valid, the breach must be a real and identifiable breach, and not a pre-arranged term under the employment contract. However, if the genuine reason for paying the compensation is to recognise past services, or as a substitute for a reward-type of payment such as a bonus, the compensation will be taxable. In Mr Chan s case, there is a risk of challenge by the Inland Revenue Department (IRD) that the compensation is effectively a substitute for the discretionary bonus which is in practice equivalent to the compensation amount, both being based on one month s salary. (4) The sum withdrawn from the Occupational Retirement Scheme Ordinance fund upon termination of service, to the extent it represents previous contributions from the employee and the subsequent return of fund investments, is not taxable. The portion of the sum withdrawn upon termination representing the employer s contribution is also not taxable, provided that it does not exceed the proportionate benefit as calculated under the following formula: Accrued benefit x (number of completed months of service)/120 Accrued benefit in the case of termination is defined as the maximum amount that the person would have been entitled to receive had he retired at the termination date. In Mr Chan s case, as his employment with the Company is less than 120 months (96 months from April 2004 to March 2012), the proportionate benefit would be calculated as $96,000 ($120,000*96/120). Therefore, the Company s contribution which exceeds the proportionate benefit in the amount of $54,000 ($300,000/2 $96,000) needs to be returned as taxable. (5) The compensation is paid with the intention of covering the loss suffered by Mr Chan arising from the disposal of his car in Hong Kong as a result of the termination of his employment. Given that he was actually asked to terminate his employment, the compensation could be argued to be a genuine compensation for the personal damage suffered by him, which is not an expected reward for his services nor arising in connection with his employment. On this basis, there is a strong case to argue that the compensation is not taxable. (6) Compensation for agreeing to enter into a covenant restricting an employee s activities is a payment for deprivation of rights, not a payment for employment or services, and thus would not be taxable. However, there have been cases in recent years illustrating that the IRD is now taking a stance that, if a compensation type of payment has been pre-arranged as part of the terms of employment, it is, in reality, deferred remuneration from employment. Therefore, despite its nature being compensation and its actual payment being post-termination, the compensation may be treated as taxable. In Mr Chan s case, it is uncertain whether the compensation for this restrictive covenant is in existence in his employment contract. If it is already part of his employment terms, there is a risk that the IRD would treat it as taxable. In terms of the timing of receipt of the compensation being in six months time, s.11d provides that a payment from employment after its termination would be deemed to be received on the last day of employment. Therefore, the compensation for agreeing to enter into the restrictive covenant would be deemed to be paid on 31 March 2012, Mr Chan s last day of employment, and be taxed in the year of assessment 2011/12. However, should Mr Chan elect, he may relate the compensation payment back for three years so that the sum would be spread over and brought to assessment for the years of assessment 2011/12, 2010/11 and 2009/10 respectively. If necessary, revised assessments would be issued for the years of assessment 2010/11 and 2009/10. Tax implications for the rental income received from properties (i) If rental income is received from properties which are held by Mr Chan s daughter as an individual, property tax is payable under s.5(1). Under this section, property tax is levied on any owner of land or building or land and buildings situated in Hong Kong, at the standard rate (15%) on the net assessable value of the property. Net assessable value 18

(ii) as defined under s.5b includes any consideration payable in money or money s worth in respect of the right to use the land or/and buildings, as reduced by two types of deduction: (a) government rates paid by the owner if it has been so agreed between the owner and the tenant; and (b) a one-off statutory allowance of 20% of assessable value after deducting rates, if applicable. This statutory allowance is deemed to cover all related expenses incurred by the owner on the property. All other actual expenses incurred, such as repairs, management fees and mortgage interest, are not deductible for property tax purposes. There is no deduction for mortgage interest for property tax. Upon election for personal assessment, the net assessable value of the property can be reduced by the amount of mortgage interest down to zero, any excess mortgage interest not so offset cannot be offset against other income, or carried backward or forward to other years (s.42). However, as Mr Chan s daughter is not a temporary or permanent resident in Hong Kong, she is not entitled to elect for personal assessment (s.41). If rental income is received from properties which are held by a special purpose company, s.5(1) is still applicable on the basis that the company will be considered as owner of the properties. Any rental income so received is subject to property tax calculated in the same manner as for an individual (as explained in (i) above). However, according to s.2, business is defined to include the letting or sub-letting of property by a corporation. Moreover, under s.14, any person who carries on a trade, profession or business in Hong Kong and derives assessable profits in Hong Kong will be chargeable to profits tax. So in the case of the special purpose company, it will be regarded as carrying on business by virtue of its property letting in Hong Kong, and it will be chargeable to profits tax on the rental profits which is sourced from immovable properties in Hong Kong. The double taxation of the special purpose company, which is subject to both property tax and profits tax by definition, can be eliminated by the application of s.5(2)(a). Under this section, any corporation which is subject to profits tax in respect of rental profits can apply for an exemption from property tax in relation to the same rental profits. In the case of the special purpose company, it will be advisable for it to claim exemption under s.5(2)(a) so that the rental profits are only subject to profits tax under s.14. Any property tax paid can be offset against profits tax chargeable on the company for the same rent receivable under s.25, any excess thereof will be refunded. Profits tax under s.14 is imposed on assessable profits which take into account all relevant expenses and outgoings that are incurred in the production of those assessable profits (s.16). It is therefore possible to deduct related expenses such as mortgage interest, management fees and repairs. Depreciation allowances will be calculated on the renovation costs as well as the qualifying costs of construction of the property (if the property is not a trading stock) and deductible against the rental profits. In a situation where total deductible expenditure exceeds total rental revenue, the excess loss can be carried forward to subsequent years and is eligible for deduction against any future taxable profits. In Mr Chan s case, this will possibly be the case since the monthly rent is expected to be insufficient to cover the mortgage interest. Currently, the profits tax rate applicable is 16 5%. As compared to (i) above, although the applicable tax rate for a company (16 5%) would be higher than that applicable for an individual (15%), the company s taxable profits should be lower, possibly even reduced to zero, as more expenditure is allowable and no limitation is imposed for the tax-deductible mortgage interest incurred. (c) (d) Effectiveness of the tax planning ideas One of Mr Chan s ideas is to hold the property in the name of his daughter, who has always lived in the UK and has no connection with Hong Kong. It is Mr Chan s belief that this would render the rental income to be tax-free for Hong Kong tax purposes. As mentioned in (b)(i) above, property tax is imposed on any owner of land or building (or land and building) situated in Hong Kong. As long as the land or building (or land and building) is situated in Hong Kong, property tax is payable on any rental income received for the right to use. The citizenship, residence or place of domicile of the owner is irrelevant. Another idea is to hold the property in the name of a company incorporated in an offshore tax haven with a view to avoiding tax in Hong Kong. Under the property tax regime, as explained above, the rental income received from properties located in Hong Kong will be taxable regardless of the citizenship, residence or place of domicile of the owner. This is also applicable in the case of a corporate owner. Therefore, if rental income is received by an offshore tax haven company which is the registered owner of a property located in Hong Kong, property tax is still payable by the company. As far as profits tax is concerned, however, whether or not the tax haven company is taxable under s.14 depends on whether or not the company carries on its property letting business in Hong Kong. The issue of carrying on business is a matter of fact but is usually contentious. Simply setting up the company offshore may not necessarily be sufficient to prove that the company does not carry on a business in Hong Kong. By having a property located in Hong Kong and let for rent, it will be regarded as carrying on business in Hong Kong and thus subject to profits tax under s.14(1), since the rental income must have a source in Hong Kong. Tax implications arising from the disposal of properties In the event of the disposal of the properties, any profits arising from the disposal will be subject to profits tax in Hong Kong if they are considered revenue in nature. Profits which are capital in nature are not taxable in Hong Kong. Whether the profits are capital or revenue will be decided by applying the principles commonly known as the badges of trade, which look at various parameters of facts, including the nature of the subject matter itself, the intention at the time of acquisition, 19

circumstances leading to the disposal, length of ownership, frequency of transaction, profit-motive, any additional work done to the property before sale, and method of financing, etc. These factors are relevant regardless of whether the properties are held by an individual or a company. If the properties are held by an individual as a trading stock, i.e. for trading, property tax and profits tax are both chargeable during the period in which rental income is received, subject to offsetting under s.25 (as in (b) above). A loss is allowed under profits tax but not property tax. In the event of disposal, profits tax will be calculated based on the excess of the disposal proceeds over the original cost of the properties. Direct related costs such as legal fees may be deducted. If the properties are held by a company, upon exemption from property tax under s.5(2)(a), profits tax is paid during the period when the ownership remains with the company. As stated above, it is possible to incur a loss if the total expenditure such as mortgage interest and depreciation allowance is in excess of the rental income received and such a loss incurred can be carried forward by the company for offset against future profits. In the year of disposal when taxable revenue profits are derived, the profits will be reduced by the accumulated tax loss brought forward. It is therefore possible that the taxable profits from the disposal will be reduced. Where commercially feasible, it is also possible to dispose of the shares in the special purpose company instead of the property itself. Whether the gain arising from the disposal of shares is taxable or not again depends on the badges of trade as mentioned above. However, the main difference here is the different rate of stamp duty applicable to a transfer of shares as opposed to a transfer of property. For a transfer of shares, the contract notes (both bought and sold notes) will be liable to stamp duty under Head 2 of the Stamp Duty Ordinance (SDO) at the rate of 0 2% on the consideration or the value of shares bought and sold. For a transfer of property, the agreement for sale and purchase of the property will be liable to ad valorem duty under Head 1(1A) of the SDO at the rate of 1 5% to 4 25% on the greater of the consideration or the unencumbered value of the property. The formal assignment executed in conformity with the stamped agreement will only be liable to duty at the fixed rate of $100. 3 Mr Hui and GA Ltd (a) Based on the proposed changes of appointment terms given, it is likely that the consulting company established by Mr Hui would be regarded by the IRD as a Type I service company and the provisions of s.9a would be applied to determine whether the new appointment constitutes a contract for service (i.e. an independent contractor), or a contract of service (i.e. an employment). If s.9a applies, the arrangement would be looked through such that the relationship between GA Ltd (GAL) and Mr Hui would continue to be treated as an employer employee relationship. Any payment made to the consulting company would be deemed as employment income of Mr Hui who provided the employment services to GAL in return for the income. For s.9a to successfully apply, the following conditions must be satisfied: (i) There is an agreement in this case, the service agreement between GAL and the consulting company will be the relevant agreement. (ii) There is a relevant person in this case, GAL is the relevant person who carries on business in Hong Kong and who has entered into an agreement for the provision of services by Mr Hui in return for a payment. (iii) There is a relevant individual in this case, Mr Hui is the relevant individual who provides services to the relevant person as required by the relevant agreement. (iv) The remuneration for the relevant individual s services is paid to a service company which is under the control of the relevant individual in this case, the remuneration for Mr Hui s services is to be paid to the consulting company, which is presumably wholly owned and controlled by Mr Hui. Control is defined under s.9a to mean the power of a person to secure that the affairs of the company are conducted in accordance with the wishes of that person either through the holding of shares or relevant voting power. In this case, although the question has not clearly stated the power of Mr Hui, the fact that Mr Hui is required to establish the consulting company and ensure that the company enters into the proposed arrangement with GAL would be sufficient to demonstrate the power or control by Mr Hui over the consulting company. If the above conditions are satisfied, the arrangement is regarded as a disguised employment between Mr Hui and GAL. However, s.9a can have no application to deem such an employer employee relationship if ALL of the following criteria are satisfied in relation to the appointment terms: (1) Neither the agreement in question nor any related undertaking provides for remuneration to include annual leave, passage allowance, sick leave, pension entitlements, medical payments, accommodation or any similar benefit, or any benefit (including money) in lieu thereof in Mr Hui s case, the service agreement not only specifies the monthly remuneration but also the annual profit-sharing bonus as well as the maximum number of days of annual vacation. (2) If the agreement, or a related undertaking, requires any of the services to be carried out personally by the relevant individual, that the relevant individual also carries out similar services for persons other than the relevant person during the term of the agreement in this case, Mr Hui is the designated individual to provide services to GAL but it is silent as to whether Mr Hui is allowed to provide similar services to other parties. 20

(3) The performance of any of the services by the relevant individual is not subject to any control or supervision commonly exercised by an employer in this case, Mr Hui will continue to be under the instruction and supervision of his current boss, GAL s Group IT director. (4) The remuneration is not paid or credited periodically or calculated on a basis commonly used in employment contracts the payment in this case will be made by GAL directly into the consulting company s bank account on a monthly basis. (5) The relevant person does not have the right to order the cessation of services in a manner or for reasons which are commonly provided for in a contract of employment the question does not provide details as to whether GAL has the right to terminate Mr Hui s services as if it is his employer. (6) The relevant individual is not held out to the public to be an officer or employee of the relevant person Mr Hui is requested to continue with his current title of Regional IT manager, and thus it is obviously expected that he will be presumed by others to be GAL s employee. As shown above, Mr Hui s case satisfies some but not all of the above criteria. In the circumstances, it is likely that s.9a would apply. Nonetheless, s.9a(4) also provides an escape clause for the benefit of taxpayers. It is provided that the Commissioner of Inland Revenue (CIR) has a wide discretionary power to exclude a case from being deemed as an employment, if he is satisfied that in substance an individual is not holding an office or employment. In considering cases under this escape clause, the CIR will usually look at the case law distinguishing between a contract of service (i.e. an employment) and a contract for service (i.e. an independent contractor). Although there is no single decisive test that can be used for all cases (Hall v Lorimer), there are factors which are commonly used by the courts to establish the existence of an employment. These factors are generally known as the integration test, control test and economic reality test. Briefly speaking, the integration test examines whether the service provider is part of the organisation and held out to the public as an officer of that organisation. The control test examines whether the person demanding the service has control over how and when the services are performed. The economic reality test examines whether the service provider performs the services on his own account and bears his own business risk. In the case of Mr Hui, it is fairly obvious that the proposed arrangement would be likely to fail all these tests. In conclusion, it is highly likely that the proposed arrangement would be regarded as a disguised employment and thus Mr Hui would continue to be treated as the employee of GAL. Tutorial note: An arrangement which falls outside the scope of s.9a may nevertheless be charged to salaries tax by the IRD through the application of the general anti-avoidance provisions in s.61 and s.61a. (b) Where s.9a operates to look through the arrangement and deem Mr Hui as the employee of GAL, the whole amount paid by GAL to the consulting company would be regarded as the employment income of Mr Hui. This whole payment would continue to be subject to salaries tax in the name of Mr Hui as is the case prior to 1 September 2012. If Mr Hui has entered into an employment contract with the consulting company and receives remuneration under that contract, such remuneration will be exempt from salaries tax in order to avoid Mr Hui being doubly taxed on the same income. In the case of the consulting company, since the arrangement has been looked through, the income received by the consulting company from GAL would not be subject to profits tax. This is to avoid double taxation because such income has been deemed as employment income received by Mr Hui and brought into the salaries tax net. In addition, the remuneration paid by the consulting company to Mr Hui under the new employment contract would not be allowed as a tax deduction. In the case of GAL, it will be regarded as the employer of Mr Hui regardless of the proposed arrangement and irrespective of what clauses have been explicitly included in the service agreement. As an employer, GAL will be obliged to comply with the necessary reporting obligations of an employer such as annual employer s return for reporting remuneration, notification of commencement and cessation of employment, and notification of leaving Hong Kong and retention of money. Failure to comply with the reporting obligations would render GAL liable to penalties. 4 Compass Ltd and David Lo partnership The additional information needed to determine the profits tax payable by the partnership business is as follows: (1) Cost of sales The basis of stock valuation and whether any goods were taken for private use by the partners. (2) Interest income A breakdown of the interest income to check whether the interest is on trade debts (which is taxable), or from a loan provided in Hong Kong (which is onshore) or outside Hong Kong (which is offshore), or from a deposit placed with a bank in Hong Kong (which is sourced in Hong Kong), or outside Hong Kong (which is offshore); and whether the deposit is pledged as a security for any bank overdraft facilities or bank loans. Interest accrued on deposits with financial institutions in Hong Kong is exempt from profits tax under the Exemption from Profits Tax (Interest Income) Order 1998. However, the exemption does not apply to interest on a deposit which is used to secure or guarantee money borrowed from a financial institution, if the borrowing fulfils s.16(1)(a), any of the conditions in s.16(2)(c), (d) or (e) is satisfied, and s.16(2a) does not apply. 21

(3) Compensation for cancellation of a sales contract Whether the compensation received for the cancellation of the sales contract is a capital or a revenue item. In general terms: (a) Compensation is revenue in nature and taxable if the compensation is made to cover the revenue loss suffered from the cancellation of a sales contract. Since income from the contract is taxable revenue income, compensation made to cover the loss of such income is accordingly revenue in nature and taxable. (b) Compensation for the cancellation of a sales contract which constitutes the whole business of the company leading to the closing down of the company s business will be regarded as capital in nature and non-taxable. (4) Salaries The amount, if any, of any salaries paid to the partner (Mr Lo) and his spouse. Any such amount is not deductible: s.17(2). (5) Contributions to mandatory provident fund scheme (MPFS) A breakdown of the contributions to check whether they are tax deductible. The tax treatment for contributions made to MPFS are as follows: (a) Regular contributions to MPFS are deductible, but limited to 15% of each employee s remuneration: ss.16(1) and 17(1)(h). (b) Contributions other than regular contributions to MPFS are deductible over five years in equal annual instalments, commencing from the year the contributions are made: s.16a. (c) A provision for regular contributions (mandatory or voluntary) to MPFS is deductible, but limited to 15% of each employee s remuneration: ss.16(1) and 17(1)(i). (d) Contributions to MPFS where a provision has previously been allowed as a deduction are not deductible: s.17(1)(k). (e) Mandatory contributions to MPFS made by a self-employed person (Mr Lo as the partner) are deductible, if not otherwise allowable and not exceeding $12,000: s.16aa. (6) Repairs and alterations A breakdown of the amount to check whether any capital expenditure, such as that on improvement, was included. If any expenditure is of a capital nature, it is necessary to ascertain whether it qualifies for depreciation allowances or is otherwise deductible as refurbishment and renovation expenses on a straight-line basis over five years under s.16f. (7) Interest expenses A breakdown to check whether the general and specific provisions of s.16(1)(a) and s.16(2) are satisfied. Interest payable to a bank is tax deductible if the following conditions are fulfilled: (a) the bank interest is incurred in the production of assessable profits: s.16(1); (b) the bank borrowing is not secured by any deposits or loans which derive non-taxable income in Hong Kong (the secured loan test ): s.16(2a); and (c) there is no arrangement in place such that the interest payment is ultimately paid back to the borrower or any connected person (the interest flow-back test ): s.16(2b). Any amount of interest paid to the partner (Mr Lo) and his spouse is not deductible: s.17(2). (8) Rent and rates The proportion, if any, of any rent and rates, representing private as opposed to trading expenses, and the basis upon which the proportion is calculated. Any private portion must be disallowed: s.17(2). (9) Legal and professional fees and sundry expenses A breakdown to check whether any capital or private items are included. Expenses of a revenue nature incurred in the course of business would normally be allowed. Any capital and private items must be disallowed, particularly in the case of the purchase of non-current assets. However, legal fees in connection with the borrowing of money used for the purpose of producing chargeable profits are specifically allowed under s.16(1)(a). (10) Research and development Ensure that: (i) the expenditure is incurred on any activities in the fields of natural or applied science for the extension of knowledge; and any systematic, investigative or experimental activities in respect of any feasibility study, or any market, business or management research; (ii) (iii) the scientific research is related to the partnership s trade or class of trade; and any capital expenditure on machinery and plant which is required for scientific research is deductible in full, but no deduction is allowed for capital expenditure on land or buildings (depreciation allowance may be granted). (11) Patent expenses Ensure that the amount claimed represents a payment to purchase patent rights specifically deductible under s.16e. To be deductible, the patent must not be purchased from an associate. (12) Property tax This expense has been charged as paid but no rent has been included in the accounts. This should be clarified. (13) Dividends A nominal adjustment may also be made in the tax computation under IRR 2C to reflect the expenses incurred to produce non-taxable income. In other words, an amount of overhead expenditure relating to the investment portfolio should be added back in the tax computation. (14) Ascertain the ratio in which the partners share the profit or loss. Allocation of profits among the partners is necessary as the corporate partner s share of profits is taxed at the corporate rate of 16 5%. (15) Ascertain if there is any loss brought forward for set-off against this year s profit, and whether the partner, David Lo, will elect for personal assessment for 2011/12. (16) Movements of non-current assets for computing the depreciation allowance. It is necessary to ascertain whether new additions qualify for depreciation allowances or are otherwise deductible in full as prescribed fixed assets under s.16g. 22

5 (a) Take Care Insurance Ltd (i) Computation of assessable profits under each of the two alternative methods: Per cent premium method under s.23(1)(a) Year of assessment 2010/11 (Basis period: 1 October 2010 to 31 March 2011) Premiums from life insurance business in Hong Kong = $8m Assessable profits = $8m*5% = $400,000. Year of assessment 2011/12 (Basis period: 1 April 2011 to 31 March 2012) Premiums from life insurance business in Hong Kong = $16m Assessable profits = $16m*5% = $800,000. Adjusted surplus method under s.23(1)(b) Adjusted surplus of the life fund: $ $ Life fund at 31 March 2012 19,510,000 Liability at 31 March 2012 (10,200,000) Excess 9,310,000 Add: Transfer to contingency reserve 2,000,000 Allowance for doubtful debts 750,000 2,750,000 Less: Profit from disposal of non-current assets 60,000 Transfer from contingency reserve 1,200,000 (1,260,000) Adjusted surplus before charging management expenses and depreciation allowances 10,800,000 Year of assessment 2010/11 (Basis period: 1 October 2010 to 31 March 2011) Allocation of adjusted surplus over the basis period for 2010/11: Net premiums for 1 October 2011 to 31 March 2011 management expenses depreciation Adjusted surplus x Net premiums for 1 October 2010 to 31 March 2012 allowances = $10,800,000*$8m/$24m $2 7m $660,000 = $240,000 Year of assessment 2011/12 (Basis period: 1 April 2011 to 31 March 2012) Allocation of adjusted surplus over the basis period for 2011/12: (ii) Net premiums for 1 April 2011 to 31 March 2012 management expenses depreciation Adjusted surplus x Net premiums for 1 October 2010 to 31 March 2012 allowances = $10,800,000*$16m/$24m $5 5m $720,000 = $980,000 From the above calculations, it appears that the adjusted surplus method produces a lower assessable profit and is to be preferred. Moreover, proper adjustments are made to ascertain the true assessable profits, taking into account expenses and depreciation etc; losses are recognised and carried forward for future set off. However, it should be noted that election for this method is not revocable and will apply to all future years once elected; as the computation is complicated, compliance cost is higher. On the other hand, the per cent premium method is simple and easy to apply, and compliance cost is limited. Tax can be saved if the actual profit margin is higher than 5%; but more tax has to be paid if the actual profit margin is lower than 5%. Moreover, the method does not reflect the true assessable profits; losses are not taken into account. (b) Ms Yan In Hong Kong there is, by virtue of s.4(1) of the Stamp Duty Ordinance (SDO), a specific obligation to stamp any document, wherever executed, which falls within a specified list of documents (the First Schedule). Documents effecting the sale or purchase as well as transfer of Hong Kong stock (Head 2 and s.19(1)) are included in the list. Sections 4(3) and (4) then go on to provide that if an instrument is not stamped, there is a civil liability to pay the duty and that the parties executing the instrument are jointly and severally liable to pay the duty. Assuming the register of members, i.e. the shareholders register, of the company is kept in Hong Kong as required by the Companies Ordinance, shares in the company are Hong Kong stock and Ms Yan and her relative have effected a sale or purchase of Hong Kong stock. Therefore, in accordance with the provisions of s.19(1) of the SDO, she and her relative must: (1) forthwith make and execute a contract note (a bought note and a sold note); (2) cause the contract note to be stamped; 23

(3) as the sale and purchase was effected outside Hong Kong, the contract note must be stamped not later than 30 days after execution; and (4) prepare an instrument of transfer which indicates that stamp duty has been paid on the contract note in accordance with Head 2. Head 2(1) also provides that, as Ms Yan and her relative have effected the purchase of Hong Kong stock, they are liable to pay stamp duty of 0 2% (in aggregate) of the consideration or value of the stock (whichever is the greater) as at the date on which the contract note falls to be executed. 24

Professional Level Options Module, Paper P6 (HKG) Advanced Taxation (Hong Kong) June 2012 Marking Scheme Available Maximum 1 (i) Net income from the PRC contracts S.14 scope of charge 0 5 Whether taxable depends on the nature and source of income 0 5 Broad guiding principle 1 Operation test 0 5 All relevant facts approach 0 5 Income-generating activities 0 5 Antecedent and incidental activities ignored 1 Activities of agents abroad taken into account 1 Arguments for the offshore claim Service income 1 Source determined by the place of service 0 5 Service provided in the PRC, therefore offshore 0 5 Smart-PRC acts as agent 1 Activities in Hong Kong antecedent and incidental 1 Without Smart-PRC, no income 0 5 Sub-contract fee not deductible 0 5 Arguments against the offshore claim Profit made out of contracting and sub-contracting, not service 1 Contract effected test 1 Contract signed in Hong Kong, therefore taxable 0 5 Sub-contracting indicates that Smart-PRC is not an agent 0 5 20% represents value for Hong Kong activities, therefore taxable 1 Partly Hong Kong and partly PRC, income apportioned 0 5 Opinion (either for or against, with valid reason) 1 16 14 (ii) S.16 general tax deduction principle 0 5 Assuming income taxable, sub-contract fee deductible under s.16 0 5 DIPN 46 transfer pricing rules 0 5 Transfer between associated enterprises 0 5 Definition of associates 1 Arm s length principle 1 Independent enterprise as benchmark 1 80% sub-contract fee to be justified 0 5 Methodologies such as comparable uncontrolled price or cost-plus pricing 1 Transfer pricing information to be sought from Smart-HK 0 5 Restrict tax deduction under s.16 1 Alternative adjustment under Article 9 1 Potential s.61 or s.61a challenge 1 Sub-contract fee excessive 0 5 Excessive dividend 0 5 Funding investment activities in the PRC and share return 0 5 11 5 10 (iii) Royalty income of Smart-PRC Deemed trading receipts under s.15, not s.14 0 5 S.15(1)(b) right to use copyright in Hong Kong 0 5 S.15(1)(ba) right to use offshore Hong Kong and royalty payment claimed as a tax deduction 1 Deemed 30% taxable profit 0 5 Royalty from copyright used by Smart-HK in HK taxed under s.15(1)(b) 0 5 Tax liability $445 0 5 Smart-HK as agent responsible for reporting and withholding 1 Smart-HK to prove compliance 1 Singapore royalty not claimed as a deduction, therefore not taxable 1 6 5 6 25

Available Maximum (iv) Other tax compliance obligations (1) Profits tax returns, computations and notices of assessments 0 5 Correspondences with the IRD 0 5 Re-open assessment in six years 0 5 Seven years record keeping requirement 1 (2) Adequacy of tax provisions 0 5 Implications for the acquisition price 0 5 (3) Outstanding dispute, objection or appeal 0 5 Assess outcome 0 5 (4) Correspondence with tax consultants 0 5 Substantiate overseas claim 0 5 (5) Copies of contracts, licence agreements etc 0 5 Substantiate inter-company charges 0 5 (6) Tax related information in the PRC and Singapore 0 5 Reporting and tax compliance in the PRC and Singapore 0 5 (7) Employer s returns 0 5 Reporting compliance as employer in Hong Kong and the PRC 0 5 8 5 6 Appropriate format and presentation 2 Effectiveness of communication 2 4 40 26

Available Maximum 2 (a) Taxability of the termination payments Final salary 0 5 Compensation for leave 0 5 Compensation for loss of office For breach of contract 1 For past services or a substitute for a reward-type of payment 1 Risk of challenge that it is a substitute for a discretionary bonus 1 Sum withdrawn from the ORSO fund Employee s contributions and return of fund investments 1 Employer s contributions not exceeding the proportionate benefit 1 Formula for calculating the proportionate benefit 0 5 Definition of accrued benefit 0 5 Calculation of the proportionate benefit and the taxable sum 1 5 Compensation for loss from selling the car 2 Compensation for agreeing to enter into a restrictive covenant Payment for deprivation of rights 1 Pre-arranged as part of the terms of employment 1 Need to clarify actual contractual position 0 5 Deemed to be received on the last day of employment 0 5 Taxed in 2011/12 0 5 Can be related back for three years 1 Revised assessments for 2010/11 and 2009/10 0 5 15 5 14 (b) (c) Tax implications for the rental income (i) Property held by an individual (the daughter) Chargeable to property tax under s.5(1) 0 5 Definition of net assessable value under s.5b 0 5 Deductions under property tax 1 Election for personal assessment not available 1 (ii) Property held by a special purpose company Chargeable to property tax as owner of property 0 5 Business includes letting by a corporation 0 5 Rental income sourced in Hong Kong 0 5 Chargeable to profits tax under s.14 if regarded as carrying on the business of property letting in Hong Kong 0 5 Exemption from property tax under s.5(2)(a) 0 5 Related expenses deductible under s.16 0 5 Depreciation allowance for renovation costs 0 5 Loss can be carried forward 0 5 Conclusion/recommendation 0 5 7 5 7 Effectiveness of the tax planning ideas Charge to property tax Citizenship/residentship/place of domicile of the owner irrelevant 1 The daughter and the company are still chargeable to property tax 1 Charge to profits tax Depends on whether a business is carried on in Hong Kong 0 5 Not sufficient that the company is set up offshore 0 5 Rental income sourced in Hong Kong 0 5 3 5 3 27

(d) Available Maximum Tax implications arising from the disposal of properties Profits from disposal capital or revenue in nature 1 Depends on the badges of trade 0 5 Property held by an individual No loss under property tax 0 5 Losses permitted under profits tax if held as trading stock 0 5 Excess of disposal proceeds over cost and direct related cost chargeable to profits tax if revenue in nature 1 Property held by a special purpose company Rental income subject to profits tax 0 5 Profit from disposal reduced by losses brought forward 0 5 Disposal of shares in the company instead of the property Whether the gain from disposal of shares is taxable 0 5 Stamp duty applicable to transfer of shares 1 Stamp duty applicable to transfer of property 1 7 6 30 3 (a) Comment on proposed changes of terms Type I service company 0 5 Contract for service vs contract of service 0 5 Arrangement looked through and treated as employer employee relationship 0 5 Deemed as employment income 0 5 Conditions for s.9a to apply An agreement 0 5 A relevant person 0 5 A relevant individual 0 5 Remuneration paid to a service company under the relevant individual s control 0 5 Definition of control 0 5 Application to Mr Hui and consulting company 0 5 Disguised employment between Mr Hui and GAL 0 5 Six criteria for s.9a not to be applied Non-employment type of remuneration 0 5 Similar services for other persons 0 5 Performance of relevant individual not under control by employer 0 5 Manner of remuneration payment 0 5 Right to cease services 0 5 Held out to the public as the relevant person s employee 0 5 Application to Mr Hui s.9a applies 2 Escape clause: Commissioner s discretion 1 Integration test, control test, economic reality test 1 5 13 11 (b) Tax implications Payments by GAL treated as employment income 0 5 Subject to salaries tax 0 5 Remuneration from consulting company exempt from salaries tax 0 5 Consulting company exempt from profits tax 0 5 Remuneration paid to Mr Hui not deductible 0 5 GAL regarded as Mr Hui s employer 0 5 Regardless of clauses in the consultancy agreement 0 5 Normal reporting obligations as an employer apply to GAL 0 5 4 15 28

Available Maximum 4 Cost of sales Basis of stock valuation 0 5 Any goods taken for private use 0 5 Interest income Breakdown of nature of interest income 0 5 Whether onshore or offshore 0 5 Whether deposit pledged as security 0 5 Bank interest exempt under the Exemption Order 0 5 Exemption not applicable to deposit pledged as a security 0 5 Compensation for cancellation of sales contract Made to cover revenue loss taxable 0 5 Leading to closure of business capital in nature and not taxable 0 5 Salaries Amount paid to partner and spouse not deductible 0 5 Contributions to MPFS Regular contributions and provision for regular contributions not exceeding 15% of employee s remuneration deductible 0 5 Other contributions deductible over five years 0 5 Contributions where a provision has been allowed not deductible 0 5 Contributions by partner not exceeding $12,000 deductible 0 5 Repairs and alterations Capital expenditure not deductible 0 5 Whether qualifies for depreciation allowance 0 5 Or deductible as refurbishment expenses over five years 0 5 Interest expense Whether s.16(1)(a) and s.16(2) satisfied 0 5 Requirement of s.16(2a) 0 5 Requirement of s.16(2b) 0 5 Interest to partner and spouse not deductible under s.17(2) 0 5 Rent and rates Any private portion which is not allowed under s.17(2) 0 5 Legal and professional fees and sundry expenses Any capital or private nature 0 5 Any legal fees in connection with borrowing 0 5 Research and development Nature of activities 0 5 Related to the partnership s trade 0 5 Expenditure on machinery and plant deductible 0 5 Patent expenses Whether deductible and not purchased from an associate 0 5 Property tax Why no rent has been included 0 5 Dividends Overhead expenditure relating to the investment portfolio added back under IRR 2C 0 5 Profit and loss sharing ratio 0 5 Whether any brought forward losses 0 5 Whether personal assessment elected 0 5 Movements of non-current assets 0 5 Any prescribed fixed assets 0 5 17 5 15 29

Available Maximum 5 (a) (i) Computation of assessable profits of life insurance business Per cent premium method Identifying the two basis periods 1 Application of the method 1 Adjusted surplus method Calculation of the adjusted surplus Excess of the life fund 1 Additions to the excess 1 Deductions from the excess 1 Allocation of adjusted surplus: Correct formula 1 Application to the two basis periods 2 8 7 (ii) Factors to be considered in choosing between the two methods Adjusted surplus method Produces a lower assessable profit in this case 0 5 Reflects true assessable profits 0 5 Losses are recognised and carried forward 0 5 Election is not revocable 0 5 Complicated computation and higher compliance cost 0 5 Per cent premium method Simple and limited compliance costs 0 5 May result in lower/higher tax liability than reflected in actual profits margin 1 Losses are not taken into account 0 5 4 5 4 (b) Obligations under the SDO To stamp a chargeable document wherever executed 0 5 Civil liability to pay the stamp duty 1 Make and execute a contract note 0 5 Stamp the contract note 0 5 Not later than 30 days after execution 0 5 Prepare an instrument of transfer 0 5 Basis of calculation of stamp duty payable on transfer of shares 1 4 5 4 15 30