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

ADMINISTRATORS

International Qualifying Scheme Examination

HONG KONG TAXATION JUNE 2011

Suggested Answers

The suggested answers are published for the purpose of assisting students in their

understanding of the possible principles, analysis or arguments that may be identified

in each question

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SECTION A

Q1. Mr. Lee has approached you, a tax consultant, for your advice in respect of his

Hong Kong tax affairs. In a meeting on 30 May 2011 with Mr. Lee, you obtained

the following information from him:

1. Mr. Lee was born and raised in Hong Kong. During the 1990s, Mr. Lee

emigrated to the (US) and has subsequently become a US citizen.

Meanwhile, he still retains his Hong Kong permanent resident identity card,

his bank accounts and driver’s license in Hong Kong.

2. In the US, Mr. Lee was employed by Golden Gate Electronics (US) Limited,

a large multinational company based in the US, as an engineer. Golden

Gate has subsidiaries in Hong Kong and Mainland China. In order to

develop the engineering capability in Mainland China, Golden Gate

Electronics (US) Limited decided to transfer Mr. Lee to oversee the

Shenzhen factory, which is Golden Gate Electronics (US) Limited’s

subsidiary in Mainland China.

3. For administrative convenience, Mr. Lee was attached to Golden Gate

Electronics (HK) Limited, the Hong Kong subsidiary of Golden Gate

Electronics (US) Limited, because it has an experienced team of accounting

and human resources professionals.

4. The Hong Kong subsidiary issued, under its own letterhead, a Letter of

Transfer to Mr. Lee. The letter documents that Mr. Lee is to transfer to the

Shenzhen factory for the period from 1 April 2010 to 31 March 2011. The

letter also set out Mr. Lee’s salary and benefits in detail. In particular, he is

entitled to a monthly salary of HK$60,000 and a monthly overseas

allowance of HK$40,000. After deducting for the relevant PRC Individual

Income Tax (IIT), the net amount is to be paid into Mr. Lee’s bank account in

Hong Kong.

5. Due to an agreement with the Shenzhen Local Tax Bureau, Mr. Lee’s

overseas allowance is not subject to IIT.

6. Mr. Lee arrived in Shenzhen on 1 April 2010 to carry out his employment

duties. Because of the proximity between Shenzhen and Hong Kong, Mr.

Lee occasionally crosses the border and spends the weekend in Hong

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Kong. During the year ended 31 March 2011, he spent 305 days in

Shenzhen and 60 days in Hong Kong. Sometimes, he brings documents

and samples from the Shenzhen office to the Hong Kong office and vice

versa in order to save time and shipping expenses.

7. While in Shenzhen, Mr. Lee felt in love with his assistant, who also came

from Hong Kong. As a result, Mr. Lee decided that he would not go back to

US at the end of the transfer period. In February 2011, Mr. Lee tendered his

resignation and his last working day was 31 March 2011.

8. At the end of the working day on 31 March 2011, Mr. Lee came back to

Hong Kong and has been living in his girlfriend’s apartment since then.

9. In addition, Mr. Lee made some investments in Hong Kong as follows:

a) He purchased 2,000 shares in a public company listed on the Hong

Kong stock market for $40,000 in December 2010. In January 2011, he

gave all these Hong Kong shares to a Hong Kong charitable institution.

The market value of the shares at the date of gift was $25 per share.

b) He acquired a flat in Hong Kong for $7 million in January 2011. The

provisional and final agreements for sale were signed 21 days apart.

On 1 February 2011, Mr. Lee leased the apartment to a tenant on the

following terms:

(i) Lease period: 1 February 2011 to 31 January 2014.

(ii) Monthly rent of $10,000, payable on the first day of each month

starting February 2011.

(iii) Rent deposit of $20,000 payable at the start of the lease.

(iv) Premium of $20,000 payable at the start of the lease.

10. In April 2011, Mr. Lee received a letter from Golden Gate Electronics (HK)

Limited. The letter enclosed a copy of the Employer’s Return form IR56F in

which Golden Gate (HK) reported Mr. Lee’s salary and benefits to the Hong

Kong Inland Revenue Department for the year ended 31 March 2011.

11. In early May 2011, Mr. Lee received a green envelope from the Inland

Revenue Department which contained his Individual Composite Tax Return

form BIR60. Mr. Lee believes that he can ignore his tax return because he

did not work in Hong Kong during the year ended 31 March 2011, and he

has come to you for advice.

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REQUIRED:

Q1 (a) Advise Mr. Lee whether, and if so to what extent, h e will be subject to

Hong Kong salaries tax for the year ended 31 March 2011.

Specifically, you should advise Mr. Lee about his s ource of

employment and his entitlement to all possible reli efs, including

exemptions, under the Inland Revenue Ordinance. You should also

advise Mr. Lee how much of his income would be subj ect to Hong

Kong salaries tax under the various scenarios; howe ver, you are not

required to perform any salaries tax computations.

Note: Even if you consider that Mr. Lee is not enti tled to a particular

relief, do not skip it. You should also identify th e relief and discuss

why Mr. Lee may not be entitled to claim it.

Ans (a) According to the Goepfert case and DIPN No. 10, the source of

employment is generally determined by the following three factors:

• the residence of the employer;

• the place where the contract of employment was negotiated, and

entered into, and is currently enforceable; and

• the place where the employee’s remuneration is paid to him.

In Mr. Lee’s case, it is clear that his employment during the period 1 April

2010 to 31 March 2011 is with Golden Gate Electronics (US) Limited’s

subsidiary in Mainland China. This would be considered a non-Hong Kong

employment. The issue is whether there was a change in employer (from

Golden Gate Electronics (US) Limited to its subsidiary in Mainland China)

when he was transfer to the Shenzhen factory: in either case, it is a

non-Hong Kong employment. Although Mr. Lee’s remuneration was paid

to him in Hong Kong, this factor is not a determinative factor when viewed

on its own. It could be argued that the Letter of Transfer issued by the

Hong Kong subsidiary represents a new contract, and therefore Mr. Lee’s

employer had been changed to the Hong Kong subsidiary. On the other

hand, it could be argued that the letter did not represent a new contract as

sometimes such a letter is required to support visa applications.

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(Note: It is acceptable for candidates to suggest for a Hong Kong

employment with appropriate arguments.)

If Mr. Lee had a non-Hong Kong employment, only his income related to

services rendered in Hong Kong would be subject to Hong Kong salaries

and in practice this means his total salary could be subject to the

time-apportionment claim. Mr. Lee’s total salary would be subject to time

apportionment because some services have been rendered in Hong Kong

(see discussion below).

On the other hand, Mr. Lee would be entitled to claim the

no-services-rendered exemption if he did not render any services in Hong

Kong. If successful, Mr. Lee would be fully exempt from Hong Kong

salaries tax. Based on the information in the question, Mr. Lee

occasionally brought documents and samples to and from the Shenzhen

and Hong Kong offices. Whether the activities in Hong Kong are

considered as part of employment services is fact-specific as indicated in

different decisions by the Board of Review. In D129/98, the Board of

Review held that such activities by the taxpayer were purely gratuitous

and were not duties of the taxpayer’s employment. However, in D39/04,

the Board of Review considered that the taxpayer cannot be exempt

unless he did not carry out a single jot of services in Hong Kong. The fact

that Mr. Lee carried the documents and samples in order to save the

company’s time and shipping expenses could arguably be not gratuitous.

As such there are services rendered in Hong Kong.

If Mr. Lee did perform some services in Hong Kong, he would also be

entitled to claim the 60-day exemption if he visited Hong Kong for not

more than 60 days during the relevant year of assessment. If this is

case, Mr. Lee would be fully exempt from Hong Kong salaries tax. Based

on the question, Mr. Lee came to Hong Kong for exactly 60 days so he

would meet the number-of-days requirement. However, Mr. Lee’s

coming to Hong Kong must be considered “visits”: this term is not defined

in the IRO and must be given its natural meaning. The fact that Mr. Lee

held a Hong Kong permanent ID card, and maintained bank accounts and

a driver’s license in Hong Kong are not determinative. However, the fact

that Mr. Lee returned to Hong Kong on 31 March 2011 to start a long

period of residence is likely to be devastating to his argument.

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Finally, Mr. Lee is entitled to claim the foreign tax paid exemption under

section 8(1A)(c) because he paid PRC Individual Income Tax (IIT) on his

salary. If successful, Mr. Lee could exclude the part of his income that

had been subject to PRC IIT. In other words, his overseas allowance of

$40,000 per month would still be subject to Hong Kong salaries tax.

(Note: However, in practice, this exemption would be irrelevant if Mr. Lee

had a non-Hong Kong employment because time apportionment claim

would generally be more beneficial.)

Q1 (b) Other than possible penalties for non-compliance, a dvise Mr. Lee the

consequences if he chooses to ignore his tax return and refuses to

pay any tax subsequently demanded by the Inland Rev enue

Department. (Note: You are not required to discuss the penalty

provisions under the Inland Revenue Ordinance.)

Ans (b) Consequences:

• The IRD will issue an Estimated Assessment to Mr. Lee based on

the information provided by the employer on the Employer’s

Return.

• If the Estimated Assessment demands tax payment, tax not paid by

the due date shall be deemed to be in default and a surcharge of

5% shall be added.

• If any part of the tax and surcharge remain in default for a further

six months or more, a further surcharge not exceeding 10% on the

unpaid amount shall be added.

• The CIR may also recover tax in default by taking civil action in the

district court, recover tax from a debtor of Mr. Lee (e.g. banker) and

apply to a district judge for the issue of a departure prevention

direction to prevent Mr. Lee from leaving Hong Kong.

Q1 (c) Advise Mr. Lee whether, and if so to what extent, t he documents

executed for the transactions in item 9 above attra ct Hong Kong

stamp duty.

Ans (c) Stamp duty:

• The sale and purchase of Hong Kong stock is subject to stamp duty

under Head 2.

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• The stamp duty payable = $40,000 x 0.2% + $5 = $85.

• Gifts of Hong Kong stock to a Hong Kong charitable institution is

exempt from stamp duty under section 44(1) of the Stamp Duty

Ordinance (SDO).

• An agreement for sale of residential property is subject to stamp

duty under Head 1(1A).

• Since the provisional and final agreements are 14 days apart, the

first agreement is chargeable with ad valorem stamp duty and the

second agreement is chargeable with a fixed stamp duty of $100.

• The ad valorem stamp duty = $7m x 3.75% = $262,500.

• The stamp duty on conveyance is subject to stamp duty under

Head 1.

• Since the conveyance is executed in conformity with the agreement

for sale which is stamped, the conveyance is chargeable with

stamp duty of $100 only.

• A lease of immovable property in Hong Kong is chargeable with

stamp duty under Head 1(2).

• The stamp duty payable on the lease = $20,000 x 4.25% + $10,000

x 12 x 0.5% = $850 + $600 = $1,450

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SECTION B (Answer THREE questions from this section)

Q2. In the 2010/2011 Budget, the Financial Secretary said (at paragraph 30):

“The Inland Revenue Department (IRD) has established procedures to track

property transactions involving speculation and will follow up each case closely.

If it is found that such transactions constitute a [trade or] business, the IRD will

levy profits tax on the persons or companies concerned for profits arising from

such transactions.”

REQUIRED:

Q2 (a) Explain, critically, the definition of a “trade” an d a “business” with

reference to the Inland Revenue Ordinance.

Ans (a) � Trade is defined in section 2(1) of the Inland Revenue Ordinance (IRO)

as including “every trade and manufacture, and every adventure and

concern in the nature of trade”.

� However, the definition is circular and does not assist in defining the

term.

� As a result, one usually resorts to the case law (see answer to part (b))

to determine whether a taxpayer is carrying on a trade.

� Business is defined by section 2(1) to include “agricultural undertaking,

poultry and pig rearing and the letting or sub-letting by any corporation

to any person of any premises or portion thereof, and the sub-letting by

any other person of any premises or portion of any premises held by

him under a lease or tenancy other than from the Government”.

� However, the definition is not exhaustive. It appears that business

covers a wider scope than trade.

Q2 (b) Analyse when profits arising from property transact ions will be

subject to profits tax, with reference to the six b adges of trade.

Ans (b) The six badges of trade are:

� Subject matter of transaction

� Length of ownership

� Frequency of similar transactions

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� Supplementary work on the property

� Circumstances responsible for disposal

� Profit-seeking motive

The candidates should discuss each badge in the specific circumstances

of a real property transaction.

Q2 (c) If profits arising from a property transaction are subject to profits tax

but the seller fails to notify the IRD of his charg eability to tax without

reasonable excuse, explain the potential consequenc es and

penalties under the Inland Revenue Ordinance.

Ans (c) � Any person who without reasonable excuse fails to comply with section

51(2) is liable to prosecution under section 80(2).

� The Commissioner may compound such an offence.

� If the person is prosecuted and convicted under section 80(2), a fine at

level 3 ($10,000) plus treble the amount of tax undercharged will be

imposed.

� Alternatively, the IRD can impose a penalty in the form of an additional

tax under section 82A. If an additional tax under section 82A is made,

no prosecution will be instituted under section 80(2).

� Under section 82A, the maximum amount of additional tax is treble the

amount of tax undercharged.

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Q3. Consider the following employment benefits and expenditures:

(i) Amount paid by an employer in connection with the education of a child

of an employee.

(ii) Company car made available by an employer for the private use of an

employee with an option to receive transportation allowance (in cash) in

lieu of using the car.

(iii) Payment of an employee’s utilities by the employer.

(iv) Loans provided to employees at less than market interest rates either

from the employer’s own funds or from money borrowed from the bank at

market rates by the employer.

(v) Benefits from the use of corporate credit cards for private purposes by

an employee.

(vi) Travelling expenses of an employee.

(vii) Subscriptions to professional associations by employees.

(viii) As specified in the employment contract, a sum equivalent to one month

salary is required to paid by an employee to the employer in lieu of

proper notice of resignation."

(ix) Depreciation of the cost of a computer purchased by an employee for

employment purposes.

REQUIRED:

For items (i) to (v) above, fully explain, with rea sons, whether they are

assessable under Hong Kong salaries tax.

For items (vi) to (ix) above, fully explain, with r easons, whether they are

deductible under Hong Kong salaries tax.

Consider all possibilities and make any necessary a ssumptions.

Ans (i) An amount paid by an employer in connection with the education of a

child of an employee is specifically assessable by virtue of section 9(2A).

It is irrelevant whether the liability is that of the employer or the employee.

(ii) When an employee is allowed to use for private purposes a car owned by

his employer, the benefit is not assessable, provided that the employee is

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not in any way able to convert the benefit into money. If the employer

was given a choice to receive cash or use the car, the cash offered is

assessable even though the employee chose to use the car.

(iii) Payment of utilities by the employer is not assessable if it is not a

discharge of the employee’s personal liability, e.g. when the utilities are

registered in the employer’s name. On the other hand, the benefit is

assessable if it is a discharge of the employee’s personal liability.

(iv) Low-interest loans provided to employees are not chargeable provided

that the employee cannot convert the benefit into cash. Likewise, if the

employer borrows money from a bank at a market rate and re-lends it to

the employee at a preferential rate, there is no taxable benefit unless the

employee guarantees the repayment of the loan.

(v) In DIPN 16, the IRD states that where the card is used for private

purposes by an employee, the benefit obtained is chargeable to salaries

tax. However, this is not necessarily correct. Whether the benefit is

chargeable depends on whether the liabilities (of the purchases) are

those of the employer or the employee. To ensure that the benefit is not

taxable, the employee should make clear to the supplier of goods and

services before entering into contract that he is making the contract on

behalf of his employer.

(vi) Travelling expenses between home and place of employment are not

allowable. But the expenses for travelling from one place of

employment to another are allowable.

(vii) Strictly speaking, professional subscriptions are not deductible under the

IRO. However, by concession, the IRD allows the deduction of one

professional subscription which is related to the taxpayer’s employment.

Only full membership fees are deductible.

(viii) The payment in lieu of notice is not incurred in the production of

assessable income and thus not allowable (CIR v Sin Chun Wah

HCIA000004/1987).

(ix) This depends. Depreciation allowances are granted in respect of plant

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and machinery, the use of which is essential to the production of

assessable income. An item of plant and machinery used by an

employee does not qualify for depreciation allowances if it merely

facilities his work and he can still perform his duties without the asset.

Depreciation allowances can only be granted if the employer does not

provide the equipment.

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Q4. Dolly Limited was incorporated in Hong Kong. It carries on a business as a

stationery trader in Hong Kong. For the year ended 31 December 2010, its

profit and loss account is as follows:

Notes $ $

Income

Turnover 6,000,000

Less: Cost of goods sold (4,200,000)

Gross profit 1,800,000

Unrealised exchange

gain

(i) 200,000

Compensation income (ii) 250,000

2,250,000

Expenses

Administrative expenses 20,000

Bad debt expenses (iii) 40,000

Depreciation charges 80,000

Donations (iv) 1,000,000

Employee expenses (v) 400,000

Legal and professional

fees

(vi) 30,000

Other expenses 50,000 (1,620,000)

Net profit for the year 630,000

Dolly Limited also provides you with the following additional information:

(i) The unrealised exchange gain arises from the conversion of accounts

receivable in foreign currency to local currency at the end of the

accounting period.

(ii) Compensation income represents insurance compensation for the total

loss of a company car (original cost: $400,000; 30% pool) that was

involved in a traffic accident.

(iii) Bad debt expenses: $

Write-off of a loan made to a director 60,000

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Less: Recovery of bad debt previously allowed (20,000)

40,000

(iv) Donations: $

Cash donations to Community Chest, Hong Kong 800,000

Donations in kind to Community Chest, Hong Kong 200,000

1,000,000

(v) Employee expenses: $

Salary 250,000

Payments to a retiring director for agreeing not to compete

with the company

150,000

400,000

(vi) Legal and professional fees: $

Audit fees 10,000

Tax return preparation 5,000

Objection against 2008/09 Notice of Assessment 15,000

30,000

Additional information:

As at 1 January 2010, the tax written down values of the plant and machinery

used in the business to produce assessable profits were as follows:

� 20% pool: $200,000

� 30% pool: $550,000

On 1 July 2010, the company purchased two identical pieces of office furniture

(20% pool). The purchase price of furniture item #1 of $50,000 was settled in

full in cash. Due to cash flow problems, furniture item #2 was financed by

instalments with a $20,000 upfront payment and 12 instalments of $3,000 each.

On 31 December 31, 2010, furniture item #1 was sold for $60,000.

On 1 September 2010, the company purchased a computer (30% pool) for

$30,000.

REQUIRED:

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Q4 (a) Prepare Dolly Limited’s profits tax computation for the year of

assessment

2010/11. (Ignore provisional tax.)

Ans (a) Dolly Limited

Profits tax computation

Year of assessment 2010/11

$ $

Net profit per accounts 630,000

Add:

Bad debt expenses 60,000

Depreciation charges 80,000

Donations 1,000,000

Employee expenses 150,000

Legal and professional fees 15,000 1,305,000

1,935,000

Less:

Compensation income 250,000

Depreciation allowance

(Note 1: 154,000 + 26,800 + 30,000)

210,800

(460,800)

1,474,200

Less: Donations

(Limited to 35% of 1,474,200)

(515,970)

Assessable profits 958,230

@ 16.5%

Profits tax payable for 2010/11 158,107

Note 1: Depreciation allowance

20% Pool 30% Pool Total

WDV b/f 200,000 550,000

Addition (after IA of 60% x

$50,000 = $30,000)

20,000 30,000

Less: Disposal (50,000) (250,000)

Sub-total 170,000 300,000

AA (34,000) (90,000) 124,000

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WDV c/f 136,000 210,000 154,000

furniture

under HP

Allowances

Addition 50,000

IA: 60% on 35,000 (21,000) 21,000

29,000

AA: 20% on 29,000 (5,800) 5,800

WDV c/f 23,200

Total allowances for car under

HP

26,800

The cost of the computer, i.e. 30,000, is fully deductible as it is a

prescribed fixed asset under section 16G.

Q4 (b) Explain the tax treatment that you have applied to items (i), (ii), (iv)

and (v).

Ans (b) (i) According to DIPN No. 42, if an exchange gain/loss is recognised in

the income statement, it cannot be excluded from the tax

computation on the ground that it is unrealised. Since accounts

receivable record trading receipts, the exchange gain is revenue in

nature and therefore taxable.

(ii) Compensation for permanent loss of a fixed asset is capital in

nature, therefore not taxable. However, the amount received up to

the original cost of the asset should be removed from the

depreciation pool.

(iii) Donations must be donations of money to a recognised charity.

Donations in kind do not qualify for a deduction.

(iv) The payment is capital expenditure because it increases the

company’s goodwill. Therefore, the payment is not deductible.

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Q5. The following information pertains to Eric for the year ended 31 March 2011:

(i) Eric received a monthly basic salary of $45,000 from his employer, which

is a Hong Kong company.

(ii) During the first half of the year, Eric lived in a flat provided by his

employer. During the second half of the year, Eric lived in his newly

purchased apartment in Tai Koo Shing and received a monthly housing

allowance of $6,000 from his employer.

(iii) Eric owned a flat in Ma On Shan. On 1 April 2009, Eric rented this flat to

a tenant for $9,000 per month. In addition, Eric received non-refundable

rent of $18,000 up front. The rental period is for two years.

(iv) During the year, Eric earned $80,000 teaching guitar on a private basis.

(v) Eric paid $100,000 and $120,000 to a bank: this represents the

mortgage interest payments in respect of the Ma On Shan property and

the Tai Koo Shing property respectively.

(vi) Eric paid $2,500 per quarter and $3,000 per quarter to the government

for rates in respect of the Ma On Shan property and the Tai Koo Shing

property respectively.

(vii) During the year, Eric made various charitable donations totalling

$250,000 to approved charitable organisations.

(viii) Eric is single with no dependents.

REQUIRED:

Q5 (a) Show whether or not it is more beneficial for Eric to elect for

personal assessment for the year of assessment 2010 /11. Support

your answer with detailed computations.

Ans (a) Eric

Salaries tax computation

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Year of assessment 2010/11

$

Salary ($45,000 x 12) 540,000

Housing allowance ($6,000 x 6) 36,000

576,000

Add: Rental value ($45,000 x 6 x 10%) 27,000

Assessable income 603,000

Less: Charitable donations

(Limited to 35% x 603,000)

(211,050)

Home loan interest (100,000)

Net assessable income 291,950

Basic personal allowance (108,000)

Net chargeable income 183,950

Tax at standard rate @15% 43,792

Tax at progressive rates 19,271

Tax payable 19,271

Eric

Property tax computation

Year of assessment 2010/11

Premium ($18,000 x 12/24) 9,000

Rent ($9,000 x 12) 108,000

Assessable value 117,000

Less: Rates ($2,500 x 4) (10,000)

107,000

Less: Statutory deduction (20%) (21,400)

Net assessable value 85,600

Property tax (15%) 12,840

Eric

Profits tax computation

Year of assessment 2010/11

Net assessable profits 80,000

Profits tax (15%) 12,000

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Eric

Personal assessment computation

Year of assessment 2010/11

Net assessable income (before deduction of concessionary

deductions)

603,000

Net assessable profits 80,000

Net assessable value (NAV) 85,600

Total income 771,000

Less: Interest on rental property (limited to NAV) (85,600)

Total income after deduction of interest 683,000

Less: Charitable donations

(Limited to 35% x 683,000)

(239,050)

Home loan interest (100,000)

Reduced total income 343,950

Less: Single person allowance (108,000)

Reduced total income after personal allowance 235,950

Tax at standard rate @15% 51,592

Tax at progressive rates 28,111

Tax payable 28,111

Q5 (b) Explain why it is/is not more beneficial for Eric t o elect for personal

assessment for the year of assessment 2010/11.

(Note: Ignore provisional tax and any rebate announ ced in the

2011/12 Budget in your answers.)

Ans (b) Comparing the tax payable under personal assessment (28,111) vs

separate assessments for different incomes (19,271 + 12,840 + 12,000 =

44,111), it is more beneficial for Eric to elect for personal assessment.

It is more beneficial for Eric to elect for personal assessment because (1)

he is entitled to a larger charitable donations limit, and (2) he can deduct

the mortgage interest in respect of the rental property under personal

assessment.

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Q6. Taxpayers may set up service company arrangements to minimise their Hong

Kong tax liabilities. Two types of arrangements have been identified as causing

particular concern. The Inland Revenue Department (IRD) has classified these

two types of service companies as Type I and Type II.

Section 9A of the Inland Revenue Ordinance (IRO) was enacted to deal with

Type I cases, while Type II cases are dealt with in Department Interpretation

and Practice Notes (DIPN) No. 24.

Q6 (a) Explain how and why taxpayers structure Type I serv ice companies.

Explain how section 9A of the IRO deals with Type I service company

arrangements.

Ans (a) Type I service companies

� The nature of Type I service companies is where an individual or any of

his associates controls a service company and the company enters

into a service agreement with another person to provide the services of

the individual.

� The purpose is to disguise an employer-employee relationship so that

the income so derived is subject to profits tax instead of salaries tax.

� To deal with Type I companies, section 9A of the Inland Revenue

Ordinance (IRO) has been enacted.

� Under section 9A, the remuneration received by the service company

under the service agreement is deemed to be the income of the

individual chargeable to salaries tax.

� Section 9A does not apply if ALL of the following six criteria are

satisfied:

1) the service agreement does not provide for fringe benefits which

are commonly provided in an employment;

2) the individual provides services for other person during the term

of the agreement;

3) the individual is not subject to any control or supervision

commonly exercised by an employer;

4) the remuneration is not paid periodically or calculated on a basis

commonly used in employment contracts;

5) the payer has no right to dismiss the individual as if he is an

employee; and

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6) the individual is not held out to the public to be an officer or

employee of the payer.

Q6 (b) Explain how and why taxpayers structure Type II ser vice companies.

Explain how DIPN No. 24 deals with Type II service company

arrangements.

Ans (b) Type II service companies

� The nature of Type II service companies is where a service company

controlled by the proprietor or partners of a professional firm provides

services to the firm in return for “management fees”.

� The purpose is to reduce the overall tax liability of the total income

derived by the same person through the professional firm and the

service company. The method makes use of the deduction of

expenses, which is available to the service company, while such

expenses are not allowed in the professional firm under section 17 of

the IRO. At the same time, the proprietor or partners of the

professional firm are also directors of the service company and they

can make use of the remuneration package such as provision of

accommodation, refund of rent, etc. to minimise their salaries tax

liabilities.

� DIPN No. 24 sets out the minimum requirements which must be

satisfied to support a management fee claim, and what deductions can

be allowed.

� For non-professional services rendered to the professional firm, the

expenses plus a mark-up can be deducted by the firm. The IRD

considers a mark-up of 12.5% to be reasonable.

� For professional services rendered to the professional firm, the

expenses without any mark-up can be deducted by the firm, except

remuneration paid to the proprietor or partner of the professional firm.

END

22

Tax Rates and Allowances

Personal Allowances

2010/11

$

Basic 108,000

Married Person 216,000

Child 1st and 9th (each)

– year of birth 100,000

– other years 50,000

Dependent Brother or Dependent Sister Allowance 30,000

Dependent Parent Aged 60 or more 30,000

Aged between 55 and 59 15,000

Additional Dependent Parent Aged 60 or more 30,000

Aged between 55 and 59 15,000

Dependent Grandparent Aged 60 or more 30,000

Aged between 55 and 59 15,000

Additional Dependent Grandparent Aged 60 or more 30,000

Aged between 55 and 59 15,000

Single Parent Allowance 108,000

Disabled Dependant Allowance 60,000

Salaries Tax and Personal Assessment Tax Rates 20 10/11

Progressive Rates: First $40,000 2%

Next $40,000 7%

Next $40,000 12%

Remainder 17%

Standard Rate 15%

Profits Tax Rates (2008/09 onwards)

Unincorporated Business 15.0%

Corporation 16.5%

Property Tax Rates (2008/09 onwards) 15.0%

Depreciation Allowances (2004/05 onwards)

Plant and Machinery

Initial Allowance 60%

Annual Allowance 10%, 20% or 30% (as specified in question)

23

Industrial Building

Initial Allowance 20%

Annual Allowance 4%

Commercial Building 4%

Stamp Duty Payable (2010/11 onwards)

Head 1(1) $1 - $2,000,000 $100

& $2,000,001 - $2,351,760 $100 + 10% of value above $2,000,000

Head 1(1A) $2,351,760 - $3,000,000 1.5% of consideration

$3,000,001 - $3,290,320 $45,000 + 10% of value above $3,000,000

$3,290,321 - $4,000,000 2.25% of consideration

$4,000,001 - $4,428,570 $90,000 + 10% of value above $4,000,000

$4,428,571 - $6,000,000 3% of consideration

$6,000,001 - $6,720,000 $180,000 + 10% of value above

$6,000,000

$6,720,001 -

$20,000,000 3.75% of consideration

$20,000,000 -

$21,739,120

$750,000 + 10% of value above

$20,000,000

Above $21,739,120 4.25% of consideration

Head 1(2) Premium Same as under Head 1(1)

Rent: Uncertain term 0.25% of annual rent

Term of less than a year 0.25% of total rent

Term of 1 year to 3 years 0.5% of annual rent

Term of more than 3 years 1% of annual rent

Head 2(1) 0.1% of the consideration

Head 2(2) $5

Head 2(3) $5 + 0.2% of value

Head 2(4) $5

Head 3(1) 3% of market value

Head 3(2) $5