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1 THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND ADMINISTRATORS International Qualifying Scheme Examination HONG KONG TAXATION MAY 2013 Suggested Answer 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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1

THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES

THE INSTITUTE OF CHARTERED SECRETARIES AND

ADMINISTRATORS

International Qualifying Scheme Examination

HONG KONG TAXATION

MAY 2013

Suggested Answer

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

2

SECTION A

1. Timely Limited carries on a watch trading and distribution business in Hong Kong. Presented

below is information extracted from the company’s financial statements for the accounting

year ended 31 March 2013, which indicated net income of $7,123,000 after taking into

account the following items:

Note $ Income: Dividend income 33,000 Interest income 1 74,700 Profit on disposal of fixed assets 121,000 Compensation 2 100,000 Expenses: Bad debts 3 79,200 Depreciation 321,500 Donations 4 148,800 Interest 5 963,000 Legal and professional fees 6 130,400 Repairs and maintenance 7 142,600

Notes to the accounts:

$

1. Interest income: 27,000

Interest on deposits placed with DBS Bank in Hong Kong 44,000

Interest on a loan advanced to a director* 3,700

Interest on overdue trade debts 74,700

* The company has advanced a low-interest rate loan to a director to finance

his acquisition of a residential property in Taiwan. The funds were remitted

to his bank account in Taiwan.

2. One of the company’s distributors has terminated the distribution contract

with the company and paid compensation of $100,000 as liquidated

damages pursuant to the contract.

3. Bad debts:

Increase in allowance for doubtful accounts computed at various

percentages of trade debts outstanding based on their aging

26,000

Writing off of trade debts for which recovery action taken in vain 113,200

Partial recovery of a loan advanced to a distributor (written off as

bad in 2010)

(60,000)

79,200

3

4. Donations:

Cash donated to Red Cross Hong Kong 50,000

Purchase of a commemorative banknote (the proceeds of which

were to be donated to an approved charity in Hong Kong)

88,800

Purchase of raffle tickets issued by Tung Wah Group of Hospitals 10,000

148,800

5. Interest:

Bank interest paid to DBS Bank (banking facilities being secured

by the deposits placed with the same bank, see note 1 above)

163,000

Debenture interest* 800,000

963,000

* The debentures were listed on a recognised stock exchange. Throughout

the year, 20% of the debentures were held by Affluent Limited, a fellow

subsidiary carrying on a trading business in Taiwan.

6. Legal and professional fees:

Annual retainer fee for general legal consultation 30,000

Legal fees for recovery of a loan to a distributor (see note 3 above) 5,000

Fine for illegal parking 2,000

Other (allowable) 93,400

130,400

7. Repairs and maintenance:

Replacement of carpet 42,000

Renovation of showroom* 55,000

Repair of office equipment 16,000

Other (allowable) 29,600

142,600

* The whole amount incurred has been charged to the income statement.

Additional note:

Total depreciation allowance for profits tax purposes for the year is $579,000.

Additional information:

Timely Limited is going to introduce a new series of watches in the Hong Kong market

bearing the trademark “SCLOCK” which is owned by TM Limited, an unrelated company

carrying on business in Country A. TM Limited has registered the trademark in many

jurisdictions including Hong Kong. The management has negotiated with TM Limited and

the following alternatives are open to both parties:

4

(1) Timely Limited licenses the right to use “SCLOCK” in Hong Kong from TM

Limited at a royalty computed at 2% of the value of sales in Hong Kong.

(2) Timely Limited acquires the trademark registered in Hong Kong from TM

Limited for a consideration of $4 million.

(3) Timely Limited sets up a subsidiary company in a low tax jurisdiction and

arranges for the subsidiary to acquire and hold the registered trademark,

which in turn will be licensed to Timely Limited at a royalty computed at 10%

of the value of sales in Hong Kong.

The board of directors will discuss the available options in the coming meeting and has

instructed the financial controller to advise on the tax implications of these options.

REQUIRED:

1. (a) Prepare the Hong Kong profits tax computation for Timely Limited for the year of

assessment 2012/13. Ignore provisional tax and any one-off tax waiver.

Ans (a) Timely Limited

Profits tax computation

Year of assessment 2012/13

Basis period: Year ended 31 March 2013 (Section 18B(1))

$ $

Profit per accounts 7,123,000

Add: Depreciation 321,500

Donations 148,800

Debenture interest ($800,000 x 20%) 160,000

Increase in general allowance for doubtful debts

26,000

Renovation of showroom ($55,000 x 4/5) 44,000

Legal fee to recover a loan 5,000

Fine 2,000 707,300

7,830,300

Less: Dividend (33,000)

Interest on a loan to a director (44,000)

Profit on disposal of fixed assets (121,000)

Recovery of a loan (60,000) (258,000)

7,572,300

Less: Depreciation allowance (579,000)

6,993,300

Less: Approved charitable donation (50,000)

Assessable profit 6,943,300

Profits tax payable at 16.5% 1,145,644

5

1. (b) Analyse the proper tax treatments for all items given in notes 1 to 7 above in your

computation in part (a) above.

Ans (b) Interest income

Interest income received or accrued to a corporation is taxable under section

15(1)(f) if the person carries on a business in Hong Kong and the interest income is

arising from Hong Kong

Timely Limited carries on business in Hong Kong

Interest on deposits placed with DBS Bank is sourced in Hong Kong and chargeable

to profits tax

Income cannot be exempt from profits tax as the deposits were used to secure the

bank borrowings on which interest expenses are deductible

For the loan advanced to a director, the funds were first made available to the lender

outside Hong Kong and hence under section 15(1)(f) the interest income is not

taxable

Interest on overdue trade debts is considered part and parcel of the original sales

transaction; it is also taxable if the sales income is chargeable to tax

Compensation income

If the distribution contract is only one of many similar contracts of the company and

its cancellation will not affect the entire operating structure of company, the

compensation is a revenue receipt and taxable

Bad debts expenses

Bad debts incurred are deductible under section 16(1)(d) if the trade debts are

proved to have become bad, or are estimated to the satisfaction of the assessor to

have become bad during the basis period, and they have been included as taxable

trading receipts

Where recovery action has been taken on trade debts in vain, the write-off of bad

debts is deductible

Allowance for doubtful accounts which is estimated based on a certain percentage

of trade debts outstanding is not regarded as “incurred” and cannot be deducted

Since the loan advanced to a distributor was not money lent in the ordinary course of

a money-lending business carried on by Timely Limited, the write-off of the loan

could not be deducted in the year 2010; the subsequent recovery of the loan is not

taxable

6

Donations

For a donation to be deducted under section 16D, it must be made to approved

institution and in money, and no advantage of a material character shall be received

in return

The cash donation to the Red Cross is deductible

The cost of purchasing a commemorative banknote cannot be deducted because

advantage of a material character has been received

The same applies to the raffle tickets even though the donee is an approved

charitable institution

Interest

To be deductible, under section 16(1)(a) interest expenses must be incurred in the

production of chargeable profits

Interest paid to DBS Bank is interest on money borrowed from a financial institution

and satisfies the condition under section 16(2)(d)

Although the borrowing was secured by bank deposits, interest income on the

deposits is taxable in Hong Kong; hence, the restriction under section 16(2A) does

not apply

For the debenture interest, the debentures were listed on a recognised stock

exchange and the condition under section 16(2)(f) is satisfied

20% of the debentures were held by Affluent Limited (the fellow subsidiary in

Taiwan); the debenture interest received by the fellow subsidiary is not chargeable

to profits tax in Hong Kong because the subsidiary does not carry on a business in

Hong Kong and the interest was sourced outside Hong Kong; the “market maker”

exclusion under section 16(2G) and 16(2H) apparently is not applicable to Affluent

Limited

Under the interest flow-back test (section 16(2C)), interest which has flowed back to

a connected person shall not be deducted ($800,000 x 20% = $160,000)

Legal and professional fees

The annual retainer fee was incurred in the normal course of business with a view

to earn profit, and is deductible

The loan advanced to a distributor was not made in the ordinary course of business

of Timely Limited; the cost of recovery of the loan is not deductible

Breaking the law is not a normal business transaction and the fine is not deductible

7

Repairs and maintenance

Carpet is an “implement, utensil or article” and the cost of replacement can be

deducted under section 16(1)(f)

The cost of renovating the showroom can be deducted by 5 yearly installments

under section 16F, i.e. $55,000 x 1/5 = $11,000 for the year of assessment 2012/13

Expenditure incurred in the repair of any item of plant or machinery employed in the

production of profits can be deducted under section 16(1)(e)

1. (c) In respect of the trademark “SCLOCK”, advise the board of directors on the Hong

Kong profits tax implications arising from all the three options available from the

perspectives of TM Limited, Timely Limited and the proposed subsidiary in option

(3). You may also need to alert the board if any anti-tax avoidance provisions

under the Inland Revenue Ordinance are potentially applicable.

Ans (c) Option 1 – Licensing the use of trademark

Royalty paid to TM Limited for using the trademark in Hong Kong can be deductible

under section 16(1) as the expense is incurred in the production of assessable

profits, i.e. for selling the watch bearing the trademark in Hong Kong

A sum paid for the use or right to use a trademark in Hong Kong is deemed to be a

taxable trading receipt under section 15(1)(b); TM Limited would be chargeable to

profits tax for the royalty received from Timely Limited

The assessable profit is deemed under section 21A to be 30% of the gross receipt

as Timely Limited and TM Limited are not associates

Timely Limited is obliged under section 20B to report, withhold and pay the tax on

behalf of TM Limited

Option 2 – Acquisition of the trademark by Timely Limited

If Timely Limited acquires the registered trademark directly in its own name, the

acquisition cost can be deducted over five years of assessment under section

16EA(2) and (3), provided that the trademark is used for producing chargeable

profits and it has not been sold at the end of the basis period for that year of

assessment

There is no payment of royalty under this option, and the issue of the deductibility

and taxability of the royalty no longer exists

8

Option 3 – Acquisition of the trademark by a newly set up subsidiary

If a new subsidiary is set up to acquire the trademark and the right to use the

trademark is licensed to Timely Limited, it may deduct the royalty payment as in the

Option 1 above

While the subsidiary is not carrying on business in Hong Kong, section 15(1)(b) will

be applied to deem the royalty as taxable trading receipt

Since the two companies are associates, the deemed assessable profits will be 30%

of the royalty payment only if the trademark has not been at any time owned partly or

wholly by any person carrying on a business in Hong Kong – this is a matter of fact

to be ascertained; otherwise, the whole amount of royalty payable will be deemed as

assessable profit

Anti-avoidance provisions

Option 3 may result in tax benefits as the expense may be fully deductible to Timely

Limited, but not fully taxable to the subsidiary

Furthermore, the rate of royalty to be charged by the trademark holding subsidiary is

appreciably higher than that charged by an unrelated party (TM Limited); this

coupled with the fact that the subsidiary will be established in a low tax jurisdiction

may suggest that the arrangement is tax-motivated by siphoning Hong Kong profits

to an offshore company

Under section 20, where a non-resident person carries on business with a resident

person with whom he is closely connected, and the course of such business is so

arranged that it produces to the resident person either no profits which are sourced

in Hong Kong, or less than the ordinary profits which might be expected to arise in or

derived from Hong Kong, the business done by the non-resident person in

pursuance of his connection with the resident person is deemed to be carried on in

Hong Kong, and the non-resident person will be assessed in respect of the profits

derived in the name of the resident person as if he were the agent of the

non-resident person

The high percentage of royalty charged by the overseas subsidiary will substantially

reduce the profits of Timely Limited; in such circumstances, the subsidiary will be

liable to Hong Kong profits tax and being assessed on the deemed profits, and the

assessment could be raised in the name of Timely Limited as its agent

9

Section 61A could also apply if a transaction is entered into for the sole or dominant

purpose of obtaining a tax benefit; the assistant commissioner may disregard the

royalty payment computed at 10% on sales and substitute it by an arm’s length price

(e.g. 2%) in ascertaining the profits of Timely Limited

Section 61 can also be applied by an assessor to deny an excessive deduction claim

of royalty payment if the transaction is regarded as artificial or fictitious

Alternatively, the assessor may refuse to allow the excessive royalty paid by Timely

Limited under section 16(1)

10

SECTION B

2. Dickson Leung joined Trendy Garment Limited (TGL), a company carrying on garment

manufacturing and trading business in Hong Kong, as a production manager on 1 April

2012. He is responsible for overseeing the company’s manufacturing operations in

Shantou in Guangdong Province. Dickson normally comes back to Hong Kong every

Saturday and returns to the Mainland factory on the following Monday. On the first

Monday of every month, he attends a production meeting in Hong Kong. Apart from this,

he is not required to perform any regular duties in Hong Kong.

Dickson provides you with the following notes for the year ended 31 March 2013:

1. He received a monthly salary of $35,000.

2. He received a meal allowance of $2,000 per month.

3. He was provided with a flat in Shantou which was leased by TGL at a monthly rent

of $1,500. He has the exclusive right to occupy the flat without the payment of any

rent.

4. He joined TGL’s medical insurance scheme and received a refund from the

insurance company of $6,500. TGL has paid an insurance premium of $2,000 in

respect of his cover.

5. He was awarded 30,000 shares in the holding company of TGL on 1 July 2012.

However these shares will only be registered in his name one year from the date of

award if he is still employed by TGL during that year. He received dividend income

of $3,600 on 10 January 2013 from these shares. The shares were quoted on the

Stock Exchange of Hong Kong at $5.00 and $5.20 on 1 July 2012 and 31 March

2013 respectively.

6. He completed a degree course in textile studies offered by a Hong Kong university

during year and TGL refunded him $17,000 of the course fee he paid during the

year. He also received a gift voucher of $3,000 from TGL in appreciation of his

completion of the study.

7. He joined TGL’s MPF scheme and has contributed $3,000 per month to the

scheme.

Dickson is single and is a Hong Kong permanent resident. When he returns to Hong

Kong during the weekend, he stays in his parents’ self-owned property in Lam Tin. His

parents were aged 53 and 56 during the year ended 31 March 2013. Dickson has paid

$6,000 per month to his parents in support of their living expenses.

Dickson wonders if he is required to pay salaries tax in Hong Kong for this employment

as he has performed all his services outside Hong Kong. He reckons that he may need

to pay tax in the Mainland but would like to explore whether any tax relief would be

available to him as a Hong Kong resident. You are informed that he has not yet paid any

tax in the Mainland so far.

11

REQUIRED:

2. (a) Advise Dickson of his Hong Kong salaries tax position and whether or not

he is entitled to any tax relief in the Mainland as a Hong Kong resident.

Ans (a) As Dickson’s employer (TGL) is resident in Hong Kong, it is highly likely that

the IRD would regard his employment as sourced in Hong Kong

All income from a Hong Kong sourced employment will be chargeable to tax

under section 8(1)(a) unless no service is rendered in Hong Kong or services

are rendered in Hong Kong during visits of not more than 60 days

Although Dickson is not required to perform any regular duties in Hong Kong,

he has attended production meetings in Hong Kong every month and it could

not be said that he has not rendered any services in Hong Kong; the

exemption under section 8(1A)(b) does not apply to him

As Dickson has spent more than 60 days in Hong Kong during the year, the

60-day exemption rule does not apply; whether he is a “visitor” for tax

purposes is unimportant

However, if a taxpayer has rendered services outside Hong Kong and has paid

tax of substantially the nature as Hong Kong salaries tax, he could exclude the

income already subject to tax elsewhere by virtue of section 8(1A)(c)

Furthermore, as Hong Kong has entered into double taxation arrangement

with Mainland China (DTA), tax payable in the Mainland could be allowed as a

credit against the Hong Kong salaries tax payable under section 50

Under the said DTA, a Hong Kong resident will be exempt from income tax in

the Mainland if:

- he is present in the Mainland for not more than 183 days in any 12-month

period commencing or ending in the taxable year concerned;

- his remuneration is not paid by a Mainland employer; and

- his remuneration is not borne by a permanent establishment in the

Mainland

It is unlikely that Dickson could be exempt from income tax in the Mainland as,

inter alia, he would have spent more than 183 days in the Mainland

12

2. (b) Assuming that Dickson is liable to pay salaries tax in Hong Kong, calculate

his tax liability for the year of assessment 2012/13. Ignore provisional tax

and any one-off tax waiver.

Ans (b) Dickson Leung

Salaries tax computation

Year of assessment 2012/13

$ $

Salary ($35,000 x 12) 420,000

Meal allowance ($2,000 x 12) 24,000

Dividend income 3,600

Rental value 44,760

492,360

Less: Contribution to MPF scheme (14,500)

477,860

Less: Personal allowances

Basic allowance 120,000)

Dependent parent allowance - aged 56 (19,000) (139,000)

Net chargeable income 338,860

Salaries tax at progressive rates 45,606

2. (c) Assuming that Dickson is liable to pay salaries tax in Hong Kong, advise

him of the tax treatments for the information given in notes 3, 4, 5 and 6.

Ans (c) Under section 9(2), rent-free accommodation provided by the employer is

assessable at 10% of the income from the employer after deducting outgoings,

expenses and depreciation allowances

The rental value is assessable as Dickson has the exclusive right to occupy

the property as his place of residence; the fact that it is located outside Hong

Kong is irrelevant

The medical refund from the insurance company is not assessable as it is

only paid due to the contractual entitlement of the employee as a beneficiary

under the insurance policy, and not an income arising from employment

The insurance premium paid by the employer is also not assessable as the

payment is a discharge of the employer’s sole and primary liability for which no

person was surety – section 9(1)(a)(iv)

13

Shares awarded to an employee by virtue of his employment are taxable

perquisites under section 9(1)(a), forming part of his employment income

According to DIPN No. 38, the 30,000 shares awarded to Dickson will not be

assessed to tax until the fulfillment of the specified condition on 1 July 2013

when the shares will be vested in him (the back-end approach)

The market value at the time of fulfillment of the condition will be used for

valuation purposes

Dividend income received during the vesting period is regarded as

employment income and is taxable

The textile studies course offered by a local university qualifies as a

self-education expense, being a course undertaken to gain or maintain

qualifications for use in employment

As the course fee is reimbursed by the employer, no further deduction is made

in the tax computation – section 12(6)(b)

(Alternatively, the reimbursement is chargeable to tax while Dickson could

claim a deduction of $17,000)

The gift voucher is not assessable as it is given in appreciation of Dickson’s

personal success and is not for services rendered

14

3. Fortune Limited wholly owns Treasure Limited and holds 85% interest in Wealth

Limited. All the companies were incorporated in Hong Kong. Fortune Limited has

100,000 authorised shares of $1 each, of which only 50,000 shares were issued and

held by Kelvin Kwan.

On 15 September 2012, Treasure Limited transferred a residential property in North

Point to Wealth Limited at a consideration of $9 million to be used as a director’s

quarters. As both companies are in the same group, the assignment deed has not been

submitted for stamping.

In January 2013, Treasure Limited leased a shop unit to a third party for a term of two

years commencing on 1 February 2013, with a renewal option for another two years.

The monthly rent was $50,000. The tenant was required to pay a rental deposit of

$100,000 and a non-refundable premium of $150,000. Treasure Limited allowed the

tenant a rent-free period of one month for carrying out renovations.

On 5 March 2013, Treasure Limited exchanged a piece of land in Sha Tin with a third

party, Lily Limited. The consideration stated in the deed of exchange was $5 million

payable by Treasure Limited to Lily Limited. The market values of the two pieces of land

exchanged were $7 million and $13 million respectively.

Kelvin is going to marry his fiancée, Christina, next month. Kelvin has decided to

transfer his 10% interest in Fortune Limited to Christina for a consideration of $10. The

accountant has informed Kelvin that the fair market value of the company is $150

million. He wishes to transfer the shareholding in the most cost effective manner.

REQUIRED:

3. (a) Analyse the Hong Kong stamp duty implications arising from all the

completed transactions given above. Compute the stamp duty payable

where applicable.

Ans (a) Conveyance of immovable property in Hong Kong is chargeable to stamp duty

under Head 1(1)

Stamp duty is computed at the higher of the stated consideration and value of

the property; assuming that the stated consideration represents the fair market

value, stamp duty is payable on the assignment deed at:

$9 million x 3.75% = $337,500

15

Exemption from stamp duty under section 45 only applies to a transfer between

associated bodies corporate, including the situation where a third body

corporate is the beneficial owner of not less than 90% of the issued share

capital of two companies

Treasure Limited and Wealth Limited are not associated bodies corporate as

Fortune Limited holds less than 90% interest in Wealth Limited

The instrument must be stamped within 30 days after execution

Late stamping is subject to a penalty at 10 times of the amount of stamp duty

payable if the delay is more than two months

However, the Collector may remit the whole or any part of the penalty in a

voluntary disclosure case; the following formula will be adopted in calculating

the reduced penalty, subject to a minimum of $500:

14% x Stamp duty payable x (No. of days of delay / 365 days)

An agreement for the lease of immovable property is subject to stamp duty

under Head 1(2)

Stamp duty payable is:

Rent portion: $50,000 x 23 /24 x 12 x 0.5% = $2,875

Premium: $150,000 x 4.25% = $6,375

If the lease is executed in duplicate, the duplicate copy is stamped at $5 under

Head 4

The deed of exchange falls into the charge under Head 1(1) because it

concerns immovable property in Hong Kong

Under section 25(7), only the equality money will be subject to stamp duty;

equality money is the higher of the amount payable by one owner to the other

owner or the difference in the value of the two properties

Stamp duty payable is $6 million x 3% = $180,000

16

3. (b) Advise the possible ways that Kelvin can transfer part of his shareholding in

Fortune Limited to Christina, and recommend the cost effective ways from

the stamp duty perspective.

Ans (b) Kelvin may transfer 5,000 issued shares in Fortune Limited to Christina in order

to transfer 10% of his shareholding

Transfer of shares in a Hong Kong company is subject to stamp duty under

Head 2(3), which applies to voluntary disposition inter vivos

The instrument of transfer is chargeable with ad valorem stamp duty at the rate

of 0.2% of the value of the shares transferred plus a fixed duty of $5, i.e. $150

million x 10% x 0.2% + $5 = $30,005

Under section 27(4), no stamp duty will be payable if marriage is the

consideration; Kelvin may take advantage of this provision to obtain exemption

from payment of stamp duty for the transfer of shares

The instrument must be submitted for adjudication by the Collector under

section 13

Alternatively, issue of new shares does not attract stamp duty as there is no

transfer of Hong Kong stock; Fortune Limited may allot new shares to Christina

to dilute Kelvin’s shareholding to 90% of the company’s issued shares

Stamp duty could be minimised or avoided by the latter two ways

17

4. Alex Wang and his brother, Brandon, acquired a residential property located in Tseng

Kwan O as joint tenants in February 2012 for a consideration of $7 million. The

acquisition was partly financed by a mortgage loan from Hang Seng Bank. The brothers

let out the property to Ricky Lai on the following terms:

1. Lease term: 2 years from 1 April 2012, renewable for another one year

2. Rental deposit: $30,000 to cover any cost of repairs or loss of revenue due to default

by the tenant

3. Lease premium: $60,000

4. Monthly rent: $15,000 payable on the 1st day of each month

5. Rates and government rent: $2,700 and $1,620 per quarter respectively payable by

the owner (ignore any rates concession)

6. Building management fee: $1,100 per month payable by the tenant to the building

management office

Starting from January 2013, Ricky has delayed the payment of rent. As of 31 March

2013, rent for February and March 2013 was still outstanding.

During the year, Alex and Brandon have paid loan interest of $140,000 and repair

expenses of $8,500 in respect of the property.

Alex is single. He works as a part-time lecturer with a local tertiary institution and

received a salary of $204,000 for the year ended 31 March 2013. He also runs a

consultancy business in Hong Kong under the name of Alex Business Solutions

Company (ABSC). During the year ended 31 March 2013, ABSC has made a profit of

$530,000 which is after the deduction of his mandatory contribution to the MPF scheme

of $14,500 as a self-employed person, and his medical insurance premium of $3,000.

He is also a partner of a partnership business carried on with his friends. His share of

partnership loss is $75,000 for the year of assessment 2012/13.

Brandon is married and has a son aged 5. Brandon is a resident of Mainland China who

visits Hong Kong regularly and generally spends around a week in Hong Kong every

month. Apart from the rental income, Brandon has no other source of income in Hong

Kong.

18

REQUIRED:

4. (a) Calculate the Hong Kong property tax payable for the year of assessment

2012/13. Ignore provisional tax.

Ans (a) Property tax computation

Year of assessment 2012/13

$

Rent ($15,000 x 12) 180,000

Lease premium ($60,000 x 12/24) 30,000

Assessable value 210,000

Less: Rates ($2,700 x 4) (10,800)

199,200

Less: 20% statutory deduction (39,840)

Net assessable value 159,360

Property tax payable at 15% 23,904

Credit for non-inclusion of the following items:

Bad debt

Government rent

Loan interest

Repair expense

4. (b) Advise whether or not Alex and Brandon are eligible to elect for personal

assessment for the year of assessment 2012/13, and the procedures for the

election.

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

age of 18, or under the age of 18 with both parents dead; and who, or whose

spouse, is either a permanent resident or a temporary resident

“Temporary resident” means an individual who stays in Hong Kong for more

than 180 days during the year of assessment in which election is made; or stays

in Hong Kong for more than 300 days in two consecutive years, one of which is

the year of assessment in which the election is made

“Permanent resident” means an individual who ordinarily resides in Hong Kong

It appears that Alex is ordinarily resident in Hong Kong (with a part-time

employment and a sole-proprietorship business carrying on in Hong Kong) and

he will be eligible to be assessed under personal assessment

19

As Brandon is a resident in the Mainland, maintains no place of abode in Hong

Kong and only visits Hong Kong for about a week every month (roughly 84 days

per year and 168 days in two consecutive years), he is unlikely to meet the

criteria of permanent resident nor temporary resident in Hong Kong

Hence, Brandon is not eligible for electing personal assessment unless his wife

is a temporary or permanent resident of Hong Kong

The election must be made in writing and lodged with the Commissioner of

Inland Revenue not later than two years after the end of the year of assessment

concerned or one month after an assessment forming part of the total income

for the year of assessment is final and conclusive; or further period as the

Commissioner may allow; whichever is the later

4. (c) Assuming that Alex is eligible to be assessed under personal assessment,

calculate his tax liability under personal assessment for the year of

assessment 2012/13. Ignore any one-off tax waiver.

Ans (c) Alex Wang

Personal assessment

Year of assessment 2012/13

$

Net assessable value ($159,360 x 50%) 79,680

Assessable income 204,000

Assessable profit ($530,000 + $3,000) 533,000

Total income 816,680

Less: Interest expense (70,000)

746,680

Less: Share of partnership loss (75,000)

671,680

Less: Basic allowance (120,000)

Net chargeable income 551,680

Tax charged under personal assessment 81,785

20

5. Crunchy Snack Limited (CSL) carries on a food manufacturing business in Hong Kong.

In December 2008, it acquired a piece of land for $40 million in Yuen Long and signed a

contract to construct a five-storey building to house its manufacturing operation there.

The construction cost of $20 million is payable as follows:

On signing the contract $8 million

Progress payment $8 million (paid on 5 August 2009)

Upon completion of contract $4 million (paid on 10 April 2010)

The building was immediately put into use by CSL upon its completion in April 2010.

Apart from 50% of the gross area on the ground floor which was used as an office, all

other areas were used as a workshop and warehouse for storage of raw materials and

finished products.

In May 2012, CSL sold the whole building to Healthy Nutrition Limited (HNL) for a

consideration of $72 million (including land and building cost). HNL used the third floor

and fourth floor of the building as a laboratory for research and development, and the

rest of the floors for the production of nutrition products.

HNL has imported a testing machine (30% depreciation rate) from Germany for product

development. It was acquired from a local supplier on hire purchase terms with details

as follows:

List price: $1,200,000

Down payment: $200,000 (paid in June 2012)

Monthly instalment: $90,000 for 12 months commencing on 15 July 2012)

HNL also paid freight and installation expenses of $30,000 and $10,000 respectively in

respect of the machine in June 2012.

Movement of other assets of HNL during the year ended 31 March 2013 are presented

below:

1. New additions include:

Furniture and fixtures $130,000

Motor vehicles $360,000

Production machines $415,000

2. Old furniture was scrapped for $5,000.

21

3. A director donated three air-conditioners to the company in December 2012; he had

bought these at a cost of $18,000 in November 2010. The second-hand value of

these air-conditioners was $4,000.

The tax written down values of the pooling system as of 31 March 2012 are:

20% pool (including air-conditioners, furniture and fixtures): $201,000

30% pool (including motor vehicles): $105,000

Both companies end their accounts on 31 March annually.

REQUIRED:

5. (a) Analyse the tax treatments of the building in Yuen Long for both CSL and

HNL for all the relevant years in the question.

Ans (a) An industrial building is defined in section 40(1) to include a building used for

the purposes of a trade which consists of the manufacturing of goods or

materials or the subjection of goods or materials to any process

It also includes a building used for the purposes of research and development

related to any trade, profession or business

An industrial building does not include any building used as an office unless

the non-qualifying use is not more than 10% of the total capital expenditure

which has been incurred on the construction of the whole building

An allowance is granted on the capital expenditure incurred on the

construction of the industrial building only and hence the land cost does not

qualify for the allowance

CSL carries on a food manufacturing business in the Yuen Long building

which is a qualifying trade for the purposes of an industrial building allowance;

the area used as an office does not exceed 10% of the overall capital

expenditure incurred and can be ignored

CSL is entitled to claim an initial allowance at 20% of the cost of construction

incurred during the basis period

CSL is also entitled to claim an annual allowance at 4% of the qualifying

expenditure as long as it holds the relevant interest and the building is used for

the qualifying trade at the end of the basis period

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Upon disposal of the building, a balance allowance or balancing charge will

arise, but any balancing charge should be restricted to the initial and annual

allowances previously granted to CSL

HNL used the building for research and development purposes as well as for

the production of nutrition products; hence it also qualifies to claim industrial

building allowances based on the residue of expenditure after sale

5. (b) Calculate the depreciation allowances applicable to CSL and HNL for all the

relevant years of assessment up to and including the year of assessment

2012/13.

Ans (b) Industrial building allowance

Crunchy Snack Limited $

Qualifying expenditure 20,000,000

Less: Initial allowance for 2008/09 ($8m x 20%) (1,600,000)

18,400,000

Less: Initial allowance for 2009/10 ($8m x 20%) (1,600,000)

16,800,000

Less: Initial allowance for 2010/11 ($4m x 20%) (800,000)

Annual allowance for 2010/11 ($20m x 4%) (800,000)

15,200,000

Less: Annual allowance for 2011/12 (800,000)

Residue before sale 14,400,000

Less: Sales proceeds ($72m x 20m / 60m) (24,000,000)

(9,600,000)

Balancing charge (for 2012/13) restricted to 5,600,000

Healthy Nutrition Limited

Residue before sale 14,400,000

Add: Balancing charge 5,600,000

Residue after sale 20,000,000

Year of first use of building 2010/11

25th year after year of first use 2035/36

Year in which sale has taken place 2012/13

No. of years from year of sale to the 25th year 24

Annual allowance for 2012/13 ($20m / 24) $833,333

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Year of assessment 2012/13

Depreciation allowances on plant and machinery

20% Pool 30% Pool

$ $

W.D.V. b/f 201,000 105,000

Add: Motor vehicles 360,000

Less: Initial allowance (60%) (216,000)

Furniture and fixtures 130,000

Less: Initial allowance (60%) (78,000)

Air-conditioners brought-in* 11,520 _________-

264,520 249,000

Less: Sale proceeds of furniture (5,000) _________-

259,520 249,000

Less: Annual allowance (51,904) (74,700)

W.D.V. c/f 207,616 174,300

* $18,000 x 0.8 x 0.8

Testing machine under hire-purchase

Cost ($1,200,000 + $30,000 + $10,000) 1,240,000

Less: Initial allowance

($240,000 + $1,000,000 x 9/12) x 60% (594,000)

646,000

Less: Annual allowance (30%) (193,800)

W.D.V. c/f 452,200

Production machines ($415,000) qualify for a deduction as prescribed fixed assets

under section 16G

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6. The statement of income and expenditures of My Doggy Club for the two years ended

31 December 2012 and 2011 were as follows:

2012 2011

Income $ $

Annual subscriptions 50,000 35,000

Sales of food and accessories 153,000 112,000

Grooming and bathing receipts 84,200 57,000

Donations - 80,000

Rental income 48,000 42,000

335,200 326,000

Expenditure

Administrative expenses 177,000 161,500

Cost of food and accessories 98,000 76,000

Supplies 23,000 17,500

298,000 255,000

Surplus for the year 37,200 71,000

The following additional information is available:

1. Apart from annual subscriptions, members were required to pay an entrance fee on

admission to the club, and this fee is credited to the accumulated fund account

directly. The entrance fees received were $9,000 and $12,000 for 2012 and 2011

respectively. All members have voting rights at the general meeting.

2. The club sells food and accessories to both members and non-members. It is

estimated that one half of the sales are from members. However, all grooming and

bathing receipts are from members only.

3. The donation was received from a supplier of dog foods.

4. The club owns premises and has leased out part of the unused space to a third

party, which operates a coffee bar.

REQUIRED:

6. (a) Advise the Hong Kong tax position of My Doggy Club for the years of

assessment concerned. Where applicable, compute the Hong Kong profits

tax and/or property tax payable by the club. Ignore depreciation

allowances, provisional tax and any one-off tax waiver.

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Ans (a) For a club, section 24(1) provides that if not less than one half of the club's

gross receipts on the revenue account (including entrance fees and

subscriptions) are from its voting members, the club is deemed not to carry on

a business

Otherwise, it is deemed to carry on a business and the whole of its income

from both members and others (including entrance fees and subscriptions)

shall be considered as business receipts and chargeable to profits tax

A club is liable to property tax in respect of rental income from non-voting

members and non-members no matter whether it is subject to profits tax or

not; however, if it is subject to profits tax, it may apply for exemption under

property tax under section 5(2)(a) or if property tax has been paid, setting off

the property tax paid against profits tax under section 25

2012/13 2011/12

Receipts from voting members $ $

Subscriptions 50,000 35,000

Entrance fee 9,000 12,000

Sales of foods and accessories 76,500 56,000

Grooming and bathing receipts 84,200 57,000

219,700 160,000

Receipts from non-voting members

Sales of foods and accessories 76,500 56,000

Donation - 80,000

Rental income 48,000 42,000

124,500 178,000

Total gross receipts 344,200 338,000

% of receipts from members 63.8% 47.3%

For the year of assessment 2012/13, the club derived more than 50% of its

receipts from voting members and hence is deemed as not carrying on

business and is not liable for profits tax; however, the rental income will still

be subject to property tax

For the year of assessment 2011/12, the club received less than 50% of its

income from voting members; hence profits tax is payable for this year

As the club is subject to both property tax and profits tax in 2011/12, it could

offset the property tax paid against the profits tax payable for the year under

section 25

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2012/13 2011/12

Property tax computation $ $

Rent 48,000 42,000

Less: 20% statutory deduction (9,600) (8,400)

Net assessable value 38,400 33,600

Property tax at 15% 5,760 5,040

Profits tax computation

Surplus for the year 71,000

Entrance fee 12,000

Assessable profits 83,000

Profits tax at 15% 12,450

Less: Property tax paid set-off (5,040)

Profits tax payable 7,410

6. (b) Johnny Chan carries on a decoration business in Hong Kong. He was recently

investigated by the Inland Revenue Department (IRD) for having omitted certain

income and over-claimed deduction of expenses, resulting in an understatement

of profits for the past few years. As most of the transactions were paid in cash

and Johnny has not kept all his receipts, he used to estimate his profits for

reporting to the IRD, which he believed to be a usual practice. He found it

difficult to reckon the actual profits due to the lapse of time and insufficient

records.

REQUIRED:

Advise Johnny on the distinction between tax avoidance and tax evasion,

and the possible methods which may be used by the IRD to quantify the

understatement of profits.

Ans (b) Tax avoidance refers to the legitimate minimisation of tax payable within the

framework of the Inland Revenue Ordinance

Legal means are employed by a taxpayer to reduce his tax liability by making

use of the characteristics of the Hong Kong tax system, such as the territorial

source principle, generous deduction for specified items, etc.

Tax avoidance normally will not attract any penalty when the tax plan fails

unless there is concealment of facts; the taxpayer is required to pay the tax

as if such arrangements have not been implemented

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Tax evasion refers to the failure on the part of the taxpayer to supply full and

correct information relevant to the assessment of tax because of deliberate

attempt or negligence

Illegal means are used to reduce the tax liability which usually involve

omitting or understating income or over-reporting of expenses in the returns

Tax evasion is an offence punishable by a fine and/or imprisonment

A direct method cannot be used to quantify the income or profits understated

when the taxpayer’s records are incomplete or not reliable

Depending on circumstances of individual cases, indirect methods such as

the assets betterment statement method, bank deposits method, business

economics (percentage computation) method and projection method may be

employed to quantify the profits

Under the assets betterment statement method, all expenditures of a

non-allowable nature are added to the taxpayer’s yearly asset increase (i.e.

the excess of net assets in any one year over the preceding year), from which

receipts of capital nature or otherwise not assessable are to be deducted to

arrive at the betterment profits

Under the bank deposit method, it is assumed that moneys deposited in the

taxpayer’s bank accounts are surplus funds received from customers; the

total deposits plus moneys withdrawn for the taxpayer’s private use would

represent the total business receipts

The percentage computation method involves the application of percentages

or ratios considered typical of the business operations under investigation to

particular known amounts, e.g. sales to determine the assessable profits

Under the projection method, the IRD would examine the accounting records,

bank statements, etc. in detail for one year to ascertain the profit after

investigation; the net profit ratio for that year will be used to estimate the

assessable profits for other years

END