Profits Tax Planning
Answer 1
(a)
The basic principles governing liability to profits tax are authoritatively set out in the Privy
Council’s decision in CIR v Hang Seng Bank Ltd. In considering the principles relating to the
source of profits from a business carried on in Hong Kong, the Privy Council emphasised that
this ‘is always in the last analysis a question of fact depending upon the nature of the
transaction’ and that although ‘it is impossible to lay down precise rules of law by which the
source of profits is to be determined’, nevertheless there is a ‘broad guiding principle’. The
principle is that ‘one looks to see what the taxpayer has done to earn the profits in question’.
This is an express recognition that the source of profits should not be determined by reference
to all the taxpayer’s operations which give rise to the profits but only by reference to the
specific acts that were more directly responsible for generating the relevant gross profits.
When applying those principles to the source of trading profits, the Privy Council indicated
that profits arise where the contracts of sale and purchase are ‘effected’. There has been some
uncertainty as to the meaning of ‘effected’. It may, but should not, mean where the contract is
made. This test would be too easily manipulated and would not satisfy the hard, practical
matter of fact test: Nathan’s case. It could also mean performance of a contract, i.e. putting it
into effect. It is, however, thought that a better approach is that the word ‘effected’ means the
process whereby the contract is brought into existence, namely the negotiating, bargaining
and exchange of information which eventually leads to striking a deal.
(b)
The Commissioner’s practice for determining the source of trading profits is found in para 8
of DIPN 21 and can be summarized as follows:
In accordance with the Hang Seng Bank case, the locality of trading profits ‘is the place
where the contracts of sale and purchase are effected’. ‘Effected’ means not only the formal
execution but also the actual steps leading to the existence of the contracts including the
‘negotiation and, in substance, conclusion of the contracts’. Although the purchase and sale
contracts are important factors, a better approach is to consider the totality of facts: CIR v
Magna industrial Co Ltd. Where both the contract of purchase and contract of sale are
effected in Hong Kong, profits are sourced in Hong Kong and fully taxable. Profits are also
presumed to be sourced in Hong Kong and no apportionment will be accepted where (1) a
contract of sale is effected in Hong Kong; (2) a contract of purchase is effected in Hong Kong;
(3) the sale is made to a Hong Kong customer; or (4) the goods are purchased from a Hong
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Kong supplier or manufacturer. Where the effecting of the purchase or sale contract does not
require travelling outside Hong Kong but is carried out in Hong Kong by telephone, fax, etc;
the contracts will be considered to be effected in Hong Kong.
(c)
The general charging provision, s.14, requires various cumulative conditions to be satisfied,
that is (1) a business being carried on in Hong Kong, (2) profits from that business and (3)
those profits arising in or being derived from Hong Kong. However, the fact that a company
carries on business in Hong Kong does not of itself indicate that its profits must have a Hong
Kong source. Also, the facts that management of the business and decisions as to trading (i.e.
decisions as to sales and purchases) are made in Hong Kong are not relevant in determining
the source of a taxpayer’s profits (Mehta’s case; Hang Seng Bank case). As stated in (b) above,
in determining the source of profits, the broad guiding principle is that one looks to see what
was the activity that gave rise to the profits (Hang Seng Bank case). Put another way, one
looks to see what were the operations that in substance gave rise to the profits (HK-TVB
International Ltd v CIR).
Tutorial note: In the ING case, the Court of Final Appeal appeared to put more emphasis on
the ‘transaction’ that gave rise to the profits. The IRD apparently takes the position that the
ING case only applies to the industry of securities brokerage and not to any other industries
though some commentaries thought the practice should apply to all cases under s.14. This
discrepancy of view has yet to be resolved possibly by a subsequent court. The following
comments follow the approach taken by the IRD.
In the present case, Apple is incorporated in Hong Kong and has an office in Hong Kong. The
only reasonable conclusion is that it carries on business in Hong Kong. Further, there is no
doubt that its profits are derived from such business. The only issue to consider is whether its
profits arise in or are derived from Hong Kong.
Apple is a trader, i.e. its profits are made from the purchase and sale of goods. A trader’s
profits are made where the purchase contracts and the sale contracts are ‘effected’ (Hang Seng
Bank case). The question indicates that:
(i)
(ii)
(iii)
(iv)
both the supplier and customer were located outside Hong Kong;
communication with both supplier and customer were followed up outside Hong Kong;
both the sale and purchase contracts were entered into outside Hong Kong; and
the goods will be shipped direct from the supplier to the customer; and no stock of
merchandise will be maintained in Hong Kong.
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It appears that both the contracts of purchase and of sale are effected outside Hong Kong and
the profits are not subject to profits tax.
However, it should be noted that the Hong Kong office will perform the functions of issuing
orders to the supplier and accepting orders from the customer. Based on case law, the
Commissioner considers that where the Hong Kong business accepts or issues sale or
purchase orders in Hong Kong, the profits will be taxable in Hong Kong (para 9 of DIPN 21):
Exxon Chemical International Supply SA and Euro Tech (Far East) Ltd.
Therefore, to ensure that the profits would be exempt from profits tax, the Hong Kong office
should limit its activities to issuing and accepting invoices, not orders, on the basis of
contracts of sale or purchase already effected by the directors outside Hong Kong (see
Advance Ruling No. 8).
Marking Scheme:
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Answer 2
(a)
If Gary acquires the property in his own name, he will be subject to property tax at the
standard rate on the net assessable value of the property.
Under Section 2 of the Inland Revenue Ordinance, the term “business” is defined to include
letting and sub-letting by corporations. Therefore, if Gary acquires the property in the name of
a limited company, the rental income to be received will be subject to profits tax. The
company should apply to the Inland Revenue Department for an exemption from property tax
under Section 5(2)(a).
(b)
If the property is held by Gary, he will be subject to property tax. The only deduction
available to him is restricted to 20% of the assessable value of the property after the deduction
of any rates paid by him.
There will be no deduction of actual expenses incurred in respect of the property, including
the loan interest, service fees paid to his agent and other expenses incurred in connection with
refurbishing the property.
If Gary wishes to claim a deduction of loan interest, he would have to elect for Personal
Assessment. However, the eligible person must be either a permanent resident or temporary
resident of Hong Kong. On the assumption that Gary continues to reside in the US after
acquiring the property, the residence criteria will not be met. It follows that he will not be
eligible for personal assessment and entitled to deduct the interest expenses.
If, however, the property is held by a limited company, he is entitled to the following tax
deduction under profits tax:
Loan interest
In the present case, the loan was obtained to finance the acquisition cost of the property,
which is held for producing rental income chargeable to profits tax. In this regard, the interest
on the loan is incurred in the production of assessable profits, i.e. it fulfils the conditions of
Section 16(1)(a).
The relevant condition under Section 16(2) is subsection (d). The loan was obtained from a
bank in New York. It is most likely that the bank would be accepted as an overseas financial
institution for the purposes of Section 16(2)(d). As the bank loan is not secured by any deposit,
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the conditions in Section 16(2)(d) should be satisfied, and the interest incurred is deductible.
Sections 16(2A), 16(2B) and 16(2C) do not apply.
Service fees paid to his agent
For profits tax purposes, the expenses are deductible if they are incurred in the production of
the taxpayer’s chargeable profits, Section 16(1). As the service fee was incurred for producing
rental income which is chargeable to tax, the expense satisfies Section 16(1) and is deductible.
Expenses incurred on refurbishing the property and furniture
The expenses are capital in nature and therefore non-deductible for tax in terms of Section
17(1)(c).
However, the company is entitled to commercial building allowance on the expenditure
incurred on refurbishing the property (4% on cost per each year of assessment).
In respect of the expenses on furniture, the company is entitled to claim depreciation
allowance in respect of the assets.
As more deductions will be available under profits tax, it is advantageous to Gary to hold the
property through a limited company.
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Answer 3
(a)
Setting up a branch in Hong Kong will not involve any capital duty or stamp duty and is less
formal. Zeta should take into account the following considerations in deciding whether to set
up a branch in Hong Kong:
(1) A branch, not being a separate legal entity, has no limited liability and Zeta will have to
bear the risk of taking up the liabilities of the branch should there be a failure in its
business in Hong Kong.
(2) It will be difficult to apply transfer pricing arrangements with a branch although a
reasonable share of the head office administrative expenses may be allowed by the IRD.
(3) No tax deferral can be obtained by Zeta if its Hong Kong branch makes a profit but
delays the repatriation of the profit to Zeta.
(b)
For there to be a charge to profits tax, s.14 of the IRO requires various cumulative conditions
to be satisfied, that is (1) a business is carried on in Hong Kong, (2) there are profits from that
business, and (3) those profits arise in or are derived from Hong Kong. Therefore, if a
company carries on a business in Hong Kong, only Hong Kong sourced profits are taxable.
Profits derived from overseas are not taxable.
A company is regarded as carrying on a business in Hong Kong whenever there is a
permanent establishment in Hong Kong. Inland Revenue Rule (IRR) 5(1) defines ‘permanent
establishment’ to mean a branch, management, or other place of business but does not include
an agency unless the agent has, and habitually exercises, a general authority to negotiate and
conclude contracts on behalf of his principal; or the agent has a stock of merchandise from
which he regularly fills orders on behalf of his principal.
Zeta would be regarded as carrying on a business in Hong Kong through its branch, i.e. a
permanent establishment, here. The issue is therefore, whether the profits earned from the
branch operations are derived from Hong Kong, i.e. having a Hong Kong source. In deciding
this issue, the broad guiding principle is to ascertain what the taxpayer has done to earn the
profits and where he has done it: the Hang Seng Bank and HK-TVB International cases.
For trading profits as in the present case, the IRD considers that the location of the profits is
determined by the place where the contracts of purchase and sales are effected. However, this
does not only mean the place where contracts are legally executed but includes the actual
steps leading to the existence of the contracts, such as negotiation, conclusion and execution;
and a better approach is to consider the totality of facts: see Magna Industrial Company Ltd v
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CIR. In the present case, it is pertinent to consider the following operations of the branch in
Hong Kong; and the places where they are carried out:
(1) Overseas sales promotions are made by the branch’s sales team outside Hong Kong.
(2) Negotiation and finalisation of the terms of sales orders are made by the branch’s sales
team outside Hong Kong.
(3) Orders are confirmed and processed in Hong Kong.
(4) Letters of credit are handled in Hong Kong.
(5) Purchases of products are made in Hong Kong.
(6) Shipments of goods are handled in Hong Kong. It should be added that shipment
through Hong Kong is relevant but the mere fact that goods do not pass through Hong
Kong would not make the profits offshore.
It is submitted that, on the whole, relevant operations are predominantly carried out in Hong
Kong and so Zeta’s profits would be chargeable to profits tax.
It should also be mentioned that the IRD’s stance is that, for trading profits, if either the
contract of sale or contract of purchase is effected in Hong Kong, the profits are fully taxable
and no apportionment would be accepted. In the present case, all the branch’s purchases are
likely to be effected in Hong Kong. It is therefore unlikely that the IRD would agree to
apportion the company’s profits between onshore and offshore profits even though some of
the branch’s operations are conducted outside Hong Kong.
(c)
Under IRR 5, the assessable profits of the branch would be ascertained as follows:
(1) If branch accounts are kept which show the true profits arising in Hong Kong,
assessable profits will be computed by reference to the branch accounts.
(2) Where (1) above is not applicable, the assessable profits will be computed as a
percentage of the worldwide profits, which are to be adjusted for tax purposes as if the
whole of those profits are chargeable to profits tax. The percentage is the ratio of Hong
Kong turnover to the worldwide turnover.
(3)
Where, because of impracticality or inequity, neither of the methods in (1) and (2) above
can be adopted, the Assessor may compute the assessable profits by taking a fair
percentage of the Hong Kong turnover. The Assessor’s decision is subject to the
taxpayer’s rights of objection and appeal.
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Marking Scheme
Answer 4
(a)
Under the profits tax regime of the Inland Revenue Ordinance, a person’s residence status is
not relevant in determining whether the person is chargeable to tax in Hong Kong. The basic
test for profits tax chargeability is whether the person carries on a trade, profession or
business in Hong Kong from which a profit is derived, and that profit is sourced in Hong
Kong. The test is multi-fold: first, there must be a trade, profession or business being carried
on; secondly, the trade, profession or business is being carried on in Hong Kong; and lastly,
the profit derived therefrom is sourced in Hong Kong.
Whether a transaction or activity constitutes a trade, profession or business is not always easy
and straightforward. Section 2 of the IRO defines trade as including ‘every trade and
manufacture and every adventure and concern in the nature of trade.’ The broad general
guideline is to look at the intention of the person at the time of the transaction; and in this
aspect, the ‘badges of trade’ are commonly used:
(1)
(2)
(3)
The subject matter of the realisation – In the case of John Yuan, the subject matter is
shares listed in Hong Kong and the US. Listed shares are generally accepted as a
common subject of trading, but there are also numerous cases that tend to support the
proposition that share trading is close to gambling. This is further analysed below.
The length of period of ownership – John’s portfolio has an average holding period of
less than 30 days, which illustrates the short-term trading intention.
The frequency or number of similar transactions by the same person – John and Peter
communicate nearly every day, and a monthly statement is prepared and monitored by
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Peter for John’s review. This demonstrates the high frequency of trading activities.
Supplementary work on or in connection with the property realised – Primarily no
supplementary work has been done on the shares before they are sold, but there is
ancillary work done by Peter in support of John’s share trading activities such as
collecting and sending the market news and analysts’ reports.
(5) The circumstances that were responsible for the realisation – In the case of share trading,
the realisation must be driven by profit maximisation or loss minimisation.
(6) The motive – A profit making motive is obviously connected with John’s share trading
activities.
(4)
Judging from the above badges of trade, it is quite obvious that John’s buying and selling of
listed shares would likely constitute a trade. However, there are numerous cases in Hong
Kong concerning individuals buying and selling shares, and most of these cases decided that
speculative transactions in shares by an individual do not amount to a trade, although it is well
recognised that each case needs to be considered on its own merits (see CIR v Dr Chang
Liang-Jen (HKTC 975); D30/84; D111/97; D74/00; and Lee Yee Shing, Jacky and Yeung Yuk
Ching v CIR (2005)). Based on the Court of Final Appeal in the case of Lee Yee Shing, Jacky,
the fact that an undertaking had a profit-making purpose, although an indicator of a trade or
business, was not determinative. The court considered that speculation was akin to gambling,
which had generally been found not to amount to a trade unless undertaken by a person with
some special knowledge of the particular activity or industry which was the subject of the
speculation (see Burdge v Pyne (45 TC 320)). In respect of this very last point mentioned by
the court, being the share trading associated with special relevant knowledge, John Yuan
could still be regarded as carrying on a trade or business through Peter Yuan by applying
Peter’s special knowledge and expertise in share trading since Peter is a registered
stockbroker or dealer.
Assuming that the share trading activities constitute a trade or business, the second issue is
whether the trade or business is being carried on in Hong Kong. Generally speaking, if a
person has established a ‘permanent establishment’ in Hong Kong (either a fixed presence in
Hong Kong or a full agent in Hong Kong), he would be considered to be carrying on the trade
or business in Hong Kong. Under Rule 5(1), a permanent establishment includes a physical
place of business i.e. a branch, management or other place of business, and also an agent. An
agent in Hong Kong would constitute a permanent establishment of the non-resident if the
agent (i) has, and habitually exercises, a general authority to negotiate and conclude contracts
on behalf of his principal; or (ii) has a stock of merchandise from which he regularly fills
orders on behalf of his principal. Once it is established that the non-resident has a permanent
establishment in Hong Kong, then in accordance with Rule 5(1), the assessable profits of the
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non-resident would be ascertained based on Rule 5(2). In the case of John Yuan, the fact that
he allows his brother, Peter Yuan, to operate his securities account with full authority and
discretion demonstrates that a general authority has been given to Peter to ‘negotiate and
conclude contracts on his behalf’. In the circumstances, it is very likely that John Yuan would
be regarded as having established a permanent establishment in Hong Kong via Peter Yuan as
his agent.
Lastly, whether John Yuan will be chargeable to tax in Hong Kong depends on whether the
profits derived from the share trading activities are sourced in Hong Kong. In general, the
source of profits is determined by applying the ‘operation test’, i.e. where do the operations
take place from which the profits in substance arise. The interpretation and application of this
test in different situations may not be the same. In the case of trading in listed shares, the
general rule as laid down by Departmental Interpretation and Practice Notes (DIPN) 21
(revised 2009) is that profit has its source where the shares are listed since this is the place
where share transfers would be registered. In the case of John Yuan, as profits are earned
partly from trading in Hong Kong listed shares and partly from trading in US listed shares, it
would likely be the case that profits arising from trading in Hong Kong listed shares would be
considered as sourced in Hong Kong and taxable; whereas profits arising from trading in US
listed shares would be considered as offshore and not taxable.
(Tutorial note: the issue of whether or not the role of agents and their activities should
determine the source of profits of the taxpayer has been widely discussed in various court
cases including Indosuez WI Carr Securities, ING Baring Securities and Kim Eng Securities.
The IRD opined in DIPN 21 that the agency concept as stated in the ING case only applied to
the brokerage business. For this question, candidates are not required to discuss these cases in
detail, but are encouraged to study the cases for learning purposes.)
(b)
Should John Yuan be determined to be chargeable to profits tax, tax assessments may be
issued by the IRD to Peter Yuan as the agent of John Yuan. ‘Agent’ is widely defined under
s.2 as including (i) an agent, attorney, factor, receiver, or manager in Hong Kong of a
non-resident principal; and (ii) any person in Hong Kong through whom a non-resident
principal is in receipt of profits or income arising in Hong Kong.
Pursuant to s.20A(1), the IRD is authorised to collect the tax due from a non-resident in
respect of profits from a business undertaken through a Hong Kong agent. This is the case
regardless of whether or not the agent has receipt of the profits. When tax is assessed on Peter
Yuan as John’s agent, Peter Yuan is obliged to pay the tax as demanded or else he would be
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deemed to be in default of tax payment. Moreover, s.20A(2) also requires Peter to retain, or
withhold, a sufficient amount from John’s assets coming into his possession or control so that
the retained amount may be used to settle the tax liability due.
In the case of a stockbroker or dealer or investment advisor, the IRO does contain specific
provisions seeking to exempt the broker or dealer, or investment advisor, from being deemed
as agent for the purpose of s.20A. The exemption was granted on the premise that it would be
practically too difficult for the stockbrokers or dealers to determine whether the investment
activities of their non-resident clients constitute a chargeable trade or business in Hong Kong
and to ascertain the net chargeable profits to which tax should apply. However, for the
exemption to apply, ALL of the following conditions must be fulfilled:
(i)
at the time of the transaction in Hong Kong, the agent was carrying on a business of
registered broker or approved investment advisor, being a person duly registered in such
capacity under Part VI of the Securities Ordinance;
(ii) the transaction was carried out by the broker for the non-resident in the ordinary course
of his business;
(iii) the broker has received remuneration at a rate not less than the customary rate for that
class of business;
(iv) all transactions through the broker must meet the exemption conditions so that after the
exemption, the non-resident has no assessable profits for the year in respect of which
(v)
the broker would be treated as agent; and
the broker was not an associate of the non-resident.
In the case of Peter Yuan, although Peter is a registered broker, the exemption under s.20A
would likely not apply due to the fact that he is an associate of John Yuan by virtue of their
relationship. It is also not clear from the facts given whether or not Peter was paid any arm’s
length remuneration by John. In any case, this aspect is no longer relevant.
When a tax assessment is issued to Peter Yuan as agent of John Yuan, and Peter pays the tax
on behalf of John by applying John’s money in his possession, Peter will be statutorily
indemnified against any claim made by John in respect of such act to apply John’s money in
settlement of tax.
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Marking Scheme
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