SUPPLEMENTARY INSTRUCTIONS 1. You should assume that the tax rates and allowances shown below will continue to apply for the foreseeable future. 2. Calculations and workings should be rounded down to the nearest HK$. 3. Apportionments need only be made to the nearest month, unless the law and prevailing practice require otherwise. 4. All workings should be shown. TAX RATES AND ALLOWANCES The following 2011/12 tax rates and allowances are to be used in answering the questions. Section A – BOTH questions are compulsory and MUST be attempted 1. Smart HK Ltd (‘Smart-HK’) is a company incorporated and carrying on business in Hong Kong as a professional training service provider. Smart-HK has a subsidiary in the PRC (‘Smart–PRC’) and is ultimately owned by a Bermuda company which also owns a subsidiary in Singapore (‘Smart-Singapore’). The four companies are collectively known as the ‘Smart-Group’. Recently, the shareholders of the Smart-Group decided to divest the whole group to Acquirer Group (‘A-Group’). A full-scale due diligence exercise is to be carried out by the A-Group. You are the person in-charge of the tax due diligence review of Smart-HK, with the aim to assess the Hong Kong tax position of the company and whether there is any potential tax risk leading to unexpected additional tax liabilities after its acquisition by the A-Group. To facilitate the review, you are provided with the following information: A simplified chart of the Smart-Group indicating the shareholdings and major transaction flows: An extract of Smart-HK’s management accounts for the preceding year, indicating the Hong Kong tax treatment of each item: Additional information about Smart-HK’s operations: (1) Smart-HK provides training services to its customers in Hong Kong and the PRC, depending on customers’ needs. Separate contracts are signed for training in Hong Kong (‘HK Contracts’) and the PRC (‘PRC Contracts’). Smart-HK sub-contracts all its obligations under the PRC Contracts to Smart-PRC which agrees to fulfil the contract obligations on behalf of Smart-HK and run the training sessions in the PRC for the customers. The sub-contract fee payable to Smart-PRC is agreed at 80% of the gross service fee under the PRC Contracts. For each training session, experienced trainers are sent from Smart-HK to assist Smart-PRC, but no cost is charged for this by Smart-HK. Other support provided in Hong Kong for the PRC Contracts include liaison with customers, arranging itinerary etc. None of the customers are related to the Smart-Group, and all the service contracts (both HK and PRC Contracts) are negotiated and signed in Hong Kong. (2) Smart-PRC is responsible for preparing the relevant training materials for use in the training sessions. It has been agreed that the copyright for these materials will remain with Smart-PRC. By virtue of the licence agreement between Smart-PRC and Smart-HK, Smart-HK is granted the right to use the training materials in Hong Kong and Singapore. The royalty payable is based on 3% of the training revenue received. Smart-HK has entered into a sub-licence agreement with Smart-Singapore under which Smart-Singapore is allowed to use the training materials for a royalty at 10% of the training revenue received. (3) Smart-PRC is the wholly-owned subsidiary of Smart-HK. Each year, Smart-HK has recorded a considerable amount of dividend income from Smart-PRC. Based on the management representation, Smart-PRC has been making a very good return from its investment activities in the PRC, and these investments are mainly funded by the large amount of cash received from Smart-HK by way of sub-contract fees. Required: As the tax advisor of Acquirer Group in charge of the tax due diligence review, prepare a report for the directors of Acquirer Group, addressing the Hong Kong tax issues set out below relating to Smart-HK, including supporting calculations where appropriate. (i) The Hong Kong profits tax implications of the training fee revenue from the PRC Contracts and the sub-contract fee payable to Smart-PRC. Your report should cover the contemporary principles/rules determining the taxability of the net income of $200,000 from the PRC training service, the arguments both for and against the offshore claim made by Smart-HK, the role played by Smart-PRC and whether you agree with the current profits tax treatments by Smart-HK; Note: For the purpose of this part only, you should assume that all amounts are charged on an arm’s length basis. (14 marks) (ii) Assuming that the training fees from the PRC Contracts are taxable in Hong Kong, the Hong Kong profits tax implications, if any, to Smart-HK of the sub-contract fee paid to Smart-PRC, taking into account the current transfer pricing rules and practices in Hong Kong. Your report should cover the current views of the Inland Revenue Department on charges made between associated enterprises, as set out in Departmental Interpretation and Practice Note (DIPN) 46 ‘Transfer pricing guidelines – Methodologies and related issues’; Note: You are NOT required to make detailed references to the Double Taxation Arrangement between Hong Kong and the PRC. (10 marks) (iii) Assuming that Smart-PRC is not carrying on business in Hong Kong, the Hong Kong profits tax implications to Smart-PRC in respect of the royalty received and the Hong Kong tax compliance obligations of Smart-HK in this context; (6 marks) (iv) Other than the potential technical risks as discussed above, any other information that you would request from Smart-HK in order for you to assess its level of tax compliance in the context of the Hong Kong tax regime, giving brief explanations as to why the information is required. (6 marks) Professional marks will be awarded in question 1 for the appropriateness of the format and presentation of the report and the effectiveness with which its advice is communicated. (4 marks) 2. Mr Chan, a Malaysian, has been working in Hong Kong for World Ltd, a company resident in Hong Kong (the ‘Company’) since 1 April 2004, at a monthly salary of $80,000. Due to a failure in an important business project, Mr Chan was asked to resign and he submitted his resignation letter to the Company’s director on 31 March 2012, notifying that he would terminate his employment with effect from 1 April 2012. However, his official last day of work in the Company would be 29 March 2012, after deducting two days of entitled annual leave. Other details of Mr Chan’s termination arrangement and payment are as follows: (I) His total termination payment represented the following: (i) his final salary accrued up to 31 March 2012; (ii) compensation for the remaining balance of his entitled annual leave days as at 31 March 2012 of 15 days, of $40,000; (iii) compensation for loss of office as agreed with the Company’s director, representing one month of his salary. It has been the practice of the Company to pay an annual discretionary bonus equivalent to one month’s salary; (iv) his entitlement payment from the Company’s provident fund registered under the Occupational Retirement Scheme Ordinance in the amount of $300,000 (Mr Chan and the Company had contributed equal amounts to the provident fund). The accrued benefit attributable to Mr Chan’s service was $120,000; and (v) compensation for the loss incurred by him from having to sell his car in Hong Kong as a result of his termination of $10,000. (II) The Company’s director agreed to pay Mr Chan an extra sum of compensation of $200,000 after six months from the date of his termination on the condition that he did not work for the Company’s competitors during this period. Mr Chan is planning to move back to Malaysia. Before he goes back, he is interested in investing in residential properties in Hong Kong. With various ideas in mind, he has approached you for advice on how to plan his investment in a tax effective manner. His plans and ideas are: (1) He will acquire one or two residential units in Tsimshatsui and lease them out for rental. (2) The acquisitions will be financed partly by his personal savings (around 50%) and partly by bank mortgage loans. It is expected that the rental income will not be sufficient to cover the mortgage interest. (3) The residential units need to be renovated before they can be leased out. A substantial amount of renovation costs is expected to be incurred after the acquisition. (4) In two to five years’ time, he may consider disposing of the units if property prices go up to a satisfactory level. (5) He has no idea as to how the properties should be owned, by an individual or by a special purpose company. However, for the former, he prefers to have the properties owned by his daughter who is single, has always been living in the UK and has no connection with Hong Kong. He believes that this will lead to a tax-free position in respect of the rental received. Alternatively, he is considering setting up a company in an offshore tax haven to hold the properties so that Hong Kong tax can be avoided; with minimal local tax payable in the tax haven country. Required: (a) Advise Mr Chan of the general principles used for determining the taxability of each item of the termination payment received upon his cessation of employment. Note: You are NOT required to calculate his assessable/chargeable income or tax payable. (14 marks) (b) Compare the tax implications for the rental income received from the residential units if the properties are held by: (i) an individual; and (3 marks) (ii) a special purpose company. (4 marks) (c) Comment on the extent to which the tax planning ideas as described in note 5 above are feasible. (3 marks) (d) Explain the tax implications arising from the disposal of the residential units in two to five years’ time, including how these may be affected by the different ownership structures. (6 marks) Section B – TWO questions ONLY to be attempted 3. Mr Hui is working as the Regional IT Manager for GA Ltd (‘GAL’), a company incorp