Feature Reference
Transcript of Feature Reference
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02 News Update Summer 2007
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Introduction
In 2005, the House o Lords in National Westminster Bank Plc v.
Spectrum Plus Limited & Others [2005] 4 ALL ER 209 unanimously
overruled the long standing authority laid down more than 25 years
ago in Siebe Gorman v. Barclays Bank Ltd . [1979] 2 Lloyd’s Law
Reports 142. In the Siebe Gorman case, Slade J held that a charge
over past and uture book debt was a xed charge i it prevented
the chargor rom disposing o the uncollected book debts and the
chargee allowed the chargor to deal with its debtors and collect
the debts. Debt proceeds had to be paid into a designated account
with the chargee bank, but the chargor was allowed to draw on the
accounts reely or its business purposes.
Beore the House o Lords, National Westminster Bank Plc
(‘Natwest’) asserted that the charge over book debts was xed and
demanded payment o the book debt proceeds rom the liquidators
o Spectrum Plus Limited (‘Spectrum Plus’). However, the Customs
and Excise Commissioners, the Commissioners o Inland Revenue
and the Secretary o State or Trade and Industry (‘Crown
Creditors’) together resisted Natwest’s claim that the charge was
xed and argued that the charge was foating so that they were
entitled to the proceeds in priority to the bank. The House o Lords
reversed the Court o Appeal’s decision which gave judgment in
avour o Natwest and that the charge granted to Spectrum Plus
was xed. Their lordships unanimously upheld the decision o the
rst instance court which held that Natwest’s charge only created
a foating charge over book debts and that the Crown Creditors
had priority to be paid beore Natwest and that Siebe Gorman was
wrongly decided.
This article examines the decision o the House o Lords and
considers some o its implications on the banking sector.
Facts o the Case
Spectrum Plus obtained an overdrat acility o £250,000
rom Natwest or the purpose o providing working capital to
the company. The overdrat acility was secured by a debenture
to the bank, which included a xed charge over all present and
uture book debts. The debenture was a Natwest standard orm
which was drated substantially the same as in Siebe Gorman. The
debenture prevented Spectrum Plus, without prior written consent
rom the bank, rom selling, actoring, discounting or otherwise
charging or assigning uncollected book debts. The debenture
did not prevent Spectrum Plus rom dealing with its debtors
and collecting its debts. Proceeds, once collected, Spectrum
Plus was required to pay them into a designated account with
Natwest to reduce the overdrat. Provided the overdrat limit
was not exceeded, Spectrum Plus was allowed to draw reely on
the account or its business purposes. The charge also required
Spectrum Plus, i so requested by Natwest, to execute a legal
assignment o the book debts in avour o the bank.
Spectrum Plus later went into creditors’ voluntary liquidation.
The liquidator collected the proceeds o the book debts in the
account but reused to account or them to Natwest. The bank
applied or a declaration that the debenture had created a xed
charge over Spectrum Plus’s book debts and that the liquidator
should hand over the proceeds. Under s.175(2)(b) o the Insolvency
Act 1986, (Hong Kong’s equivalent is s.265(3B) Companies
Ordinance) preerential creditors are entitled to be paid out o the
proceeds o a foating charge realization in priority to the foating
chargeholder. On the other hand, the Crown creditors joined in as
respondents and argued that the charge created was a foating
charge and Siebe Gorman was wrongly decided and that they were
entitled to the book debt proceeds in priority to Natwest.
Fixed or Floating Charge? House o LordsDecision in National Westminster Bank Plcv. Spectrum Plus Limited & Others(relevant to Paper 2.2 / F4)By Susan Leung
Lecturer, School o Accounting & Finance
Hong Kong Polytechnic University
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High Court Decision –
Natwest’s Debenture was a Floating Charge
In the High Court, Sir Andrew Morrit VC was o the view that
since Spectrum Plus had the reedom to deal with and use the
proceeds o the book debts in the ordinary course o business
through collection and ordinary operation o the bank account, the
book debts were under the control o the company. A restriction
which allowed collection and ree use o the proceeds was
inconsistent with the xed nature o a charge. Spectrum Plus’
s account with Natwest was an ordinary current account with no
restriction on its use or all purposes o the company’s business
so long as the overdrat limit was not exceeded. Whether a charge
was xed or foating, it did not depend on the intention o the
parties. I their intention, properly construed rom the language o
the instrument, was to grant Spectrum Plus rights in respect o the
charged assets which were inconsistent with the nature o a xed
charge, the charge could not be a xed charge despite the label
the parties put on it. Consequently, the charge over book debts
granted by Spectrum Plus to Natwest could only have been a
foating charge. Sir Andrew Morrit VC held that Siebe Gorman was
wrongly decided.
Court o Appeal Decision –
Natwest’s Debenture was a Fixed Charge
Natwest appealed. Lord Phillips MR delivered judgment o theCourt o Appeal and overturned the decision o the High Court.
He considered the construction given to the debenture in Siebe
Gorman correct and that the debenture required the proceeds o
book debts to be paid into an account o the chargee bank was
o critical importance in Siebe Gorman and could properly all into
the denition o a xed charge. Lord Philips thereore held that
a debenture imposing restrictions on the use o the proceeds o
book debts created a xed charge over book debts. Lastly, even
i the construction o Slade J had been wrong in Siebe Gorman, by
customary usage or more than 25 years, he would have held that
the orm o debenture acquired its meaning and eect as a xed
charge. The appeal would, accordingly, be allowed.
House o Lords Decision –
Natwest’s Debenture was a Floating Charge
The Crown creditors appealed. The House o Lords
unanimously reversed the decision o the Court o Appeal and
upheld the decision o the High Court to decide in avour o the
Crown Creditors. The Law Lords held that the critical question was
whether the restriction imposed on the account went ar enough o
the charge to be xed. In this case, Spectrum Plus was required to
pay the book debt proceeds into its current account with Natwest.
So ar as the overdrat limit was not exceeded, Spectrum Plus was
ree to operate on the account or its business purposes. The
Law Lords distinguished the present case with Re Keenan Bros
Ltd . [1985] I. R. 401 where the Irish Supreme Court held that
the charge on the book debts was xed as their proceeds were
to be segregated in a block account where they would be rozen
and unusable by the company without the bank’s written consent.
Thus, one o the ways to ensure a charge over book debts is xed
is to prevent all dealings with the debts other than their collection,
and to require the collected proceeds to be paid into an account
with the chargee bank. That account must then be blocked so as
to preserve the proceeds or the benet o the chargee bank’ssecurity. Accordingly, a debenture that provides or a truly blocked
account will be eective to create a xed charge.
However, in this case, although Natwest could, by notice,
withdraw or reduce the overdrat acility and amounts outstanding
on the account were repayable on demand, the account was in all
respects a current account with an overdrat limit. Pending such
a notice, Spectrum Plus was ree to draw on the account. Its
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Fixed or Floating Charge? House o Lords Decision in
National Westminster Bank Plc v. Spectrum Plus
Limited & Others (relevant to Paper 2.2 / F4)
right to do so was thereore inconsistent with the charge being
a xed charge and the label placed on it could not make it xed.
The House o Lords thereore ruled that the debenture, although
expressed to grant the bank a xed charge over Spectrum Plus’s
book debts, in law granted only a foating charge.
Overruling Siebe Gorman
Lord Phillips MR in the Court o Appeal said that, even i Slade
J’s construction o the debenture in Siebe Gorman had been
erroneous, he would have been inclined to hold that the orm o the
debenture had, by custom and usage, acquired that meaning and
eect. This was because this orm o debenture had been used
or 25 years on the understanding that this was its meaning and
eect. Banks had relied upon this understanding, and individuals
had guaranteed the liabilities o companies to banks on theunderstanding that the banks would be entitled to look rst to their
charges on book debts unaected by the claims o preerential
creditors.
The House o Lords did not agree with this view. In their
opinion, banks and nancial institutions are sophisticated operators
and they should not have regarded the Siebe Gorman case as
having nally settled the law in this area. They were well aware o
the controversy surrounding the case and since Siebe Gorman was
only a rst instance decision, it was always liable to be overruled.
This view was put orward orceully by Lord Hope in his judgment:
“These are powerul considerations, but I am in no doubt
that the proper course is or the Siebe Gorman decision to
be overruled. … But the act is that it was a decision that
was taken at rst instance, and it has now been
conclusively demonstrated that the construction which
[Slade J] placed on the debenture was wrong. This is not
one o those cases where there are respectable arguments
either way. With regret, the conclusion has to be that it is
not possible to dene the decision on any rational basis.
It is not enough to say that it has stood or more than 25
years. The act is that, like any other rst instance decision,
it was always open to correction i the country’s highest
appellate court was persuaded that there was something
wrong with it.”
Retrospective or Prospective Overruling?
When overruling the Siebe Gorman decision, a more
controversial issue which had to be resolved by the House o Lords
was whether the overruling should take eect retrospectively
or prospectively. Natwest contended that i Siebe Gorman was
wrongly decided, the House o Lords should overrule that decisiononly or the uture. The bank submitted that the Siebe Gorman
decision should continue to apply to all transactions entered into
beore their Lordship’s decision in the present case, including
the debenture under consideration in this appeal. The bank’
s submission raised a controversial issue o major importance
concerning the power o the House o Lords to give a ruling in
prospective orm only. The bank argued that the House o Lords
had this power. The Crown Creditors were content to assume the
House may have this power.
Arguments put orward by the House o Lords against
prospective overruling in this case was that it was outside the
constitutional limits o the judicial unction o the courts. It would
amount to the judicial usurpation o the legislative unction o
Parliament. Also, it was said that power to make rulings having
only prospective eect was not inherent in the judicial rule o
the courts. A court decision which took the orm o a ‘pure’
prospective overruling did not decide the dispute between the
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Summer 2007 News Update 05
parties according to what the court declared was the present state
o the law. With a ruling o this character the court gave a binding
ruling on a point o law but then did not apply the law to the present
case as declared to the parties to the dispute beore the court.
Consequently, making such a ruling would not be a proper exercise
o judicial power. It gave a judge too much the appearance o a
legislator. Legislation is a matter or Parliament, not judges.
The House o Lords also highlighted the practical diculties
o applying prospective overruling as compared to retrospective
overruling. The advantages o retrospective overruling included
a court ruling on a point o law which applied in all cases past as
well as uture and the retrospective application o court rulings was
straightorward. On the other hand, prospective overruling created
problems o discrimination. In civil cases, ‘pure’ prospective
overruling could hinder the development o the law by discouraging
claimants rom challenging a prevailing view o the law. In ‘selective’
overruling, persons in like cases were treated dierently. For
example, the ability to obtain an eective remedy would have to
depend upon which o several challenges reached the House o
Lords rst. Consequently, this would introduce an arbitrary element
into the law.
Ater in-depth considerations, their lordships admitted that
there could be circumstances where prospective overruling would
be necessary to serve the underlying objective o the courts: to
administer justice airly and in accordance with the law. There couldbe cases where a decision on an issue o law, whether common
law or statute law, would have such gravely unair and disruptive
consequences or past transactions or happenings that the House
o Lords would be compelled to depart rom the normal principles
relating to the retrospective and prospective eect o court
decisions.
Taken altogether exceptionally, i the House o Lords, as the
country’s supreme court, were to ollow this course, it would not
be regarded as trespassing outside the unctions properly to be
discharged by the judiciary under constitution o the country. I
a legal system were to be operated in a rigid manner, it would
deprive its necessary elasticity. However, in the present case, it
was miles away rom the exceptional category in which prospective
ruling would be legitimate. No doubt over the years clearing
banks had to some extent relied upon the Siebe Gorman decision
when ormulating and using their standard orms o charges. But
banks who lent money on the security o charges on a company’
s undertaking were sophisticated operators. There was no reason
to suppose the Siebe Gorman decision had led them into a alse
sense o security. Besides, Siebe Gorman was a rst instance
decision and cannot have been regarded as denitively settling the
law in this eld. The House o Lords ruled that i the decision o the
present case were given prospective eect only, the result would
deprive preerential creditors o existing liquidations their rights and
priority given to them by statute. Consequently, the House o Lords
rejected Natwest’s submission that the decision should be given
prospective eect only.
Unresolved Problems
The decision o the House o Lords in this case has caused
controversies in the banking sector. Despite their lordships
agreeing that it was conceptually possible to create a xed charge
over book debts, they gave little practical guidance as to how aneective xed charge should be taken. The result o this is that it
will be dicult to know how a debenture will be interpreted by the
courts when it was being drated. In order or an eective xed
charge to be created, one view expressed by the House o Lords
was that the book debt proceeds had to be paid into a blocked
account controlled by the chargee bank and operated as such.
However, in practice this may not be a commercially viable solution
or the chargor as money may only be released rom the blocked
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Fixed or Floating Charge? House o Lords Decision in
National Westminster Bank Plc v. Spectrum Plus
Limited & Others (relevant to Paper 2.2 / F4)
account with the specic consent o the chargee on a case-by-
case basis. The chargor may have to ace the urther uncertainty
that cash fow may be disrupted as the chargee has unettered
discretion as to whether to give or reuse consent.
Another problem resulting rom the decision o this case is
that many banks which have relied on the Siebe Gorman type
debentures will now nd that they have an inerior security than
they supposed to have. This will mean that they will have to adopt
a new strategy and to re-negotiate some o the terms o lending
acilities with their customers. Banks may require directors o these
companies to give personal guarantees in order to obtain loans or
their companies. This may prove costly to some small and medium
companies and deprive them o a valuable source o obtaining
business nance.
Conclusion
The Spectrum Plus case has no doubt claried one important
issue that in case o an ordinary secured nancing, a charge over
receivables will be a foating charge i the company is able to use
the proceeds in the ordinary course o its business. Thus, the
charge will not be xed i, in reality, the bank imposes only limited
control enabling the company to use the proceeds in its usual
course o business. However, one major uncertainty still remains:
the House o Lords did not deal with how much control by the
chargee is required in order to make the charge operate as a xed
charge. This issue may have to be dealt with by urther litigation
in the uture. Even i subsequent cases clariy the issue, banks will
always have an element o doubt as to whether a charge is xed or
foating.
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Objective o this paper
How interest income is taxable and how interest expense is
deductible are two popular questions raised in the proessional
examination and the daily work in the accounting and taxation
proessions. The deduction o interest may be ound under prots
tax, salaries tax and personal assessment. The objective o thearticle is not to cover all the three types o taxes, but restrict the
scope o this article to prots tax. The author will explain in this
article the dierent rules applied to the taxation and deduction o
interest and their relationship under prots tax. Ater reading this
article, students are able to grasp the essence o these areas o
knowledge and have a good result in the examination and a correct
tax treatment in their daily work.
Introduction
There are dierent types o interest income. These include:
a. interest income derived rom deposit,
b. interest income derived rom loan,
c. interest income derived rom clients’ trust money, and
d. interest income derived rom trade debts.
The same type o interest income received by dierent types
o businesses and entities may be dierently treated in the taxation
and deduction under prots tax.
Source Rule
Traditionally, the rule governing the taxation o interest income
is the “provision o credit test”. This means that the source
o interest income is derived at the place where the money is
rst made available to the borrower. Although this rule is still o
undamental importance in the taxation o interest income, yet
its signicance has been aded out gradually with the emergence
o new statutes and case law. This is particularly obvious in the
money lending business and banking industry ater the decision o
Orion Caribbean Ltd. v CIR (1997).
Interest Income Received on a Deposit
This may be, according to the nature o business carried on the
recipient, divided into two categories, namely: a nancial institution
and a company not carrying on the business o a nancial
institution.
a. Recipientisafnancialinstitution
The source o interest income received by a nancial institutionis governed by section 16(1)(i) o the Inland Revenue Ordinance
(IRO). The section provides that a nancial institution is taxable
on a global basis or the interest income which it receives. This
is an exception to the general Hong Kong taxation system which
taxes on Hong Kong source prot only. Thus, the interest income
received on a deposit by a nancial institution is always taxable
no matter whether the deposit is placed in Hong Kong or outside
Hong Kong.
b. Recipientisnotafnancialinstitution
Interest received on a deposit by a company not carrying
on the business o a nancial institution is governed by sections
15(1)() and (g) o IRO. The interest income received by those
entities remains to be taxable on a territorial basis. Only interest
income sourced in Hong Kong is taxable. Interest income derived
rom a deposit placed with a bank outside Hong Kong is exempt
rom Hong Kong prots tax.
Application o the “Exemption rom Profts Tax (Interest
Income) Order”
Beore 21 June 1998, Hong Kong source interest income was
chargeable with prots tax. The Exemption rom Prots Tax (Interes
Income) Order 1998was enacted and took eect on 22 June 1998
That order created a new category o interest income under prots
tax. It is the “exemption rom payment o prots tax”.
a. Exemptionromproftstax
I a deposit is placed with a bank outside Hong Kong, the
interest income derived thererom is sourced outside Hong Kong,
and it is exempt rom prots tax. I a deposit is placed in Hong
Kong, that interest income is chargeable with prots tax as it is an
onshore income.
Taxation o Interest, Deduction oInterest and their Relationship underProts Tax (relevant to Papers 2.3 HKG
& 3.2 HKG / F6 & P6)Patrick KW HO
Principal Lecturer
FTMS Training Systems (HK) Ltd.
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08 News Update Summer 2007
b. Exemptionrompaymentoproftstax
The Order 1998 exempts some Hong Kong source deposit
interest income rom payment o prots tax i certain conditions
are satised. I a deposit placed with a bank in Hong Kong is not
used as a security pledged against a loan, that interest income is
exempt rom payment o prots tax. The exemption rom paymento prots tax provided in the Order 1998 does not apply to interest
income received by a nancial institution.
c. Exemptionromproftstaxv.exemptionrompaymento
proftstax
Exemption rom payment o prots tax applies to oshore
interest income while exemption rom payment o prots tax
applies to Hong Kong source interest income.
The position o the charge o prots tax on interest income
derived rom a deposit may be summarised in the ollowing table:
(Note: F.I. means nancial institution.)
Interest Income Received on a Loan
This may be, according to the nature o business carried on the
recipient, divided into three categories as ollows:
a. a company not carrying on the business o a money lender nor
a nancial institution,
b. a company not a nancial institution but carrying on a business
o money lender, and
c. a nancial institution
a. Recipientnotamoneylendernorafnancialinstitution
The source o interest income derived rom a loan provided by
a company which is not a money lender nor a nancial institution
is governed by sections 15(1)() and (g). Only Hong Kong source
interest income is taxable. The chargeability is based on the
traditional source rule o “provision o credit test”.
b. Recipientbeingamoneylenderbutnotafnancial
institution
During the course o carrying on a money lending business,
the income is not derived rom the mere lending o money to a
customer. The income is also earned as an eort in evaluating the
risk o lending such as the repayment power and the creditability
o the borrower and the adequacy o security provided and etc. In
this situation, the source rule may rely on the operations test as
advocated in Orion Caribbean Limited v CIR, 4 HKTC 432.
In that case, although the lenders and borrowers were alloutside Hong Kong, and the provision o credit was also outside
Hong Kong, the judges did not rely on the provision o credit to
determine the source o interest income. The judges applied
operations test to decide the source o interest income. It was
ound that the source was in Hong Kong as the taxpayer’s holding
company arranged all the lending and borrowing activities on behal
o the taxpayer in Hong Kong.
c. Recipientbeingafnancialinstitution
The source o interest income derived by a nancial institution
is governed by section 15(1)(i) which provides that a nancial
institution is taxable on a global basis in respect o its interest
income.
As this appears to be harsh to the banking industry, the CIR
has made a gentleman agreement with the banking industry called
“compromised package” which is specically applicable to money
lending business carried out by a nancial institution. Under that
arrangement, the CIR does not insist to tax the interest income in
respect o a nancial institution on a worldwide basis.
Deposit Recipient not F.I. Recipient is a F.I.
Placed with a bank
in H.K.
As a security Taxable Taxable
Not as a security
Exempt rom
payment o prots
tax
Taxable
Placed with a bank
outside H.K.
As a securityExempt rom prots
taxTaxable
Not as a securityExempt rom prots
taxTaxable
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Taxation o Interest, Deduction o Interest and their
Relationship under Prots Tax
(relevant to Papers 2.3 HKG & 3.2 HKG / F6 & P6)
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The CIR looks at two actors in the determination o interest
income derived rom a loan. The two actors are:
a. the place where the loan is initiated, negotiated, nalised and
concluded, and
b. the place where the unds nancing the loan are raised.
I both actors are located in Hong Kong, all the interest income
rom that loan is taxable. I both actors are located outside Hong
Kong, all the interest income is exempt rom prots tax. I either
one actor is located in Hong Kong, only 50% o the prot is
taxable.
The situation may be summarized in the ollowing table:
Interest Income Received on Clients’ Trust Money
Many proessional rms, such as consultants, receive retainer
ee rom their clients or the provision o services at a later date.
These unds are kept in a separate trust account in the name o
the proessional rm as a trustee while the benecial owners o
such account are the clients. As a matter o practice, interest
is derived rom such trust account, and it is not oten that the
proessional rms will reund the interest to their clients in view o
small amount rom the angle o individual client. At certain intervals,
the proessional rms will transer the interest “unclaimed” by the
clients to the prot and loss account o the proessional rms.
Although the interest does not belong to the proessional rms,
yet it is credited to their prot and loss accounts. The issue is
whether such interest is taxable. Based on the decision o CIR v.
Lau, Wong & Chan, Solicitors, 2 HKTC 470 , such interest income
orms a part o the income o the proessional rm as a trade
practice, thus the interest income is chargeable with prots tax.
Interest Income Received on Trade Debts
According to paragraph 3 Inland Revenue DIPN 13, interest
has a Hong Kong source where it orms an integral part o a
trading transaction carried out in Hong Kong. In such situation,
the interest has the same source o the income as that o the
trading transactions. Thus, look at the case where the goods
are manuactured in Hong Kong, and the sales are made to an
overseas customer. As the source o the trading and manuacturing
prot is sourced in Hong Kong, the interest income derived rom
an extended credit period or the settlement o trade debt is also
sourced in Hong Kong.
Deduction o Interest Expenses and its Relationship with
Interest Income
Under the Inland Revenue Ordinance, income under prots
tax is assessable under sections 14 and 15 while expenses are
deductible under sections 16 and 17. There is no requirement that
an expense is deductible only on the condition that the income
in respective o such payment received at the other end o the
transaction is taxable in Hong Kong. In other words, generally there
is no matching o taxability and deductibility under prots tax.
However, with the introduction o sections 16(2)(c) and (2A),
the concepts o direct matching and indirect matching are ound in
the deduction o interest expenses under prots tax.
Borrowing Money Not From a Financial Institution
Section 16(2)(c) provides that, i a business borrows money
rom a company which is not a nancial institution, the interest
expense is deductible only when the interest income received by
the lender is taxable in Hong Kong. This carries the concept o
direct matching. In other words, the chargeability o tax on interest
income aects the deduction o interest expense on the loan
borrowed.
The ollowing three situations may arise:
a. Borrowingromanindividual
I the money is borrowed rom an individual who is usually
not chargeable with prots tax, the interest expense paid to an
individual is not deductible under prots tax as provided in section
16(2)(c).
Where loan is initiated Where unds are raised Chargeability to tax
In Hong Kong In Hong Kong 100% taxable
In Hong Kong Outside Hong Kong 50% taxable
Outside Hong Kong In Hong Kong 50% taxableOutside Hong Kong Outside Hong Kong 100% exemption
Summer 2007 News Update 09
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b. Borrowingromanoverseascompany
I the money is borrowed rom an overseas company which
does not carry on a business in Hong Kong, the overseas company
will be exempt rom Hong Kong prots tax. Thus, the interest
income is not taxable Hong Kong. As a result, the interest expense
paid to an overseas company is not deductible under prots tax.
c. BorrowingromaHongKongcompany
I the money is borrowed rom a company which carries on
a business in Hong Kong, the interest income received by that
company is taxable Hong Kong. As a result, the interest expense is
deductible under prots tax.
The situations provided in section 16(2)(c) borrowing may be
summarised in the ollowing table:
As a side issue, i the borrowing is made rom a nancial
institution, no matter a oreign nancial institution or a Hong Kong
nancial institution, there is no such restriction that the interest
income received by the nancial institution must be taxable in Hong
Kong beore the interest paid by the business is deductible. Section
16(2)(c) does not apply to interest paid to a nancial institution.
Borrowing Secured by a Deposit or another Loan
It is provided in section 16(2A) that the chargeability o tax
on interest income on a deposit or another loan used or security
purposes aects the deduction o interest expense on the loanborrowed. This is reerred as “indirect matching”. I a loan satises
one o the conditions o sections 16(2)(c), (d) or (e), the deduction
o interest has to satisy the conditions provided by section 16(2A)
too.
Section 16(2A) provides that in order or an interest expense to
be deductible, one o the ollowing conditions have to be satised:
a. the loan is not secured by a deposit or another loan;
b. i the loan is secured by a deposit or another loan, the interest
income derived rom such deposit or loan used as security
must be taxable in Hong Kong;
c. i the loan is secured by a deposit or another loan, and the
interest income derived rom such deposit or loan used as
security is not taxable in Hong Kong, the amount o interest
expenses deductible under prots tax may be reduced in a
manner appropriate to the situation concerned (as determined
by the CIR); or
d. i the loan is secured by a deposit or another loan provided by a
person not associated with the borrower, the interest expense
is deductible even though the interest income is not taxable in
Hong Kong at the hand o the recipient.
The situations provided in section 16(2A) borrowing may be
summarised in the ollowing table:
To make the picture complete, students have to note that the
CIR reers this as the “Secured Loan Test”. I the security is not a
deposit nor another loan, the interest expense is deductible under
section 16(2A).
ConclusionInterest expense is incurred or nancing the operation o
a business and it is very oten one o the largest expenses o a
company. I a businessman does not pay attention to the deduction
o expenses when arranging its borrowing activities, he or she may
not get the deduction o interest in the computation o prots tax.
This will lead to an increase in the unnecessary prots tax expense
As interest income and interest expense are two popular areas in
the examination, students have to exert more eort on those two
topics.
Borrowed rom Interest income Interest expense
An individual Not taxable Not deductible
An overseas company Not taxable Not deductible
A Hong Kong company Taxable Deductible
Deposit provided by Deposit interest income Loan interest expense
An individual (associated) Not taxable Not deductible
An overseas co.(associated)
Not taxable Not deductible
A Hong Kong company Taxable Deductible
An individual(not associated)
Not taxable Deductible
An overseas co.(not associated)
Not taxable Deductible
10 News Update Summer 2007
Taxation o Interest, Deduction o Interest and their
Relationship under Prots Tax
(relevant to Papers 2.3 HKG & 3.2 HKG / F6 & P6)
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Summer 2007 News Update 05
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Summer 2007 News Update 11
Corporate governance has been a avourite topic in recent
years especially ater the Enron’s scandal was exposed. Law
makers and regulators have been attempting to introduce new
rules and regulations to restore investors’ condence and public
trust on public listed companies. Following the Sarbanes-Oxley
Act o the United States enacted in 2002, new stricter corporate
governance rules and regulations are also introduced in other
countries as well:
Why Corporate Governance?
Corporate governance was dened as “a system by which
a company is directed and controlled” in the Cadbury Report,
1992. The report did not clariy the meaning o system, directed
and controlled. Instead, it provided detailed descriptions o the
structure and responsibilities o the Board, recommend Code o
Best Practices, etc.
There are a number o reasons to support why a corporate
governance system is needed or a company. Among others, the
major reasons include:
1. Protecting stakeholders’ interests;
2. Reinorcing shareholders’ trust and condence; and
3. Creating value or stakeholders.
Protectingstakeholders’interests
A company has many interactions with various parties in a
typical business environment regarding nancial and operational
matters. These parties may include investors, creditors, bankers,
regulators, customers, employees, etc. Each o these parties has
his own interest and agenda with the company. For examples,
investors have injected capital into a company and thereore
expecting a return which hopeully is above the market average;
bankers are lending money to the company on the ground that
the company is a going concern and can ulll its loan repayment
commitment; employees are providing their eort in return or a
monthly pay check and a career opportunity in the company.
However, as these parties are involved in the daily operation o
the company, they have very limited knowledge about the company
s background and operations. They do not know how well the
company is operating and whether their aspirations associated
with the company can really come true. They have limited access
to the ull inormation o the company they are associated with let
alone the knowledge o the adequacy o eective internal control
system in place. Even though they have the right to request or
inormation but more oten the inormation they are provided with
may be ltered or inadequate. Besides, they might not be able to
stop the company rom taking high-risk investments or projects
which may have impact on the company’s uture and in turn their
interests.
Obviously, ater the Enron’s case, everyone would agree that
an eective Corporate Governance system should be in place
to saeguard the assets o a company and hence the interests
o dierent stakeholders. This can be achieved, among others,
by enhancing the transparency and disclosure requirements o
signicant nancial and operating inormation. Stakeholders will be
able to make decision on a better inormed basis and assess the
company more meaningully.
Why Corporate Governance aMatter?(relevant to Papers 3.5 & 3.7 / P1)Clement Chan and Ricky ChengHorwath Hong Kong CPA Limited
2006 June The combined code on corporate governance issued
by Financial Reporting Council (rst published in 2003
July) in the United Kingdom
2004 November Code o corporate governance practices issued by
the Hong Kong Stock Exchange
2004 April Principles o corporate governance or listed
companies issued by the Tokyo Stock Exchange
2003 November Corporate governance rules approved by the New
York Stock Exchange2003 March Principles o good corporate governance and best
practice recommendations issued by ASX Corporate
Governance Council
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Reinorcingshareholders’trustandconfdence
There are normally 2 classes o parties who can exercise
their rights to control the operations o a company, they are
shareholders and company’s management (i.e. the Board o
Directors and management team). In a small or private company,
owner-manager situation is very common where the owner and
management are reerring to the same batch o persons. In
a large or public listed company, these 2 parties are usually
segregated and shareholders tend to have l imited rights to control
the operations o a company except when there are signicant
events concerning the company such as merger or acquisition,
und-raising, etc.
In the latter situation, there is a segregation o ownership rom
control. That is, the delegation o authority and responsibilities
by shareholders to the company’s management or leading and
managing the company. Besides, shareholders place trust on themanagement and believe that the company will be managed to
achieve the desired goals and objectives. This is oten reerred
to the principal-agency relationship. Shareholders are principal
and management is the agent. Management is accountable to the
shareholders and acting in good aith and in their interests.
However, in the day-to-day operation, shareholders hardly
interere with management in their daily management o the
company. In the absence o an eective monitoring system, the
possibility o management inappropriately using their authority
to advance their personal benets will increase. This may bedriven by the various reasons such as management’s sel-interest,
nancial rewards, meeting business and operational targets, etc.
Thereore, a gap exists between the shareholders and management
regarding their interests.
There are a number o ways to narrow this gap. One o the
ways is to align their interests by introducing a perormance-related
remuneration package. This can link the company’s perormance
such as turnover, prot or other indicators with the management’
s remuneration and making sure that they are running in the same
direction.
Another way is to strengthen the corporate governance
practices, apart rom increasing disclosure, by (i) clearly dening
the accountability and responsibilities o management; and (ii)
establishing an eective Board o Directors. The latter one is more
important.
An eective Board can be measured by at least 2 things, one
is its composition and the other is its perormance. According
to the listing rules and Code o Corporate Governance Practices
issued by Hong Kong Stock Exchange, a Board o Directors must
include at least 3 independent non-executive directors (INEDs). As
a best practice, 1/3 o the Board should be made up o INEDs.
Besides, a Board should perorm eectively by scrutinizing the
activities o the company, questioning high-risk investments or
projects, monitoring management’s integrity, monitoring the results
o authority delegation, reviewing regular operational and nancial
reports.
Besides, it is very common or a Board o Directors to
establish dierent board committees to discharge their duties
and overseeing responsibilities. These committees include
remuneration committee, audit committee and nomination
committee. Appointment o committee members should alsoensure that they have the relevant experience, knowledge and skill
sets. For example, it is a requirement that there should be at least
one nancial expert in the audit committee.
With the above measures, shareholders can place more trust
and condence in the management with the increased supervision
and participation o an eective Board o Directors and interests
among the parties are being aligned.
12 News Update Summer 2007
Why Corporate Governance a Matter?
(relevant to Papers 3.5 & 3.7 / Paper P1)
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Summer 2007 News Update 13
CreatingValueorStakeholders
An ideal and eective corporate governance system o a
company should also include a robust enterprise risk management
(ERM) process. Through the implementation o a systematic
process throughout a company, ERM can provide a company
with reasonable assurance to achieve its goals and objectives.More importantly, it can ensure that the company is operating
within the enterprise’s risk appetite. The ERM should include
internal environment, objectives setting, events identication, risk
assessment, risk response, control activities, inormation and
communication and monitoring.
ERM can create value or stakeholders by linking strategic
objectives with relevant risk actors, identiying events such as risk
and opportunities, preparing risk responses and viewing enterprise
risk actors as a portolio. The importance is to ensure that these
risk management elements are built into the operating businessprocesses and not just being considered on a standing alone basis.
In the context o ERM, the role and responsibilities o internal
audit unction will usually be touched on. Traditionally, internal audit
unction is viewed as a watchdog and being charged to ensure
the eectiveness o the check and balance mechanism within an
organization. The personnel to take up this role may also need to
involve in operation such as nancial reporting process. However,
with the increasing importance o corporate governance and risk
management, expectations on internal audit unction have been
raised to include the ollowing:
• Becoming a “partner” to operational departments in assisting
them to achieve their process objectives instead o detecting
wrongdoings;
• Independently reviewing business processes on a risk-basedapproach to identiy weaknesses or improvement opportunities
rather than looking or non-compliance;
• Assisting the management to align business operations with
corporate or entity-level objectives; and
• Assisting in reviewing and improving the risk management
process to ensure its eectiveness.
Finally, corporate governance aects every spectrum o an
enterprise rom the top management to operations, and not only
disclosure or paper work. The successul implementation o
corporate governance requires sel-discipline, a strong tone-at-the-top and the management with integrity to drive the process. In
return, value can be created or stakeholders.
Reerences:1. Code o corporate governance practices, The Hong Kong Stock
Exchange2. Enterprise risk management ramework, COSO 3. Audit Quality – Agency theory and the role o audit, The Institute o
Chartered Accountants
4. Report o the committee on the fnancial aspect o corporategovernance or “Cadbury Report”
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