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BUSI 0018 Hong Kong Taxation

Tutorial Questions

Unit 8 Profits Tax (2)

Answer 19

Part I

(a) Under s.15(1)(g), sums received by or accrued to a person, other than a

corporation, carrying on a trade, profession or business in Hong Kong by way

of interest are deemed taxable if (1) the interest is derived from Hong Kong

and (2) the interest is in respect of the funds of the trade, profession or

business in Hong Kong.

In this question, the interest was earned on money placed in deposit in Hong

Kong and thus was considered as derived from Hong Kong based on

provision of credit test. On the other hand, the interest was in respect of thebusiness receipts available for use in the sole proprietors business. Therefore,

the interest would be deemed as taxable under s.15(1)(g).

However, with effect from 22 June 1998, an exemption order was issued under

s.87 to exempt from profits tax all interest accrued on or after 22 June 1998 on

deposits with financial institutions in Hong Kong. An exception to this

exemption is when the deposit was used as a pledge against borrowing on

which interest expense incurred was deductible under s.16(2)(c), (d) or (e) and

where s.16(2A) does not apply. In this question, the deposit was not pledged

for any borrowing. Therefore, the exemption order would apply to exempt the

interest from profits tax although it is sourced in Hong Kong.

(b)

Under Section 15(1)(f), sums received by or accrued to a corporation carrying

on a trade or business in Hong Kong by way of interest is deemed as taxable if

the interest is arising in or derived from Hong Kong.

In this question, Tasty Bakery Company Limited is carrying on business in

Hong Kong and thus s.15(1)(f) may apply. The interest was earned from a

deposit placed with Shenzhen branch of Bank of China. By virtue of

provision of credit test, the deposit money was first made available to the

bank in Shenzhen, i.e. outside Hong Kong. As a result, the provision of credit

was outside Hong Kong and interest income is regarded as sourced outsideHong Kong. Section 15(1)(f) does not apply to tax the interest income. The

fact that the deposit money was originated from the sale money earned from

Hong Kong shops is irrelevant since the nature of money has changed once it

is put into bank deposit.

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(c)

Mr. Chan is an individual, not a corporation. Therefore Section 15(1)(f)

cannot apply. The deposit money does not represent Mr. Chans business

fund, and thus Section 15(1)(g) does not apply either. As a result, the interest

income derived by Mr. Chan, though sourced in Hong Kong, is not taxable

under profits tax in Hong Kong. There is no interest tax in Hong Kong. As a

conclusion, no tax is payable by Mr. Chan in respect of the interest income inquestion.

(d) Promoting goods in Hong Kong constitutes carrying on a business in Hong

Kong. Interest income derived from Hong Kong deposits is sourced from

Hong Kong. Therefore, the Hong Kong Branch should be subject to profits

tax in respect of the interest derived from the Hong Kong deposits under

section 15(1)(f). The above mentioned interest income exemption order is not

applicable as the relevant deposit has been used to secure for bank borrowing

and the interest expense in respect of that bank borrowing is deductible under

profits tax.

Part II

(a)

The taxability of compensation income depends on the nature of the

compensation, which in turn relies on the nature of the asset or transaction

involved giving rise to the compensation. The general test to apply is fixed

capital vs circulating capital test. In this case, the compensation was received

due to a loss of trading stock as a result of the fire. The event leading to the

loss is not relevant. It is the nature of the asset which was lost and because of

this loss, the compensation was received. Trading stock in this case is a

circulating (revenue) asset. Compensation received for loss of trading stock is

therefore of revenue nature. [Green v. J Gliksten & Son Ltd. (1929)]

(b)

Compensation was received from a supplier as a result of his cancellation of a

supply agreement with the company. Again, the nature of the compensation is

consistent with the nature of the asset or transaction involved giving rise to the

compensation. In this case, the asset lost was the contractual rights from the

supply agreement. If the supply agreement is only one of many supply

agreements of Company A, and the cancellation of such will not affect the

entire operating structure of Company, the contractual rights over the

agreement should be Company As circulating assets which are revenue in

nature. Therefore, compensation received for cancellation of a tradingcontract is a revenue receipt and taxable. [Kelsall Parsons & Co. v. CIR

(1938)].

However, if the supply agreement is the only one supply agreement of

Company A, and the cancellation of the agreement will affect the entire

operating structure of Company A, the contractual rights of the supply

agreement might be capital assets to Company A. In such circumstances, the

compensation for loss of capital assets should be capital in nature and not

taxable. [Barr, Crombie & Co. v IRC (1945) 26 TC 406]

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Part III

(a) The severance payment is deductible pursuant to the Cosmotroncase. It was

decided that severance payments made under Employment Ordinance on

cessation of business were payments representing a discharge of statutory

obligations incurred in the running of the business prior to its closure. Morespecifically, the payments were accrued as a cost of employing staff but that

the liability was only crystallised on cessation of business. The timing of

crystallisation would not affect the payment to be deductible for profits tax

purposes.

(b) The interest expenses have been capitalized under property under

development rather than being expensed in the income statement. Applying

the Secan case, the treatment is consistent with the general accounting

principle and not inconsistent with the provisions of the IRO. No adjustment

is to be made to the accounting profit for profits tax purpose. In other words,

interest expenses so capitalized would not be allowed for tax deduction until

the properties are sold when the cost of property development (including theinterest element) will be charged against sales revenue in the income

statement.

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Answer 20

(a)

As the factory was used by PCs printing business for producing chargeable

profit, S16(1)(a) is satisfied. The loan was borrowed from a financial

institution, the condition under S16(2)(d) is fulfilled. As the loan was not

secured by any deposit generating non taxable interest income and there is no

arrangement in place whereby interest payment will ultimately paid back toPC or any connected person, the limitations under S16(2A) and (2B) do not

apply. Accordingly, the interest expense should be deductible.

(b) Assuming that the office was used by PCs business for producing chargeable

profit, S16(1)(a) is satisfied. The loan was borrowed from a financial

institution, the condition under S16(2)(d) is fulfilled. However, the loan was

secured by a fixed deposit registered in the name of HC which does not carry

on any business in Hong Kong. Accordingly, the interest income derived from

the fixed deposit would not be taxable under S15(1)(f).

As the bank loan is secured by a deposit generating non-taxable interestincome, the limitation under S16(2A) applies and the interest expense paid by

PC allowable for deduction would be reduced by the amount of tax-free

interest.

(c)

On the assumption that the fund raised from the issue of the debentures has

been applied for the purpose of generating assessable profits to PC, the interest

paid on the debentures should be deductible under S16(1)(a) and (2)(f). In this

case, there is no arrangement in place whereby interest payment will

ultimately paid back to PC or any connected person. The limitation under

S16(2C) does not apply.

(d)

Where the loan is used exclusively for the purchase of trading stock and the

lender is not closely connected to the borrower in any of the relationship set

out in S16, the interest will satisfy the conditions of S16(2)(e). Alternatively,

the loan was borrowed from an overseas financial institution, condition under

S16(2)(d) is also satisfied.

The borrowing was not secured or guaranteed by any deposit but by a personal

guarantee given by Mr. CFO. The limitation under S16(2A) does not apply.

There is no arrangement in place whereby interest payment will ultimately

paid back to PC or any connected person. The limitation under S16(2B) isalso not applicable. Accordingly, the interest expenses can be deductible.

(e) Strictly speaking, trade debts are not money borrowed. Accordingly, the

general rule S16(1) instead of S16(1)(a) should be applied to determine the

deductibility of interest on trade debts. As all profits derived from printing

business in Hong Kong are taxable to PC, the interest in respect of trade debts

due to SC should be deductible.