Mid-term Test Marking Scheme (2013)

Answer 1
(a)
If an employment is located in Hong Kong, all income from that employment is, subject to
certain limited exceptions, liable to Hong Kong salaries tax. If, on the other hand, an
employment is located outside Hong Kong, only income referable to Hong Kong services is
subject to salaries tax. This is usually determined on a days in/days out basis (see s.8(1A)).

On the basis of a decision in the Goepfert’s case, the location of employment is generally
determined by the IRD as outside Hong Kong where the following three factors are present
(see DIPN 10):
(i) the contract of employment was negotiated, entered into, and enforceable outside
Hong Kong;
(ii) the employer is resident outside Hong Kong; and
(iii) the employee’s remuneration is paid to him outside Hong Kong.

If not all of the above factors are outside Hong Kong, the employment is primarily a Hong
Kong employment, though in practice the IRD may disregard the place of payment of
remuneration. If a person is recruited by an employer who is resident in Hong Kong, the
employment is unlikely to be located outside Hong Kong, even though the contract is
concluded outside Hong Kong and his remuneration is paid outside Hong Kong.
[1.5 marks]
In Andy’s case, although he is employed by the US company, he is seconded to Hong Kong to
handle two projects for the Hong Kong subsidiary, and all his remuneration is paid by the
Hong Kong subsidiary. He reports to the Hong Kong office and is under the control of the
Hong Kong subsidiary. Irrespective of whether or not he has a separate contract of
employment with the Hong Kong subsidiary, during the period of secondment Andy is
effectively under the employment of the Hong Kong subsidiary which is located in Hong
Kong. Andy’s income should therefore be assessed in full to Hong Kong salaries tax.
[1.5 marks]
However, as tax similar to salaries tax is paid on income referable to the services performed in
the PRC, Andy is entitled to claim the exemption under s.8(1A)(c). Section 8(1A)(c) excludes
income from services rendered outside Hong Kong (i.e. $380,000) if the taxpayer is
chargeable to tax in the country in which the services are rendered and tax has been paid in
respect of the income attributable to the services rendered in that country. [1 mark]

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(b)(i)
The relocation allowance
The relocation allowance of $150,000 is chargeable to salaries tax under s.8(1) if it is ‘income
from employment’ as defined in s.9(1)(a). Based on the principle in Hochstrasser v Mayer
(38TC673), it may be argued that the lump sum is paid for the financial loss Andy could incur
from the secondment, not for any services rendered and hence it is not chargeable to tax.
However, the Board of Review in a few decisions, e.g. D19/92 and D36/92, has held as
taxable a lump sum paid at the commencement of employment. The Board of Review have
held that taxable payments are not restricted to rewards for services rendered or to be
rendered. What matters is whether the source of the payment is the employment and if so, it is
taxable.
[2 marks]
In Andy’s case, the relocation allowance is payable by Healthy Ltd to compensate him for the
removal expenses that he would incur in coming to Hong Kong. It is non-accountable, paid
regardless of the actual nature and amount of expenses. It also seems to be a financial
inducement to Andy to take up the secondment (and hence for services to be rendered). It is
not a gift but a contractual payment. It is a payment related to his secondment and an integral
part of Andy’s income from his employment. As the source of the payment was a Hong Kong
employment, the allowance would be chargeable to salaries tax. [2 marks]

(b)(ii)
The gratuity
The gratuity is a contractual payment and a reward made for the services provided by Andy
for a Hong Kong employment. Hence the gratuity is wholly chargeable to salaries tax under
s.8.
[1 mark]
Pursuant to s.11D(b), the gratuity will accrue on 31 March 2006, the date on which the
secondment is completed and when Andy is entitled to claim the payment. The whole sum
will be subject to salaries tax for the year of assessment 2005/06. [1 mark]

However, proviso (i) to s.11D(b) allows Andy to apply to have the gratuity related back and
deemed to be income accrued during the two years of his secondment. The gratuity will then
be assessed over the two years of assessment 2004/05 and 2005/06, normally by time
apportionment. The application must be lodged in writing not later than 31 March 2008, i.e.
within two years after the end of the year of assessment in which the payment of gratuity was
made. [1 mark]

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(c)
Andy’s salaries tax computation for 2011/12
$ $ Marks
Salary 960,000 0.5
Housing allowance 288,000 0.5
Relocation allowance 150,000 0.5
Holiday journey benefit
- air ticket for girlfriend [(26,000 + 4,000)/2 – 4,000] 11,000 1
- hotel room charges (24,000 × 15/40) 9,000 20,000 1
1,418,000
Less: Income exempt under s. 8(1A)(c) (380,000) 0.5
1,038,000
Less: Basic allowance 108,000 0.5
Dependent brother allowance 30,000 138,000 0.5
Net chargeable income 908,000

Salaries tax at progressive rates 142,360 0.5

Salaries tax at standard rate (1,038,000 × 15%) 155,700 0.5

(d)
Explanatory notes to the items:
1. Any amount paid by an employer in connection with a holiday journey is taxable under
s.9(2A)(c), and the benefit is assessed by reference to the cost incurred by the employer
(see DIPN No. 41, para 6). Where a holiday journey benefit is associated with or
attributable to a cost paid by an employer, that benefit is taxable notwithstanding that the
employer does not incur any additional, or incremental, costs for that benefit (see DIPN
No. 41, para 11). In Andy’s case, the cost of his girl friend’s ticket is actually borne by
Healthy and is therefore taxable. [1 mark]

Where a trip is taken partly for business and partly for holiday, if a clearly identifiable
part of the journey is taken for holiday purposes, the expenses relating to that part of the
journey are taxable. In Andy’s case, the extended stay cannot be regarded as being
incidental to the business trip and is therefore taxable. Since the expenses relating to
such part cannot be readily ascertained, an apportionment based on the ‘holiday-days
basis’ will generally be adopted (see DIPN No. 41, para 14 and 15). [1 mark]

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2. Section 9(1)(d) deems any gain realised on the exercise, release or assignment of a share
option to be income from employment or office. However, the exercise of the share
option on 1 October 2011 is not taxable as the option was granted before Andy was
seconded to the Hong Kong subsidiary. Although the option was exercised in Hong
Kong, the benefit arising from the option is not attributable to services rendered in Hong
Kong. [1 mark]

(e)
The Hong Kong subsidiary, the employer, is carrying on a business in Hong Kong. In some
decided cases, the Board of Review regarded a company carrying on business in Hong Kong
as resident in Hong Kong for the purpose of deciding whether the situs of employment of its
staff is in Hong Kong. Based on such cases, it is very likely that the IRD will take the same
position. In such case, Andy’s income will be regarded as sourced in Hong Kong. The place
where services are rendered is not relevant to the determination of the location of employment
(CIR v Goepfert). It follows that Andy’s total remuneration under both contracts will be liable
to Hong Kong salaries tax under s.8(1)(a), unless exempted by s.8(1A)(b)(ii)and/or s.8((1A)
(c). [1.5 marks]

If the IRD accepts that Andy has two separate and distinct employments under the two
contracts, the remuneration accrued to him under the second contract (which covers the
services to be rendered in the PRC) will be exempted from salaries tax as he renders all
services in connection with his employment under the second contract outside Hong Kong.
His remuneration accrued under the first contract (which covers the services to be rendered in
Hong Kong) remains taxable. [1.5 amrks]

However, the Commissioner may look behind the legal form and take the substance instead.
The Commissioner is entitled to scrutinise all relevant evidence, such as the intent of the
Hong Kong subsidiary and Andy, the basis for the apportionment of the remuneration
between the two contracts, the scope of duties and responsibilities, the nature of services
rendered and the time spent by Andy in and outside Hong Kong. Depending on the actual
facts, the Commissioner may or may not accept that there are two contracts of employment
between the Hong Kong subsidiary and Andy. The Commissioner may also invoke ss.61 and
61A to counteract Andy’s exemption claim concerning the second contract. [2 marks]

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Answer 2
(a)
Section 15(1)(b) of the IRO deems the sums received by a non-resident person for the use in
HK a trademark to be receipts arising in HK from a trade, profession or business carried on in
HK. [1 mark]

Holding and Unrelated are foreign companies which have no office in HK. So, these
companies are not chargeable to profits tax under section 14 but the royalties received by
them are chargeable to profits tax under s. 15(1)(b) if royalty is paid for the use of intellectual
property in HK. [1 mark]

The trademark “GM”, “Banana” and “Cherry” were used by GML in manufacturing its
products for sale only in HK. The trademarks apparently were used in HK. Section 15(1)(b)
would operate to bring the royalties received by Holding and Unrelated into the charge of
profits tax. [1 mark]

On the other hand, AL is a company incorporated and carrying on a business in HK. The
royalty received by it for the trademark “Apple” was part of its business income subject to the
charge of profits tax under s. 14. [1 mark]

Section 14 imposes 3 conditions for profits tax to be chargeable:

(a) the taxpayer carries on a trade, profession or business in HK;
(b) the profits are derived from such trade, profession or business; and
(c) the profits arise in or derived from HK.
[1 mark]
In respect of the royalty income received by AL, the first 2 conditions obviously are satisfied.
As both AL and GML are companies carrying on business in HK and the trademark “Apple”
was used by GML exclusively in HK, the third condition is likely satisfied as well. In this
circumstances, the royalty received by AL is chargeable to profits tax under s. 14. [1 mark]

Under s. 21A(1), the assessable profits in respect of a sum deemed by s. 15(1)(b) shall be
taken to be:
(a) 100% of the sum if the sum is derived from an associate – this 100% however does not
apply if the CIR is satisfied that no person carrying on a trade, profession or business in
HK has at any time wholly or partly owned the property in respect of which the sum is
paid; or
(b) 30% of the sum in any other case.

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 [2 marks]
Royalty of $8m received by Holding in respect of the trademark “GM”
Holding is an associate of GML. However, Holding is the first owner of the trademark, i.e. it
has not been owned by a person carrying on a business in HK before. The assessable
profits is $8m × 30% = $2.4m [1 mark]

Royalty of $10m received by AL in respect of the trademark “Apple”

As AL is carrying in business in HK and the royalty income $10m would just be its normal
business income chargeable to profits tax under s. 14, so the amount of assessable profits
would be the royalty income after deducting the relevant expenses incurred in producing such
royalty income. [1 mark]

Royalty of $12m received by Holding in respect of the trademark “Banana”

Holding is an associate of GML. The trademark was purchased from BL, i.e. it has been
owned by a person carrying on a business in HK before. The assessable profits is $12m ×
100% = $12m. [1 mark]

Royalty of $20m received by Unrelated in respect of the trademark “Cherry”

Unrelated is unconnected with GML. That the trademark was purchased from CL (i.e. it has
been owned by a person carrying on a business in HK before) is irrelevant. The assessable
profits is $20m × 30% = $6m. [1 mark]

Section 20B(2) provides that, in respect of a sum deemed to be a taxable receipt by virtue of s.
15(1)(b), the non-resident person is chargeable to profits tax in the name of the person in HK
who paid the sum. [1 mark]

GML as the payer in HK of the royalties to Holding and Unrelated accordingly would be
charged to profits tax with assessable profits of $2.4m, $12m and $6m as computed above.
Section 20B(2) also provides that the tax so charged on GML shall be recoverable from GML.
[1 mark]
Section 20B(3) further provides that GML as the payer in HK should at the time it makes
payment to Holding or Unrelated deduct a sufficient sum from the payment as is sufficient to
produce the amount of tax recoverable from it. [1 mark]

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(b)
Loan $50m from Holding
As the loan was used to acquire trading stock. So, the interest was incurred in the production
of chargeable profits and thus deductible under s. 16(1)(a). However, we have to further
consider s. 16(2) conditions. [1 mark]

As Holding does not carrying on business in HK and so the interest income received by
Holding is not liable to profits tax, so interest expense is not deductible under s. 16(2)(c). In
addition, though the loan was used to acquire trading stock, the lender Holding is an associate
of CL and so interest expense is also not deductible under s. 16(2)(e). [2 marks]

As none of the conditions in s. 16(2) is satisfied, interest expense is fully not deductible
though it satisfied the secured loan test under s. 16(2A) by using only the property and
investment shares as security for loan borrowing. [1 mark]

Loan $50m from GML

Similar to above, interest expense is deductible under s. 16(1)(a). [1 mark]

GML is carrying on business in HK and the interest income received by it is liable to profits
tax (provision of credit in HK), so interest expense is deductible under s. 16(2)(c).
[1 mark]
However, further conditions in s. 16(2A) and (2B) should be satisfied before a deduction is
allowed. Now, though the loan was secured by a deposit CL placed with AL (i.e. GML’s
associate), the deposit interest is liable to profits tax on the hands of CL, so the secured loan
test in s. 16(2A) is satisfied. Assuming the interest flow back restriction under s. 16(2B) also
does not apply (no information here), the loan interest $1m paid to GML is fully deductible.
[1 mark]

Loan $50m from a local bank

Again, interest expense is deductible under s. 16(1)(a). [1 mark]

As the borrowing was obtained from a bank, the relevant condition is s. 16(2)(d). A borrowing
from a financial institution would satisfy condition under s. 16(2)(d) but further conditions in
s. 16(2A) and (2B) should also be satisfied before a deduction is allowed. [1 mark]

Now, as the loan was secured by a deposit CL placed with that bank and deposit interest
income is liable to profits tax (Note: the Exemption from Profits Tax (Interest Income) Order
1998 is not applicable here), so the secured loan test in s. 16(2A) is satisfied. Assuming the

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interest flow back restriction under s. 16(2B) also does not apply (no information here), the
loan interest $1m paid to the bank is fully deductible. [1 mark]

Answer 3
(a)
It is necessary to consider whether the exchange difference is capital or revenue in nature.

The nature depends on the underlying transaction giving rise to such exchange difference. If it
is arising from a trading transaction, it will generally be regarded as revenue nature.
[1 mark]
Exchange difference of capital nature is not taxable/deductible. However, exchange losses
arising from capital expenditure that qualifies for capital allowances can be regarded as part
of such expenditure and included in the calculation of the allowances (i.e. DA, IBA, CBA).
[2 marks]
Exchange difference of revenue nature may be taxable/deductible. However, to be taxable, the
gain must also have a HK source. To be deductible, the loss must also be incurred in the
production of assessable profits (s. 16(1)). [2 marks]

Regarding the treatment of unrealized exchange difference, all taxpayers including financial
institutions should treat exchange gains or losses recognized in the profit and loss account,
whether realized or not, as receipts or expenses for tax purpose. An adjustment in the tax
computation on the ground that an exchange difference has not yet been realized will not be
accepted (DIPN 42). Of course, the exchange gains or losses of a capital nature or sourced
outside HK are still neither taxable nor allowable. [2 marks]

(b)
The exchange gain $100,000 in fact represents an increase in the amount of trading income
receivable. It is revenue in nature forming an integral part of the trading income. [1 mark]

If the company’s trading profits is chargeable to Profits Tax, the exchange gain is also taxable.
As the unrealized amounts are recognized in the company’s accounts, it cannot be excluded
from tax computation by reason of ‘unrealized’. (DIPN 42) [1 mark]

(c)
Profits of capital nature are exempted from profits tax under s. 14 of the IRO. [1 mark]

Though the property was classified as a property investment in the company’s accounts,
however, it should be noted that the accounting treatments, by itself, cannot operate to change

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the character of an asset from investment to trading and vice versa. Whether the asset is of
capital or revenue nature is a question of fact and degree and all the surrounding
circumstances have to be considered. Normally, the six badges of trade are to be considered as
follows:
1. The subject matter of the realization
2. The length of period of ownership
3. The frequency of the transactions
4. Supplementary work on or in connection with the asset acquired
5. Circumstances leading to the sale
6. The motive / intention
[2 marks]
The intention at the time of acquisition of an asset is an important issue. Stated intention is not
conclusive. Actual intention must be identified by objective factors. It is a question of fact.
Each case is decided on its own facts and circumstances. [1 mark]

In the present case, the classification of the property under non-current asset is not conclusive
evidence to show that it was a capital asset. More information, e.g. whether the company has
dealing history before, the reason of disposal, how it was used before, how the property was
financed, etc. are required in order to ascertain whether the gain are capital nature or not. In
general, the short holding period of 1 year indicated that the property might be trading stock
in nature. Assumed so, then the gain of $800,000 is chargeable to profits tax. [2 marks]