Professional Level – Options Module

Time allowed: 3 hours 15 minutes

This question paper is divided into two sections:

Section A – BOTH questions are compulsory and MUST be attempted

Section B – TWO questions ONLY to be attempted

Tax rates and allowances are on pages 2 and 3

Do NOT open this question paper until instructed by the supervisor.

This question paper must not be removed from the examination hall. Pape

r P6 (HKG)

Advanced Taxation(Hong Kong)

Thursday 8 June 2017

The Association ofChartered Certified

Accountants

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.5. Ignore provisional tax and statutory tax reductions, unless specified otherwise.

TAX RATES AND ALLOWANCES

The following 2016/17 tax rates and allowances are to be used in answering the questions.

Profits tax ratesCompanies 16·5%Unincorporated business 15%

Salaries tax ratesFirst $40,000 2%Next $40,000 7%Next $40,000 12%Remainder 17%

Standard rate 15%

Allowances$

Basic allowance 132,000Married person’s allowance 264,000Single parent allowance 132,000Child allowance – 1st to 9th child (each) 100,000Child allowance – additional allowance in the year of birth (each) 100,000Dependent parent/grandparent allowance – basic 23,000/46,000

– additional 23,000/46,000Dependent brother/sister allowance 33,000Disabled dependant allowance 66,000

Deductions$

Self-education expenses (maximum) 80,000Home loan interest (maximum) 100,000Elderly residential care expenses (maximum) 92,000Mandatory provident fund contributions (maximum) 18,000

Depreciation allowance ratesInitial allowance:

Plant and machinery 60%Industrial buildings 20%

Annual allowance:Computers 30%Motor cars 30%Furniture and fixtures 20%Machines 10%–30%Industrial buildings 4% or formulaCommercial buildings 4% or formula

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Stamp duty ratesStock 0·2% + $5

Immovable property

Conveyance on sale and agreement for sale (ignoring marginal reliefs)Scale 1 Scale 2

Up to $2,000,000 1·5% $100$2,000,001 to $3,000,000 3·0% 1·5%$3,000,001 to $4,000,000 4·5% 2·25%$4,000,001 to $6,000,000 6·0% 3·0%$6,000,001 to $20,000,000 7·5% 3·75%$20,000,001 and above 8·5% 4·25%

Conveyance on sale and agreement for sale chargeable with special stamp dutyHolding periodNot exceeding six months 15% or 20% as applicableBetween six and 12 months 10% or 15% as applicableBetween 12 and 24/36 months 5% or 10% as applicable

Conveyance on sale and agreement for sale chargeable with buyer’s stamp duty 15%

Lease(a) Key money, construction fee etc only As for conveyances (above)(b) Rent only (as a percentage of the average yearly rent)

Undefined term 0·25%Not exceeding one year 0·25%More than one year but not exceeding three years 0·50%Exceeding three years 1·00%

(c) Key money, construction fee etc and rentKey money, construction fee etc 4·25% of the considerationRent As for rent-only lease (above)

3 [P.T.O.

Section A – BOTH questions are compulsory and MUST be attempted

1 Fortune Jewel Ltd (FJL) is a company incorporated in Hong Kong, carrying on business in Hong Kong as a retailer inhigh-end jewels. In 2014, FJL reached its record turnover from operating a network of nine retail stores, mainlyserving the increasing number of visitors from Mainland China. However, with the downturn in the visitor populationin Hong Kong since 2015, FJL’s turnover has dropped by 60% in the year ended 31 March 2017, as compared with2014.

Mr Ng is newly employed as FJL’s chief executive officer (CEO), effective from 1 May 2017. After studying FJL’sfigures for the last few years, he has decided to initiate a business re-engineering exercise to secure FJL’s sustainability.At the beginning of June 2017, he called a meeting to discuss various potential actions as follows:

(1) Downsizing of retail operations

(i) Out of the nine stores, one self-owned store building will be closed and disposed of and three leased storeswill be terminated and closed:

(ii) 80% of the employees from the terminated stores will be made redundant. The statutory redundancyamount plus an additional gratuity representing two months’ salary will be paid. The other staff will beredeployed to the continuing stores.

(2) Additional funding for continuing operations

A proposal will be made to FJL’s existing shareholder, Precious Stone Ltd (PSL), to inject additional funds intoFJL. PSL is managed and controlled in Austria and has no activities in Hong Kong. The following alternativeproposals for injecting the funds have been suggested:

(i) A loan from PSL to FJL bearing interest at 0·1% below the market rate; the loan money will be depositedinto FJL’s bank account in Austria.

(ii) As consideration paid by PSL to acquire FJL’s brand name, following which the brand name will be licensedback to FJL for continual use in its operation at a licence fee calculated based on FJL’s monthly turnover.The brand name was created as a new one by FJL at no cost, and has been owned and used by FJL sincethe commencement of its operation more than 20 years ago.

Mr Ng has approached a tax consultancy firm in Hong Kong to obtain tax advice on the major Hong Kong taximplications arising from his proposals for re-engineering FJL’s business.

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Three stores self-owned by FJL Six stores under current lease by FJL To continue 2 stores 3 storesTo terminate 1 store 3 storesActions: (a) To sell the terminated store at its

market value. FJL’s estimated valueof the store is $30m (including20% for the land portion).

(b) To assess the tax implication of thesale profit. The store’s net carryingvalue at 31 March 2016 is $25m;it was bought from a propertydeveloper in March 2010 for $15mand tax depreciation has beenclaimed based on $12m.

(a) To issue three-month terminationnotices to the landlords by 30 June2017; termination to take effectfrom 1 October 2017.

(b) To apply the three-month rentaldeposits held by the landlords tocover the rental payments and stoppaying further rentals during thenotice period. As per the leaseterms, the rental deposits arerefundable by the landlord orapplied to rental payments indefault.

Required:

As the tax adviser of the firm engaged by Fortune Jewel Ltd (FJL), prepare a report for the CEO addressing eachof the following issues from a Hong Kong tax perspective, providing supporting calculations where appropriate.

(a) Termination of leases of three retail stores

The tax implications for FJL arising from the application of the rental deposits to cover the lease rentalsduring the three-month notice period. (3 marks)

(b) Sale of retail store

(i) The tax implications for FJL of the profit arising from the sale of the store, including a calculation of theapplicable depreciation adjustment in respect of the property in the year of disposal. (7 marks)

(ii) The estimated annual depreciation allowance which might be available to the purchaser assuming thatthe store continued to be used by them upon acquisition. (2 marks)

(c) Termination of employment upon closure of store

(i) The tax implications for FJL of the redundancy payments and additional gratuities to be paid to theleaving staff. (4 marks)

(ii) The tax implications for the leaving staff from the receipt of the redundancy payments and the additionalgratuities. (3 marks)

(d) Additional funding

(i) The tax implications for both FJL and its shareholder, Precious Stone Ltd (PSL), arising from thepayment and receipt of the loan interest. (7 marks)

(ii) The tax implications for both FJL and PSL arising from the sale and license back of FJL’s brand name.(5 marks)

Professional marks will be awarded in question 1 for the appropriateness of the format and presentation of thereport and the effectiveness with which the advice is communicated. (4 marks)

(35 marks)

5 [P.T.O.

2 You should assume that today’s date is 1 March 2017.

Jeff Young is the president of a US corporation, PC Gaming Inc (PCG), which produces computer games. Jeff wantsto market the computer games throughout Hong Kong and South-East Asia. To do this, a subsidiary company calledPC Gaming (HK) Ltd (PCG-HK) will be established in Hong Kong in April 2017, which will act as the local and South-East Asian distributor of the computer games.

Jeff will appoint his son, Jack, to manage PCG-HK under a two-year contract from 1 April 2017 to 31 March 2019.Although stationed in Hong Kong, Jack will travel extensively back to the US and throughout the South-East Asiaregion. Jack’s annual remuneration package will be $1,200,000. He will also be granted an option to purchase30,000 shares in PCG-HK at a favourable option price. This option will be unconditional. Jack will be allowed tostructure his two-year remuneration package as long as the total cost of the remuneration package to PCG-HK (otherthan the share options) does not exceed $2,400,000.

Jack estimates his main annual expenses will be as follows:

(1) Rent: $240,000;(2) Car and private transport: $200,000;(3) Utilities such as electricity and telecommunications: $60,000;(4) Personal expenses: $216,000 (mostly charged to a credit card); and(5) Medical expenses: $18,000

Jack plans to return to the US when the two-year contract expires on 31 March 2019 and only to exercise the shareoption after he returns to the US, as he believes that this will result in no Hong Kong tax liability.

Required:

(a) Explain whether the income Jack Young will receive from PC Gaming (HK) Ltd (PCG-HK) will be liable tosalaries tax in Hong Kong and, if so, the actions which PCG-HK and/or Jack could take to minimise any suchliability. (8 marks)

(b) Assuming that Jack’s employment with PCG-HK is considered to be a Hong Kong employment, advise himon:

(i) The ways in which his remuneration package might be structured so as to minimise the amount ofsalaries tax he will have to pay in Hong Kong. (12 marks)

(ii) The salaries tax treatment of the share option. (5 marks)

(25 marks)

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Section B – TWO questions ONLY to be attempted

3 Mr and Mrs Li (the couple), who are both Hong Kong permanent residents, are planning to emigrate to Canada in sixmonths’ time. They both ceased their employments from 1 April 2017 and are exploring ways to deal with theirresidential property after they leave Hong Kong. The property is jointly held by the couple and is currently under abank mortgage loan. The couple have been allowed a ‘home loan interest’ deduction against their employment incomefor ten years. The mortgage loan is still outstanding and the couple intend to continue holding the property under themortgage loan for the present and review the position next year once they have settled in Canada.

The couple are considering the following options regarding their residential property:

Option 1: lease the property for rental to an outside party at market rent, which is estimated to be $20,000 per month.The couple will continue to repay the bank mortgage loan.

Option 2: lease the property to Mrs Li’s uncle at below market rent or even for free. The couple will again continueto repay the bank mortgage loan.

Option 3: the property will be occupied by the couple’s son, who will remain in Hong Kong for work. The couple willnot charge their son rent but he will take up the responsibility to repay the bank mortgage loan on behalf of Mr andMrs Li.

Required:

(a) Advise Mr and Mrs Li in respect of each of the three options as follows:

(i) Option 1: the Hong Kong tax and stamp duty implications, if any, of leasing the residential property,including whether a home loan interest deduction can continue to be claimed. Support your answer withan estimate of the annual property tax payable. (9 marks)

(ii) Option 2: any change in Mr and Mrs Li’s Hong Kong tax position, as compared to Option 1. (2 marks)

(iii) Option 3: any change in Mr and Mrs Li’s Hong Kong tax position, as compared to Option 1. (2 marks)

(b) (i) State the statutory reporting obligations with which Mr and Mrs Li should comply before they leave forCanada. (2 marks)

(ii) Advise Mr and Mrs Li of the possible actions the Inland Revenue Department may take in order torecover any outstanding tax due should they fail to comply with their reporting obligations and/or leaveHong Kong without having cleared all of their Hong Kong tax liabilities. (5 marks)

(20 marks)

7 [P.T.O.

4 (a) The Association of Food Lovers Ltd (AFL) is a company limited by guarantee, established in 2016, with thepurpose of providing facilities for its members to learn about and enjoy organic food. AFL owns premises for thesepurposes, and employs several staff. Members who join AFL pay an up-front fee of $100,000, and monthly feesof $1,000. There are currently 3,000 members. AFL buys high quality, organic food items and resells them toits members, as well as to their friends. AFL also has a restaurant on its premises which is open to both membersand their guests.

AFL’s policy is to seek to cover its costs but not to make a profit. However, during the year 2016, it made a largeprofit, and Joey, AFL’s treasurer, wishes to know whether AFL will have to pay tax on this profit.

Required:

(i) Explain the liability to tax of the profit made by The Association of Food Lovers Ltd (AFL) in 2016.Clearly specify the additional information (if any) needed in order to determine the position withcertainty. (7 marks)

(ii) State what steps AFL might take in order to avoid or minimise any future liability to profits tax.(2 marks)

(b) Ace Group (the Group) carries on a financial services business in different countries including Hong Kong. Dueto a number of high profile fraud cases, the Group’s management has been trying to negotiate a commercialcrime insurance policy, but has failed to get the comprehensive cover which the Group requires. As an alternative,the Group management intends to incorporate its own insurance company to cover the uninsured risks of theGroup. The insurance company, Ace Insurance, will be incorporated in the British Virgin Islands, and will chargeinsurance premiums to all the Group companies including Ace-Hong Kong (the company carrying on the financialservices business in Hong Kong) based on an assessment of the risks involved and the value of the business atrisk.

Required:

Advise on the Hong Kong tax positions of Ace Insurance and Ace-Hong Kong respectively with respect to theinsurance premium paid by Ace-Hong Kong to Ace Insurance. (11 marks)

(20 marks)

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5 HK Co Ltd (HK-Co) is a company carrying on business in Hong Kong. HK-Co commenced business in the year ofassessment 2016/17 and based on its projected management accounts for the year of commencement, the financemanager has identified the following items which need to be examined before the company’s profits tax computationfor 2016/17 can be prepared.

(a) Depreciation on computer systems of $30,000 (acquisition cost $100,000)

(b) Incorporation fee of $30,000 and business registration fee of $2,250.

(c) Mandatory provident fund (MPF) contributions of $50,000, including an initial lump sum of $20,000 to set upthe fund.

(d) Compensation of $100,000 for a restrictive covenant agreed by an employee who resigned after six months ofservice for a promise not to join a competitor for a period of five years.

(e) An incentive of $80,000 paid to another employee who agreed to withdraw his resignation letter and remain inemployment.

(f) Interest expense of $190,000 on a bank mortgage loan to acquire three residential units used as staff quarters.

Required:

Explain the relevant tax rules and principles underlying the Hong Kong tax treatments of each of the items (a) to(f), including in each case a conclusion as to whether and if so, how it should be adjusted in the tax computation.

Note: The following mark allocation is provided as guidance for this question:

Item (a) 4 marksitem (b) 4 marksitem (c) 3 marksitem (d) 2 marksitem (e) 2 marksitem (f) 5 marks

(20 marks)

End of Question Paper

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