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 the
business 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 outside
Hong 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 in
question.

(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 trading
contract 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 Cosmotron case. 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. More
specifically, 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 the
interest 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 to
PC 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 interest
income, 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) is
also 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.

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