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Determination of sources of profits

Presented by: Christina Ng

December 4, 2008

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Hong Kong Taxation Profits tax Income - Taxable Expenses – Deductible Tax planning techniques

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Income

Income

Revenue Capital

Onshore Offshore Not Taxable

Taxable Not Taxable

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Capital vs Revenue Six Badges of Trade:

Intention Subject matter of realization Duration of ownership Frequency Supplementary work done Circumstances for disposal

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Profits Tax- Income Active income:

Trading business Manufacturing business Servicing business

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Profits Tax- Income Passive income:

Dividend income Interest income Capital Gains Royalties Rental income Commission?

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Active income – governing factors Profits tax rate: 16.5% Section 14 of the IRO

There is a trade, profession or business in Hong Kong

That the trade, profession or business derives profits; and

The profits arise in or derived from HK. DIPN 21 Case law

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Trading income Where sales and purchases are

negotiated, executed and concluded Questions to ask: How / Where/ Whom Negotiation–

Methods / place: via email, phone, fax or in person, such as trade show or business trips?

Person: staff, agent or subcontractor? Execution – via email, fax or mail? Conclusion – how and where?

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Trading income Where both sales and purchases are

effected in HK- 100% taxable. Where both are effected outside of HK –

100% non-taxable. Where either is effected in HK – initial

presumption is – 100% taxable, subject to totality of facts.

Trading profits cannot be apportioned.

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Case studies – Trading profits Trading profits ABC Co. purchases garments from China

and derive sales profits from selling them to the following US Customers:

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Case studies – Trading profits Scenario 1 US Customer A faxes a

purchase order to the Hong Kong office of ABC Co. ABC Co. accepts the purchase order in Hong Kong and faxes a sales confirmation back to US Customer A.

Profits derived taxable or not?

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Case studies – Trading profits Scenario 1 US Customer A faxes a

purchase order to the Hong Kong office of ABC Co. ABC Co. accepts the purchase order in Hong Kong and faxes a sales confirmation back to US Customer A.

Profits derived taxable or not?

The sales contract is effected in Hong Kong as the purchase order is accepted in Hong Kong by faxing the sales confirmation in Hong Kong. The sales profits are therefore taxable in Hong Kong.

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Case studies – Trading profits Scenario 2 US Customer B sends

purchase orders to Hong Kong but does not require any acknowledgement. ABC Co approves the orders on receipt in Hong Kong but does not issue sales confirmations. It then sends a fax to the Chinese factory instructing them to manufacture the garment and ship them directly to the US.

Profits derived taxable or not?

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Case studies – Trading profits Scenario 2 US Customer B sends

purchase orders to Hong Kong but does not require any acknowledgement. ABC Co approves the orders on receipt in Hong Kong but does not issue sales confirmations. It then sends a fax to the Chinese factory instructing them to manufacture the garment and ship them directly to the US.

Profits derived taxable or not?

The sale is taxable in Hong Kong because ABC Co has received and accepted US Customer B’s order in Hong Kong. It also issues the purchase order in Hong Kong to the Chinese factory.

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Case studies – Trading profits Scenario 3 US Customer C send

its buying manager to Hong Kong once a year. While in Hong Kong he signs a sales contract with ABC Co. for the supply of the garments.

Profits derived taxable or not?

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Case studies – Trading profits Scenario 3 US Customer C send

its buying manager to Hong Kong once a year. While in Hong Kong he signs a sales contract with ABC Co. for the supply of the garments.

Profits derived taxable or not?

Since the sales agreement is negotiated and concluded in Hong Kong, the sales profits are taxable in Hong Kong.

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Case studies – Trading profits Scenario 4 The sales manager of ABC

Co. visits the US and signs a sales contract with US Customer D in the US. The sales manager informs the buying manager of the new order. The buying manager goes to China and negotiates the purchase of the garments from the Chinese factory. While in China, the buying manager signs a contract to buy the garments.

Profits derived taxable or not?

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Case studies – Trading profits Scenario 4 The sales manager of ABC

Co. visits the US and signs a sales contract with US Customer D in the US. The sales manager informs the buying manager of the new order. The buying manager goes to China and negotiates the purchase of the garments from the Chinese factory. While in China, the buying manager signs a contract to buy the garments.

Profits derived taxable or not?

Since both the purchase and sales contracts are negotiated and concluded outside Hong Kong (in China and US), the sales profits are not subject to tax in Hong Kong.

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Case studies – Trading profits Scenario 5 ABC Co. appoints a US Co

as its US agent. The US Co. is authorized to negotiate and conclude sales contracts on behalf of ABC Co. The US Co. faxes details of the orders both to ABC Co in HK and to its Shanghai buying office. The Shanghai office orders the garments from a Chinese factory and ships them to the US.

Profits derived taxable or not?

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Case studies – Trading profits Scenario 5 ABC Co. appoints a US Co

as its US agent. The US Co. is authorized to negotiate and conclude sales contracts on behalf of ABC Co. The US Co. faxes details of the orders both to ABC Co in HK and to its Shanghai buying office. The Shanghai office orders the garments from a Chinese factory and ships them to the US.

Profits derived taxable or not?

The sales profits have a foreign source because both the purchase and sales contracts are negotiated and concluded outside Hong Kong.

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Manufacturing income Determined by the location where the

goods are manufactured. Place where the goods are sold are

irrelevant. Factory outside of HK – possible 50/50%

apportionment. Subcontracting – could be viewed as

trading.

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Case studies – Mfg profits Scenario 1 XYZ Co. manufactures

typewriters at its factory in Hong Kong and sells them to customers in Europe.

How the profits derived are taxed?

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Case studies – Mfg profits Scenario 1 XYZ Co. manufactures

typewriters at its factory in Hong Kong and sells them to customers in Europe.

How the profits derived are taxed?

The source of its manufacturing profits is Hong Kong as this is where the typewriters are manufactured. Therefore, the profits derived are 100% taxable under Hong Kong profits tax.

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Case Studies – Mfg profits Scenario 2 XYZ Co. subcontracts the

assembly to a factory in China. XYZ Co. purchases the components and raw materials, designs the products, and the Chinese factory assembles into finished products in return for a processing fee. The Chinese factory is an old established company with many customers besides XYZ Co. The Chinese factory controls its own production procedures and supplies XYZ Co. as an independent contractor.

How the profits derived are taxed?

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Case Studies – Mfg profits Scenario 2 XYZ Co. subcontracts the

assembly to a factory in China. XYZ Co. purchases the components and raw materials, designs the products, and the Chinese factory assembles into finished products in return for a processing fee. The Chinese factory is an old established company with many customers besides XYZ Co. The Chinese factory controls its own production procedures and supplies XYZ Co. as an independent contractor.

How the profits derived are taxed?

XYZ Co. cannot claim 50% of its profits as tax-exempt foreign income because XYZ Co. does not control the foreign manufacturing operations of the Chinese subcontractor. In this case, the profits derived are 100% taxable under Hong Kong profits tax.

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Case studies – Mfg profits Scenario 3 XYZ Co. sets up its own

factory in China which will supply XYZ Co. exclusively. XYZ Co. negotiates with a China third party who agrees to provide factory space and 2,000 workers. XYZ Co. is responsible for the production process and training the work force. XYZ Co’s Hong Kong head office continues to handle sales, design and the purchase of raw materials.

How the profits derived are taxed?

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Case studies – Mfg profits Scenario 3 XYZ Co. sets up its own

factory in China which will supply XYZ Co. exclusively. XYZ Co. negotiates with a China third party who agrees to provide factory space and 2,000 workers. XYZ Co. is responsible for the production process and training the work force. XYZ Co’s Hong Kong head office continues to handle sales, design and the purchase of raw materials.

How the profits derived are taxed?

XYZ Co. is able to claim that 50% of its manufacturing profits are exempt from Hong Kong tax as it controls the manufacturing operations in China.

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Servicing income /commission Location where the services are rendered Not apportioned generally Passive commission –not taxable if

structured properly

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Case studies – Service income Scenario 1 Co X receives buying

commissions for purchasing textiles in Hong Kong and inspecting them at the Hong Kong factory before they are shipped to the US.

Commissions derived taxable or not?

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Case studies – Service income Scenario 1 Co X receives buying

commissions for purchasing textiles in Hong Kong and inspecting them at the Hong Kong factory before they are shipped to the US.

Commissions derived taxable or not?

The buying commission is subject to Hong Kong profits tax as Co X performs its buying services in Hong Kong.

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Case studies – Service income Scenario 2 A director of Co X takes a

US customer to see a new factory in Taiwan. The director helps the US customer negotiate a purchase in Taiwan. The director is required to visit Taiwan for inspection of the goods before they are shipped to the US.

Commission derived taxable or not?

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Case studies – Service income Scenario 2 A director of Co X takes a

US customer to see a new factory in Taiwan. The director helps the US customer negotiate a purchase in Taiwan. The director is required to visit Taiwan for inspection of the goods before they are shipped to the US.

Commission derived taxable or not?

The buying commission received should not be subject to Hong Kong tax as it is received for services rendered outside Hong Kong.

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Passive income Interest income

Interest exemption order Provision of Credit test

Dividend income Not taxable Withholding tax not applicable

Capital gains Not taxable

Royalties S15(1)(b) & S21A

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Passive income – cont’d Royalties

Charged if the use or right to use the trademark, patent, copyright etc. is in Hong Kong.

100% gross receipts taxable if paid to associates where the mark has previously been owned in HK. Otherwise, 30% taxable.

Effective tax rate: 4.95% or 16.5% Landmark case: Emerson Radio Corporation vs.

CIR

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Case studies – Interest income C Ltd , a HK company,

lends US$100,000 to another HK company, D Ltd, by transferring the money from its US bank account to the US$ account of D Ltd in New York. D Ltd paid interest to C Ltd for the money borrowed.

Interest income derived taxable or not?

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Case studies – Interest income C Ltd , a HK company,

lends US$100,000 to another HK company, D Ltd, by transferring the money from its US bank account to the US$ account of D Ltd in New York. D Ltd paid interest to C Ltd for the money borrowed.

Interest income derived taxable or not?

The interest received by C Ltd has a foreign source under the provision of credit test as the loan was made available in New York, i.e. outside Hong Kong.

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Expenses /Deductions Section 16(1) of the IRO. “Outgoings and expenses allowed to the

extent to which they are incurred in the production of profits which is chargeable to Profits tax in any period.

Expenses of a private nature or capital nature, not deductible.

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Expenses /Deductions Meaning of incurred Incurred is not the same as paid Note DIPN 40 re Prepayments (Secan

case) General provisions not normally deductible

-contingent and no fixed liability. “To the extent” – no definite rule on

apportionment. E.g. based on turnover basis, gross profit basis and asset basis.

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Expenses /Deductions “ in the production of profits” - with the

expectation of generating profits or for the purpose of trade. [re CIR vs. Cosmotron Manufacturing]

“any period” – expenses incurred are deductible irrespective of income derived in a prior or later year.

E.g. Pre-commencement trade expenses, are these deductible? How to define pre-commencement of business?

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Capital vs. Revenue expenses Capital – in the form of investment,

purchase of fixed assets etc. Some capital expenditure receives tax

concession or exemption, such as purchase of patent & know how [S16E of IRO]; Expenditure on building refurbishment [S16F of IRO]; Expenditure on prescribed fixed assets [S16G of IRO]

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Expenses - Interest Section 16(1)(a) –Deductible if for the

purpose of producing assessable profits; AND

Meet conditions in 16(2) of IRO.

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Expenses - Interest Section 16(2)

a. The borrower is a financial institution.b. The borrower is a public utility company.c. The lender is subject to Hong Kong tax on the interest

received.d. The lender is a financial institution and that:

The loan is not secured or guaranteed by any deposit with a financial institution, or

The repayment of the loan or the interest is not secured or guaranteed by or on behalf of certain connected persons against a deposit with any financial institution.

e. The loan is raised to finance purchase of plant, machinery or trading stock and the lender is not related to the borrower.

f. Interest paid by a corporation on debentures or similar marketable instrument listed on Hong Kong or any other stock exchanges.

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Case studies - Interest expenses Scenario 1 Mr. A starts a new

company, A’s Perfumes. Mr. A places a deposit of HK$1 million with the bank as security for a bank loan of HK$5M to A’s Perfumes.

Interest deductible?

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Case studies - Interest expenses Scenario 1 Mr. A starts a new

company, A’s Perfumes. Mr. A places a deposit of HK$1 million with the bank as security for a bank loan of HK$5M to A’s Perfumes.

Interest deductible? The interest paid to

the bank is not tax-deductible because the loan is secured on a deposit which produces non-taxable interest income [S16(2)(d) of the IRO].

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Case studies - Interest expenses Scenario 2 Mr. A is unhappy that

the interest paid by the business is not tax-deductible. He therefore renegotiate the bank facility so that there is no security over the deposit. Instead, Mr. A gives a personal guarantee.

Interest deductible?

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Case studies - Interest expenses Scenario 2 Mr. A is unhappy that

the interest paid by the business is not tax-deductible. He therefore renegotiate the bank facility so that there is no security over the deposit. Instead, Mr. A gives a personal guarantee.

Interest deductible? The interest on the

renegotiated loan is deductible because the loan is no longer secured on a deposit but is instead secured on Mr. A’s personal guarantee [S16(2)(d) of the IRO].

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Case studies - Interest expenses Scenario 3 Mr. A needs to purchase

plant, machinery and trading stock. He can borrow from his mother or a bank to fund the purchase. His mother offers interest rate of 4% while the bank would charge 5%. Which alternative should he choose?

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Case studies - Interest expenses Scenario 3 Mr. A needs to purchase

plant, machinery and trading stock. He can borrow from his mother or a bank to fund the purchase. His mother offers interest rate of 4% while the bank would charge 5%. Which alternative should he choose?

Since the interest earns by Mr. A’s mother would not taxable, interest expenses paid to her would not be deductible to A’s Perfumes.[S16(2)(c)].In addition, loan from associate for purchasing FA and stocks are not deductible. [S16(2)(e)].

Interest on loan from the bank would be deductible.[S16(2)(e)]

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Case studies - Interest expenses Scenario 4 A’s Perfumes continues to

expand and he needs more finance. A’s Perfumes are well known overseas and many overseas investors are willing to lend money to A’s Perfumes.

Should A’s Perfumes borrow directly from these overseas lenders?

What alternatives could be suggested?

Interest deductible? Alternatives?

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Case studies - Interest expenses Scenario 4 A’s Perfumes continues to

expand and he needs more finance. A’s Perfumes are well known overseas and many overseas investors are willing to lend money to A’s Perfumes.

Should A’s Perfumes borrow directly from these overseas lenders?

What alternatives could be suggested?

Interest deductible? Interest paid to overseas

lenders, (who are not F.I. would not be deductible. [S16(2)(c) of the IRO].

Alternatives: A’s Perfumes can consider

issue debentures or bonds quoted in Hong Kong or on a foreign stock exchange. Interest paid thereon is tax-deductible [s16(2)(f) of the IRO].

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Case studies - Interest expenses Scenario 5 A’s Perfumes borrows

US$1m loan from the bank, secured by personal guarantee, to buy 50% of the shares in S Ltd as a long term capital investment.

Interest paid on the loan tax-deductible or not?

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Case studies - Interest expenses Scenario 5 A’s Perfumes borrows

US$1m loan from the bank, secured by personal guarantee, to buy 50% of the shares in S Ltd as a long term capital investment.

Interest paid on the loan tax-deductible?

The interest paid is not tax-deductible because it is not incurred in the production of taxable profits [S16(1)(a) of the IRO].

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Expenses -Bad Debts Section 16(1)(d) The debt must have been returned as

trading receipts or incurred in the normal course of business.

Debt must have turned bad during the basis period.

Debt in respect of deposits and advances made in the normal course of business is deductible under S16(1) of the IRO.

Bad debt recovered are taxable.

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Case study -Bad Debts AKF Company Ltd is a

finance company. For the y.e. 31.12.2007, it has incurred specific bad debt of HK$2.5m. After discussion with the auditors, Management decided to provide for bad debt in the accounts on February 14, 2008.

Is the provision deductible?

In which year of assessment can the company claims the deduction?

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Case study - Bad Debts AKF Company Ltd is a

finance company. For the y.e. 31.12.2007, it has incurred specific bad debt of HK$2.5m. After discussion with the auditors, Management decided to provide for bad debt in the accounts on February 14, 2008.

Is the provision deductible? In which year of

assessment can the company claims the deduction?

The provision is only deductible in the year of assessment 2008/09 as the provision was not made before the year end. [S16(1)(d) of the IRO]

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Expenses – Legal expenses Deductible if incurred for the generation of

assessable profits. Capital vs. Revenue Revenue nature:

Debt collecting expenses Action brought against commercial fraud

Capital nature: Legal fees on office lease Legal fee incurred on Fixed asset purchase.

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Case study - Legal expenses L Co. has incurred HK$72,000

legal expenses in connection with the purchase of new office premises. The breakdown of the charges by the solicitor is as follows: Legal fee for drawing up

the purchase and sales agreement in respect of the new office premises, $38,000

Legal fee for renewing a lease term of the computer systems for the installation of the same into the new office premises, $10,000

Legal fee for preparing mortgage documentation in respect of the new office premises, $24,000

How much of the legal fee is disallowable or tax-deductible?

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Case study - Legal expenses L Co. has incurred HK$72,000

legal expenses in connection with the purchase of new office premises. The breakdown of the charges by the solicitor is as follows:

Legal fee for drawing up the purchase and sales agreement in respect of the new office premises, $38,000

Legal fee for renewing a lease term of the computer systems for the installation of the same into the new office premises, $10,000

Legal fee for preparing mortgage documentation in respect of the new office premises, $24,000

How much of the legal fee is disallowable or tax-deductible? Legal fee for drawing up the purchase and sales agreement of the new office premises - disallowable. The legal fee helps to create a new asset which will last for more than one year.

Legal fee of HK$10,000 incurred in renewing the lease term of the computer systems - deductible as such expense enable the business to retain an existing asset.

Legal fee in respect of preparation of the mortgage documentation is deductible as it is paid in connection with the borrowing of money for the purpose of producing assessable profits. [S16(1)(a) of IRO]

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Expenses - offshore Are offshore expenses deductible? What are they incurred for?

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Case studies - Offshore activities Company GHI is in the

trading business. It has a sales team who travel frequently overseas to visit buyers and conclude sales arrangement.

Would the traveling expenses be deductible?

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Case studies - Offshore activities Company GHI is in the

trading business. It has a sales team who travel frequently overseas to visit buyers and conclude sales arrangement.

Would the traveling expenses be deductible?

GHI – offshore profits claim: expenses would not be deductible.

If no offshore profits claim: expenses would be deductible.

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Case studies - Offshore expenses Company GHI

reimburses its Shanghai RO of all the expenses it incurs.

Are these reimbursements deductible?

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Case studies - Offshore expenses Company GHI

reimburses its Shanghai RO of all the expenses it incurs.

Are these reimbursements deductible?

Expenses deductible to the extent they generate taxable profits to Company GHI.

Apportionment may apply if offshore profits claim is lodged.

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Case studies - Offshore expenses F Ltd sells garments

in Hong Kong. The Hong Kong company opens an office in the Philippines to purchase the garments.

Are the expenses incurred by the Philippines office deductible in the books of F Ltd for Hong Kong tax purposes?

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Case studies - Offshore expenses F Ltd sells garments in

Hong Kong. The Hong Kong company opens an office in the Philippines to purchase the garments.

Are the expenses incurred by the Philippines office deductible in the books of F Ltd for Hong Kong tax purposes?

The expenses of the Philippines office are deductible as they are incurred in the production of the taxable profits for the Hong Kong company, F Ltd, i.e. the expenses are incurred in purchasing goods for resale in Hong Kong notwithstanding the expenses are incurred outside Hong Kong.

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Expenses – private nature S17(1)(a) of IRO Expenses of a private or domestic nature,

including traveling between residence and place of business , not deductible.

E.g. Life insurance of directors; household expenses.

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Case studies - Private expenses Mr. X is the director

and shareholder of Company XYZ. He would like to have his life insured, the company pays for his car and medical expenses.

How can he obtain these benefits while the company can enjoy the deductions?

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Case studies -Private expenses Mr. X is the director and

shareholder of Company XYZ. He would like to have his life insured, the company pays for his car and medical expenses.

How can he obtain these benefits while the company can enjoy the deductions?

For life insurance, Company XYZ has to be the beneficiary of the policy.

For car expenses, the car should be owned by Company XYZ. There are no fringe benefits tax in HK.

For medical expenses, the company could sign up a group policy or company account with the medical providers.

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Case studies - Private expenses Mr. M and Mr. N are under

partnership which incurred the following expenses: Rent paid for Mr. N’s flat Salaries to Mr. M and Mr.

N Private car expenses of

Mr. M The above private

expenses are disallowable for tax purposes under partnership according to section 17(1)(a) of the IRO.

If the partnership business is transferred to a new limited company, what is the tax treatment of the above expenses under corporation?

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Case studies - Private expenses Mr. M and Mr. N are under

partnership which incurred the following expenses: Rent paid for Mr. N’s flat Salaries to Mr. M and Mr. N Private car expenses of Mr.

M The above private expenses

are disallowable for tax purposes under partnership according to section 17(1)(a) of the IRO.

If the partnership business is transferred to a new limited company, what is the tax treatment of the above expenses under corporation?

The private expenses paid on behalf of Mr. M and Mr. N, who have now become the directors of the new limited company, are deductible as they represent employee benefits. Such benefits provided are part of the business expenses incurred for the generation of the corporation’s assessable profits.

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Tax Planning Reduce tax liabilities within the scope of

the legal framework Tax reduction vs. tax avoidance Must be commercially viable. Anti avoidance provision: S61A

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Anti-avoidance provision – S61A There must be an identifiable transaction Transaction has the effect of conferring a

tax benefit Sole or dominant purpose of conferring a

tax benefit.

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Anti-avoidance provision – S61A The manner in which the transaction was entered

into; The form and substance of the transaction; The result that would have been achieved; Any change in the financial position of the

relevant person; Any change in the financial position of the

connected person; Rights or obligations created; Participation by corporation carrying on business

outside of Hong Kong.

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Common Tax planning techniques Servicing industry Differentiate work

done in Hong Kong from those outside of Hong Kong.

Split contract arrangement.

Overseas Buyers

Hong Kong buying agent company

Hong Kong contractCommission paid for work done in Hong Kong

Overseas contractCommission paid forWork done outside of Hong Kong

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Common tax planning techniques Manufacturing

industries Set up WOFE in the

PRC rather than enter into processing arrangement or JV.

PRC tax effect should be taken into consideration.

Hong Kong company

PRC WOFE

PRC factory

Buy/sell at arm's length prices

manufacturing activities

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Common tax planning techniques Interest payment to

overseas group company

Include interest in cost of sales instead.

Customs duties effect

Overseas company

Hong Kong company

Before planning After planning

cos: $100 Sell goods cos:$110

interest: $10

tax deduction:$17.5 tax deduction: $19.25

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Common tax planning techniques Macau trading

company – no Macau tax

Subject to feasibility of moving staff

If maintain HK co, can provide auxiliary services.

Overseas Customers

Hong Kong company- buying agent / inspection agent Macau

trading company

PRC factory

sell goods

commission

processing arrangement

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Thank you!