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. TAX RATES AND ALLOWANCES The following 2010/11 tax rates and allowances are to be used in answering the questions. Section A – BOTH questions are compulsory and MUST be attempted 1. Ms Mi (Mi) is the sole shareholder of H Ltd, which was incorporated in Hong Kong during December 2010 for the purpose of acquiring the shares in K Ltd at the cost of $50 million. K Ltd is a Hong Kong incorporated company holding ten properties in Hong Kong. These properties are classified as ‘trading stock’ in K Ltd’s accounts on the basis that they are held for sale at a profit. The acquisition cost was financed by a bank loan which was secured by a personal guarantee given by Mi’s husband (Hubby). The current structure is illustrated on the left hand side of the diagram below: You recently met Mi who advised you that she was going to divorce her husband. Thereafter, her husband will withdraw his personal guarantee on the bank loan, leading to the loan to be called back by the bank. Mi has sought help from her father (Papa), who has given two proposals for her consideration. These two proposals, as illustrated in the diagrams above, have the following details: Proposal 1: A new bank loan will be extended from the bank to K Ltd, which is secured by a deposit placed by Papa with the Bank’s associate in China. K Ltd will on-lend the bank loan money to H Ltd interest free, to enable H Ltd to repay the old bank loan. Papa’s deposit will earn interest at the same rate that K Ltd pays on the new bank loan minus a 0.5% bank fee. Proposal 2: Papa will invest, via P Ltd, a company incorporated in China, into H Ltd as a 50% shareholder. H Ltd could use the additional fund to repay the bank loan. However, he is neutral as to whether the 50% shareholding is acquired by way of new shares issued by H Ltd to him directly, or the sale of shares in H Ltd from Mi to him. If Mi sells her 50% shareholding to Papa, she will lend the money, interest-free, to H Ltd. Mi anticipates that she will make a significant profit on the sale and since K Ltd is trading in properties, she is concerned that her profit from the sale of the shares will also be taxed. Moreover, under this proposal, Papa also requests that after the shareholding change, K Ltd will sell two properties to P Ltd at cost, which is about 30% below the current market price. Apart from the above two proposals from Papa, Mi also discussed with you the following alternative: Proposal 3: K Ltd will change the strategy for holding the properties from trading to investment. These properties will be leased out to earn rental income. K Ltd will then assign its income rights under these leases to an independent party for a lump sum consideration. The lump sum will either be paid up as dividend or lent to H Ltd interest-free, to enable H Ltd to repay the existing bank loan. As a friend of Mi as well as a professional tax consultant, you have promised Mi to review the above proposals from a Hong Kong tax perspective, and write a report to her. Required: Prepare a report for Ms Mi addressing the tax issues set out below, including supporting calculations where appropriate. (a) Current structure – Comment on the tax effectiveness of the current funding structure in terms of the funding cost incurred by H Ltd. (2 marks) (b) Proposal 1 – As compared with the current funding structure, advise whether there are any profits tax implications arising from Proposal 1 for: (i) H Ltd; and (1 mark) (ii) K Ltd. (4 marks) (c) Proposal 2 – Advise on: (i) The profits tax and stamp duty implications for H Ltd and P Ltd, if P Ltd subscribes for new shares to be issued by H Ltd directly to P Ltd; (2 marks) (ii) The profits tax and stamp duty implications for Ms Mi if she sells 50% of her shareholding in H Ltd to P Ltd. Discuss also whether Ms Mi’s concern that her tax position will be affected by K Ltd’s property trading business is valid; and (15 marks) (iii) The profits tax and stamp duty implications for K Ltd if it sells the two properties to P Ltd at cost. (8 marks) (d) Proposal 3 – Advise on the profits tax implications for K Ltd arising from the change of holding strategy for the properties and the subsequent assignment of its income rights under the leases. (4 marks) Notes: 1. Where appropriate, the effect of the HK–China Double Tax Arrangement (the DTA) on the transactions should be mentioned, but you are not required to discuss the detailed provisions in the DTA. 2. You should ignore provisional tax and overseas tax throughout this question. 3. You are not required to discuss any accounting treatments, and their relevant standards or principles in relation to the transactions in this case. Professional marks will be awarded in question 1 for the appropriateness of the format and presentation of the report and the effectiveness with which its advice is communicated. (2 marks) 2. Kelvin King, a Canadian resident, has been offered a new job in a Hong Kong resident company (the Company) under a two-year contract from 1 April 2012 to 31 March 2014. The following draft total remuneration package has been offered for his consideration: Other major terms of the contract include: (1) Kelvin is not allowed to work for another company engaged in the same business or industry for 12 months after the cessation or expiration of his contract with the Company. (2) Subject to application by Kelvin and approval by the Company, a staff quarter can be provided by the Company at a rent equivalent to 5% of Kelvin’s monthly salary. Details of the choices of quarters are available in the Personnel Department upon request. (3) Kelvin is entitled to benefit from the Company’s medical insurance scheme, which allows him to receive outpatient services at no cost. The annual premium per employee paid by the Company under the scheme is $6,000. (4) Kelvin is entitled to annual leave of three weeks. (5) Kelvin is given an option to choose one of two share-based benefits under the Company’s Staff Incentive Scheme: (i) Share option benefit – Kelvin will be granted an option to purchase 30,000 shares in the Company at a favourable option price. The options are unconditional. (ii) Share award benefit – Kelvin will be granted 25,000 shares in the Company. Half of the share award has no vesting period, while the other half has a vesting period of 18 months during which Kelvin is required to remain in employment with the Company; and he is only entitled to these shares at the end of the vesting period. Kelvin does not own a property in Hong Kong, nor does he have any plan to buy one in the short term. It is likely that he will rent a furnished apartment near his workplace as he has been advised that the Company quarter is unfurnished and has no club facilities. Kelvin plans to return to Canada after the contract expires on 31 March 2014. He is thinking of choosing the share option benefit as he believes that if he exercises the share option after he returns to Canada, no Hong Kong tax will be payable. The Company will allow Kelvin to restructure his two-year remuneration package as long as the total remuneration package (other than the share-based benefits) at the end of the contract does not exceed $3,120,000. Required: As tax consultant to Kelvin King, write a letter to him giving advice on the following: (a) The Hong Kong salaries tax position of the draft package. Note: you are NOT required to calculate his assessable/chargeable income or tax payable. (20 marks) (b) How Kelvin should restructure his remuneration package so as to minimise the amount of salaries tax he will have to pay in Hong Kong. (6 marks) Professional marks will be awarded in question 2 for the appropriateness of the format and presentation of the letter and the effectiveness with which its advice is communicated. (2 marks) Section B – TWO questions ONLY to be attempted 3. (a) AB Ltd, a Hong Kong resident company, is organising a pop music concert to be staged in Hong Kong in January 2012. AB Ltd has appointed another Hong Kong resident company, CD Ltd, to procure performances by various overseas artists at the concert. CD Ltd has entered into an agreement with Mr X, the US resident manager of a US resident pop star, for the performance of that pop star at the concert for a fee of $3,000,000. AB Ltd will pay $3,300,000 to CD Ltd, which will then pay $3,000,000 to Mr X. The fee payable by Mr X to the US pop star is $2,700,000. Required: Explain the withholding obligations, if any, imposed under the Inland Revenue Ordinance on each of the parties concerned and compute, with explanations, the amount of tax to be withheld. (8 marks) (b) KK Ltd is carrying on a trading business in Hong Kong, preparing accounts to 31 March each year. On 1 February 2011, it entered into a lease agreement to lease a motor vehicle, which has since been used in KK Ltd’s business, from an unrelated leasing company. The lease agreement is for a term of 24 months, with a monthly lease payment of $45,000 commencing from 1 February 2011. The cash cost of the motor vehicle was $840,000. The agreement provides KK Ltd with an option to acquire the motor vehicle at the end of the lease period upon payment of a small residual amount; and it is expected that the residual value will be higher than the exercise price. Required: Explain the tax implications of the lease agreement to KK Ltd, clearly identifying the expenditures it is entitled to claim with respect to the motor vehicle for the year of assessment 2010/11. (9 marks) 4. MRS (HK) Ltd (MRS-HK) is a Hong Kong-incorporated company, which is resident and carrying on business in Hong Kong. During the mont