ta_u7_profits_13.pdf

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BUSI 0018 Hong Kong Taxation

Tutorial Questions

Unit 7 Profits Tax (1)

Answer 17

Whether or not Mr. and Mrs. Leung are subject to Hong Kong profits tax in respect of thegain arising from the sale of property depends on whether or not they are deemed ascarrying on a trade under Section 14 of the IRO.

The question of whether a person is carrying on a trade or not is a question of fact. It isalways necessary to consider all the relevant circumstances objectively and the personsintentions in carrying out the activities.

The Royal Commission on the Taxation of Profits and Income has identified the six badges of trade, which are factors normally used for determining whether a transaction ora series of transactions constitute a trade or an adventure in the nature of trade. The sixfactors are:

1. Subject matterThe nature or characteristic of the asset, which is the subject matter of the issue,may give indication as to the purpose of holding it by the owner. An asset whichdoes not give an owner an income or personal enjoyment is likely to be for trading

purpose. In this case, the property is the subject matter. Given the booming property market and speculative environment recently in Hong Kong, transactioninvolving property purchase and sale would be a sensitive subject for this purpose.

2. Length of period of ownershipIn general, a long period of holding between the acquisition of an asset and itsdisposal may show an intention that the holding is for investment purpose. A short

period of holding may reflect the intention to acquire the asset(s) for speculation ortrading purposes. In this case, the property in Wanchai was only held by thecouple for approximately 2 months (from Oct 09 to Dec 09). This short period ofownership tends to give a trading intention.

3. Frequency of similar transactionsA repetition of similar activities by the same person would indicate that the personis carrying on a trade in those activities. However, in some situations, a stand-alone activity may still be regarded as an adventure in the nature of trade. In this

case, it was known that the couple did enter into similar transactions in Year 2009.Unless proved otherwise, this again confirms the trading intention of the couplein these transactions.

4. Supplementary work doneIf special efforts were made to enhance the value of the property, or to increase itssaleable value, or to secure its saleability, it could be considered as evidence oftrading intention. There is no sufficient information given in the question. Perhapsthe couple could provide more information in this aspect for the analysis.


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5. Circumstances responsible for the sale

If it can be proved that the sale of the asset is for reasons other than profit making,there is better chance to argue that the asset was not held for trading purposes.This information was also not provided by the question. The couple should supplytheir reasons for the sale of properties, not only for Wanchai property but also for

the previous two. If they could have non-profit making reasons for the sale, thismay help their argument.

6. MotiveThere must be motive in carrying out a transaction and this motive is usuallydetermined objectively by surrounding circumstances and by reference to the otherfactors listed above collectively. The existence of a profit-making motive is a clearindication but not always conclusive. In this case, the couple is responsible for

providing their motive in entering into the transactions.

Apart from the six badges of trade, other factors include:

7. Method of financingThe financial capability of the person who claimed that the asset is held for longterm investment purpose is always relevant. A person who borrows short termfinance to acquire an asset and sells it within a short period is likely carrying on atrade in the asset. In this case, the question did not provide enough informationabout the financing of the couples property acquisitions. This information isuseful in ascertaining the couples intention of acquiring and subsequent selling ofthe properties.

8. Destination of proceeds of saleThe way the sale proceeds was put into use may indicate the purpose for sale andthus the intention of the person carrying on such a business. For example, whetherthe sale money was retained for use in a similar activity or for another form ofinvestment. Again, the couple should provide information in this aspect for theanalysis.

Based on the facts given and by applying the so-called badges of trade, Mr. and Mrs.Leung are very likely to be regarded as carrying on a trade in property transactions inHong Kong. The gains arising from the property sales, including the property in Wanchaiand the previous two, would be subject to profits tax at standard rate under Section 14(1).


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Answer 18

Part I

Whether each case is an adventure of trade depends on the facts. In discussion of eachcase, the characteristics of each case should be considered and each case should be

considered in the totality of facts.

(a) The first piece of painting was sold after two weeks. This short duration will makethe transaction more likely to be a trading activity ( Cape Brandy Syndicate v CIR ).But the commodity itself is an item whose value will be appreciated by the lapse oftime and hence it may be bought for the purpose of investment. This can also beapplied to the second piece of painting. The long duration of ownership and thenature of commodity give a stronger indication that this transaction is not trading.

(b) Mr. Poon had no intention to sell when he purchased the flat. It was only when hisgirl friend did not find it suitable that he sold the flat. Unless there is evidence tothe contrary, it is unlikely that this will be regarded as trading. The allegedintention has to be supported by objective evidence ( Taylor v Good ).

(c) Even though Mr. Wongs activities are illegal, Mr. Wong is operating the businesswith a view to making profit. In addition, operating a casino requires a scheme to

be established. Hence this is an adventure in the nature of trade ( Mann v Nash ).

(d) The frequency of similar transactions indicates what Mr. Wong had been doing isan adventure in the nature of trade ( Leach v Pogson ).

Part II

(a) The basic charge Section 14 requires that profit is taxable in Hong Kong only whenit is earned by a person carrying on business, trade or profession in Hong Kong,and the profit is arising in or derived from Hong Kong.

In this question, since the foreign film production company does not have anyrepresentative office or agent in Hong Kong, it is not carrying on business in HongKong either by itself or through a permanent establishment. Permanentestablishment was defined as a branch, management or other place of business oran agent who has and habitually exercises a general authority in Hong Kong tonegotiate and conclude contracts for his principal or has a stock of merchandise in

Hong Kong from which the agent regularly fills orders.

While s.14 does not apply to tax the foreign film production company, the summay still be deemed as Hong Kong business receipt under s.15. Under s.15(1)(a),sums received by or accrued to a person from the use in Hong Kong of televisionfilm are deemed as business receipt in Hong Kong and subject to Hong Kong

profits tax. In the circumstances, the foreign film production company will bedeemed as receiving Hong Kong sourced income arising from the assignment orlicensing of rights to show the film in Hong Kong. The basis of assessment for


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s.15(1)(a) purpose is laid down in s.21A. Generally, the assessable profit is 30%of the gross income received from the deemed transaction. However, theassessable profit will become 100% of the gross receipt if the following twoconditions are satisfied:1. the receipt was received from an associate of the person, and2. the intellectual property (i.e. the right in the film) has been owned by a person

carrying on business in Hong Kong.

In this case, assuming that the film production company is not an associate of theHong Kong television company, or that the right in the film has not been owned byany person carrying on business in Hong Kong, the film production company willonly be subject to profits tax based on 30% of the sums received.

(b) As analysed in (a) above, the foreign patent owning company will be subject toHong Kong profits tax under s.15(1)(b) in respect of the royalty it received fromthe Hong Kong associate for the use of the patent in Hong Kong. The basis ofassessment, however, is 100% of the gross amount received, with no deduction ofexpenses. It is because the foreign patent company received the sum from theassociate, and the right in the intellectual property has been owned by the HongKong associate before.

(c) The profits earned by a manufacturing company in Hong Kong will be subject totax under s.14(1) if the profits are regarded as sourced in Hong Kong. The test toapply in manufacturing activities is activities test which depends on the locationof the manufacturing activities, i.e. factory.

Based on DIPN21 (revised), where goods are manufactured in Hong Kong, the profits arising from the sale of such goods will be fully taxable given the profitmaking activity is considered to be the manufacturing operation (i.e. factory)carried out in Hong Kong. However, if it can be proved that a substantial part ofthe production is conducted in the PRC, and most importantly, the company wasgreatly involved in the PRC manufacturing activities (in particular in the supply ofraw materials, training and supervision of local labour), the IRD will usually assessthe profits on the sale of goods on 50% basis (DIPN 21 revised). This is normallyreferred to as a contract processing arrangement.

In this question, it is likely that the company will be subject to profits tax based on50% of the profits arising from the sale of products concerned. However, if themanufacturing activities in PRC were conducted via an import processing

arrangement with minimal involvement by the Hong Kong company (or the HongKong company is selling the raw materials to the PRC entity and then purchases back the finished goods), 100% of its profits will be taxed as the Hong Kongcompany will be treated as a trader rather than a manufacturer (see Datatronic case).

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